Understanding MEV2.0: How can users become MEV beneficiaries?

Since 2017, Maximum Extractable Value or “MEV” has undergone several major innovations. These advancements revolve around two actors, miners and MEV searchers. One of the biggest leaps in the MEV space is the creation of Flashbots, which aims to democratize MEV for these two players. However, in the existence of MEV today, one key player is still ignored: the user. While Ethereum’s proof-of-work (“PoW”) consensus mechanism is widely accepted today, proof-of-stake (“PoS”) opens the door to redefining MEV to potentially include users. Most of today’s MEV solutions focus on miners, MEV searchers, and even builders. We believe users can and should be included in this mix too.

This paper introduces the concept of MPSV (MEV Profit Sharing Validator), a novel concept that can make users the beneficiaries of MEV, which will eventually complete the full democratization of MEV. By full democratization, I mean that users may end up getting a portion of the MEV profits because they “choose” where to stake. Before we jump into MPSV, however, we first need to understand: (1) today’s advanced MEV participants, (2) the economic market structure of MEV, (3) the general proof-of-stake (PoS) system and the role of validators, and Finally (4) some game theory.

MEV participants

Maximum Extractable Value (MEV) remains one of the areas in the crypto market where participants can extract profits, be it bull or bear. MEV refers to extracting value from users by reordering, inserting, and reviewing transactions within a block.

MEV can be profitable in both bear and bull markets because the design space for trading strategies is vast and relatively untapped. Given the current market dynamics, players are incentivized to continue to devise new and innovative long-tail strategies to extract value. According to Flashbots, $20 million worth of MEVs have been withdrawn on Ethereum alone in the past 30 days. Even if the Terra ecosystem collapses and the entire crypto market goes into a downturn, we see one of the highest (if not the highest) gross profit for daily extraction MEV throughout 2022 to occur on May 12, 2022:

Understanding MEV2.0: How can users become MEV beneficiaries?

Source: explore.flashbots.net

* Gross Profit = Daily withdrawal value of successful MEV transactions without removing miner payouts

Today, there are two categories of winners in MEVs: miners and searchers. In this world, searchers are the main recipients of MEV rewards:

Understanding MEV2.0: How can users become MEV beneficiaries?

Source: explore.flashbots.net

Economic Market Structure and MEV

Before analyzing market dynamics, it is important to clearly define its structure. Let’s first look at the overall structure of the MEV market, followed by the sub-markets of MEV searchers and miners.

Understanding MEV2.0: How can users become MEV beneficiaries?

MEV market

The MEV market is unique in that there are two players, miners and MEV searchers, who work together to extract value. When assessed as a whole, the overall MEV market is more like an oligopolistic structure.

An oligopoly is a market or industry dominated by a few large sellers or producers, in which case block space is a commodity produced and monetized via MEV. Let’s see how oligopoly translates into today’s MEV market:

1. New entry barriers are high:

  • Miners: High upfront costs of equipment, technical expertise and capital requirements make market entry extremely difficult for individuals
  • MEV seekers: While this may not be capital-intensive, the high barrier to entry comes from the technical skills, specialization, and deep understanding of DeFi, ETH, and other blockchains required to run an MEV strategy.

2. Imperfect competition/pricing power:

Typically, MEV searchers and miners will work together to maximize total extractable value, even if it costs users. Additionally, miners have an advantage because they can choose to accept whichever MEV searcher offers the highest reward — thus making these miners price setters.

3. Business interdependence:

Because of their large size and minimal competition, how miners build MEVs influences the actions of other miners.

Furthermore, MEV searchers and miners are interdependent, as searchers are the ones who look for MEV opportunities and submit them to miners to decide whether to reorder, insert, and/or review in-block transactions.

4. Non-price competition:

In general, miners do not compete for profit distribution between MEV searchers and miners, but on other factors: specialized equipment, hosting, service levels, and branding.

5. Possibility of collusion:

Given the centralization of miners, they can actually work together in this space as well. There may be an agreement among miners that they will only accept to share 95% of MEV profits with searchers. However, Flashbots solve this problem in the current MEV market.

Likewise, if MEV searchers join forces, they may demand a higher profit split between miners and MEV searchers.

MEV Searcher Marketplace

Now that we have defined the entire MEV market, we can also look at its submarkets. Now let’s take a look at the MEV searcher market.

MEV searchers are like the “plumbers” of the blockchain. They dig into the transactions within the block to find the MEV. It is a group of artisans and professional anonymity who have valuable technical knowledge on how to extract value. This dynamic is characteristic of monopolistic competition.

Monopolistic competition (not to be confused with monopoly) is imperfect competition where there are many producers competing with each other but selling services that are different from each other and not perfect substitutes.

Let’s see how monopolistic competition characteristics align with the MEV searcher market:

1. Slightly different services:

MEV searchers are all trying to find extractable value on-chain, although MEV’s approach varies from searcher to searcher. For example, searchers can focus on arbitrage, liquidation, sandwich strategies, or specialized long-tail strategies.

2. Many Searchers:

Self-explanatory

3. Maximize profits:

MEV seekers seek to maximize profits and therefore extract as much MEV from blocks as possible. Similar to pure gaming monopoly, each searcher will try to find as many MEVs as possible without penalty from the user (usually).

4. Incomplete information:

MEV searchers have an informational advantage over users, who often unknowingly give up value to searchers.

5. Results:

Searchers know that their actions will not affect the actions of other searchers.

MEV mining market

One of the core reasons why the MEV market resembles an oligopoly is that the miner market is oligopolistic. Given that MEV searchers cooperate with miners – the two markets combined are more like oligopoly and monopolistic competition. In this section, instead of revisiting the characteristics of oligopoly, we can calculate the Herfindahl-Hirschman Index (HHI) to understand the degree of centralization of the miner market.

The HHI index is a measure of the size of a company in relation to its industry and the level of competition between them. The calculation is as follows:

Understanding MEV2.0: How can users become MEV beneficiaries?

In this equation, MSi is the market share of firm i and N is the total number of firms. We add numbers to understand the concentration of the industry. We square the MSi because squaring all weights provides greater weights to players with greater market share.

Understanding MEV2.0: How can users become MEV beneficiaries?

We can use MiningPoolStats to get an idea of ​​each miner’s hash rate, which is ultimately a benchmark for their market share (about 81 miners listed). We use the following steps:

  1. Convert each miner’s computing power to TH/s
  2. Total computing power TH/s
  3. Divide the hashrate of each miner by the total hashrate
  4. Square each value in #3
  5. Summary #4 Totals

If we calculate the HHI of these miners, we get an HHI of about 545 or 0.545, which means that the miner market is highly centralized and belongs to an oligopolistic market structure.

Optimal Perfectly Competitive MEV Market

Perfect competition is an ideal market structure where all producers and consumers have sufficient and symmetrical information and there are no transaction costs.

A perfectly competitive market is characterized by:

  1. Lots of buyers and sellers
  2. product homogenization
  3. Free entry and exit of enterprises
  4. Perfect market knowledge
  5. Seller earns normal profit (as opposed to extraordinary profit)

In this market, we reach the point where the quantity supplied equals the quantity demanded, thus having Pareto Efficiency. Pareto efficiency is a situation in which no individual or preference criterion can be made better without making at least one individual or preference criterion worse.

One of the greatest innovations in the MEV space was the creation of Flashbots to democratize MEVs.

“Mitigating the negative externalities of the current maximum extractable value (MEV from now) extraction technology and avoiding the existential risks that MEV may pose to state-rich blockchains like Ethereum.”

3 goals of Flashbots:

  1. Democratize access to MEV revenue
  2. Bringing Transparency to MEV Activities
  3. Redistribute MEV revenue

Flashbots help level the playing field for MEV searchers by helping to prevent collusion and democratize MEV. While Flashbots democratized MEV opportunities for searchers, users were still left out. One could argue that anyone can participate in MEVs, including users, however, we know this is unrealistic as most DeFi users do not have access to MEVs.

So, while MEV searchers and miners get better from Flashbot’s MEV system in a proof-of-work system, users either get nothing or become targets of extractable value. The MEV dynamics of today’s searchers and miners are not sufficient to fully democratize MEV and bring it to a perfectly competitive market. However, proof-of-stake could change that and eventually bring us to a theoretically perfectly competitive market.

The New Paradigm: Entering Proof of Stake

As we all know, Ethereum is moving towards a proof-of-stake (PoS) system. In PoS, instead of miners competing with each other to verify and confirm transactions, “validators” are randomly selected to validate transactions according to the leader’s schedule.

Proof of Stake (PoS) is a cryptocurrency consensus mechanism that requires you to stake or set aside coins to be randomly selected as a validator.

What fundamentally breaks the oligopolistic competition in proof-of-stake is that users are able to decide which validators to stake their assets with, which can influence leader selection or stake weighting (more on that below).

We might be able to learn some lessons from Solana on how users can potentially participate in MEV earnings and benefit from “extractable value”. The game-changer for users in Proof of Stake is where they decide to stake their tokens, opening the door to MEV innovation. The greater the stake weight of the validator – the higher the chance of being elected as the leader.

Before starting to understand how it helps to understand some basic information about validators on Solana.

Solana consensus and validators

Solana uses Proof of History, its own novel Proof of Stake consensus mechanism. Solana’s network infrastructure consists of validators and RPC nodes. Validators are the backbone of the Solana network and are responsible for processing transactions and participating in consensus. Validators are the “consensus nodes” of the network, meaning they validate transactions, vote on blocks, and drive the Solana network’s consensus mechanism. Running a validator (or RPC node) requires a dedicated bare metal server with high-end specs.

From Solana’s documentation on the leader scheduling generation algorithm (note #3):

Leader Plan Generation Algorithm

Leader plans are generated using predefined seeds. The process is as follows:

  1. Periodically seed a stable pseudorandom algorithm with PoH tick heights (monotonically increasing counters).
  2. At that height, sample banks for all staking accounts that have leader status and vote within the cluster’s configured ticks. This sample is called the active set.
  3. Sort activity sets by stake weight.
  4. Stake-weighted nodes are selected using a random seed to create a stake-weighted ordering.
  5. This ordering takes effect after the number of ticks configured by the cluster.

Understanding MEV2.0: How can users become MEV beneficiaries?

Today, validator rewards fall into 3 categories:

  1. Protocol-Based Rewards: Issued by a global protocol-defined inflation rate – Rewards are provided on top of earned transaction fees.
  2. Staking: Stakers are rewarded for helping to validate the ledger. Users can benefit from staking because they can delegate their staking to validators. Validators are responsible for replaying the ledger and sending votes to each node’s voting account, to which stakers can delegate their stake. When a fork occurs, the rest of the cluster uses these stake-weighted votes to choose a block.
  3. Staking Pools – These are liquid staking solutions that help promote censorship resistance and decentralization, such as Marinade Finance and Lido.

The staking yield today is based on the current inflation rate, the total amount of SOL staked, and the uptime and commissions of individual validators. The validator’s commission is the percentage fee paid to validators by network inflation. Validator uptime is determined by validator votes.

In other words, the rewards of staking come from Solana’s inflation plan. Validators offer staking rewards to users, but validators may also charge users fees/commissions. What if we could raise the reward above standard inflation in a way that benefits everyone?

Users can stake with their favorite validators and switch to other validators if they wish, which takes 2-4 days on Solana. Additionally, with solutions like Marinade’s liquid mSOL, users can instantly unblock mSOL tokens for SOL in real-time. This creates an interesting competitive dynamic among validators. Users will choose the validator that offers them the highest reward and the validator that charges the lowest fees/commissions.

Other things being equal, users will choose the validator with the highest rate of return and the lowest fee.

This is where things get really interesting! The more SOL a validator can pool and stake, the higher the stake weight a Validator can get. The greater the stake weight of the Validator, the greater the chance of becoming a Leader. Think of it as a lottery system, the more stake a validator has, the better the chance of being elected as a leader.

Today’s MEV on Solana

Today, most of the MEVs extracted on Solana go to MEV searchers. Most of the MEV on Solana comes from bots spamming the Solana blockchain, constantly trying to find arbitrage opportunities or preempt NFTs. Since transaction costs on Solana are so cheap, running bots is an easy strategy to capture MEV opportunities.

Future MEVs on Solana

Now, one way to break the cycle of these spam bots is to set up a sealed bid-state auction, so that contested resources cost more to get locked than other resources. On Solana, Jito Labs is building a sealed silent bid auction to enable searchers to bid on block space. The benefits of this include being able to have MEV transactions run off-chain in some kind of public memory pool (Solana doesn’t currently have one). Transactions sent via Jito will be prioritized and the reward split with the validator, similar to Flashbots. The benefits of doing this include:

  1. Kill spam bots – they can no longer find meaningful MEVs because they are not a priority deal
  2. better user experience
  3. Help unblock the Solana network and make it run more efficiently

So how can we fully democratize MEV and bring it to a perfectly competitive market?

User choice!

Enter MPSV, the future of the efficient MEV market

Some interesting game theory emerges when MEV seekers are able to collaborate with validators to extract MEVs. An optimal outcome is that users end up passively earning a portion of the MEV reward, but how?

MPSV = MEV Profit Sharing Validator

Understanding MEV2.0: How can users become MEV beneficiaries?

Let’s first explore two game theory exercises. Game 1 is trivial, but let’s look at it. Should validators and MEV searchers share rewards? For simplicity, let’s assume: there is only one MEV searcher and one validator.

Understanding MEV2.0: How can users become MEV beneficiaries?

  • As I mentioned, this case is trivial because neither party will agree to work together if neither party wants to share any kind of reward and wants to keep 100% of the MEV withdrawn. The best solution in the diagram above is to distribute profits between MEV searchers and validators. Although 50% is a bit arbitrary, it’s in everyone’s best interest to work together. It doesn’t matter if it’s 60/40, 90/10, etc. — they have to work together.
  • It is clear that there is an interdependence between MEV searchers and validators in the MEV marketplace. It cannot exist without the other.
  • In the long run, we may see validators bring MEV searchers into the world or start running MEV strategies themselves – leaving only exotic forms of MEV available to searchers.

The next case is a bit more interesting. We have established above that there will be some profit sharing between validators and MEV searchers. Now we ask, should validators themselves decide to share any MEV profits with users who stake on their platform?

Let’s assume the following:

  • The interdependence of MEV searchers and validators has been established according to Game 1.
  • There are now two validators: Validator A and Validator B
  • Both start with the same amount of stake weight (i.e. the same amount of staked assets)
  • Users are economically rational, i.e. users will choose to stake with the validator who provides the highest reward
  • Validator A and Validator B each decide how much MEV profit they want to share with their respective users
  • If a validator loses its users, it can no longer be a leader (assuming all its tokens have been transferred to another validator)
  • If a validator loses its users, it no longer receives any MEV transactions from the searcher, but instead forwards the MEV transactions to another validator
  • Assuming that the generated MEV is uniform and constant, that is, each validator has an MEV of $100, the numbers outside the box represent how much profit each validator decides to keep.
  • We are assuming a long-term situation, not a short-term situation.

Understanding MEV2.0: How can users become MEV beneficiaries?

Now let’s look at each scene in each box.

1. A = B。

Validator A sets its MEV profit to $100 (User A profit = $0).

Validator B sets its MEV profit to $100 (User B profit = $0).

Total User Profit = $0.

Both validators take home $100 each, while the user gets nothing.

2. A < B。

Validator A sets its MEV profit to $60 (user profit = $40).

Validator B sets its profit to $100 (user profit = $0).

Users earn $40 per MEV transaction ($80 total).

In the long run, Validator B’s users leave and Validator B ends up with $0 in profit.

At the same time, Validator A gets an additional MEV transaction and earns an additional $60 ($60 + $60 = $120). The logic is as follows:

  • long run
  • Again, the user is rational because Validator A offers a higher staking return – the user transfers funds to Validator A and abandons Validator B over time.
  • Because users transfer all their staked assets to Validator A, Validator B no longer has the opportunity to become a Leader and no longer receive MEV transactions from Seekers.
  • * MEV generated by Validator B should flow into Validator A – providing the same level of profit, ie $60 + $60 = $120.
  • This eventually pushes Validator B’s MEV profit to $0.

3. A > B。

The logic in #2 above applies.

4. A = B。

Validator A sets its MEV profit to $60 (User A profit = $40)

Validator B sets its profit to $60 (User B profit = $40)

Users earn $40 per MEV transaction ($80 total).

In this case, the user from A stays in place, and the user from B stays in place. No validators are abandoned.

MPSV Nash Equilibrium

A Nash Equilibrium is a decision theorem in game theory that states that players can achieve desired outcomes by not deviating from their initial strategies. In a Nash equilibrium, each player’s strategy is optimal when considering the decisions of the other players.

From the graph above we can see that if both Validator A and Validator B set their profits equal to each other, they would both be better than setting their profits at a higher level (i.e. Box 1 instead of Box 4). But the question remains, is Box 1 the outcome we can expect? To fix this, let’s first find the responses of Validator A and Validator B:

Understanding MEV2.0: How can users become MEV beneficiaries?

Similar to above, let’s step through each response starting with validator A:

A. For Validator A, if Validator B sets her profit at $100, then Validator A has two profit options (Box 1 vs Box 2):

  • $100 if validator A sets profit to $100
  • If validator A sets a profit of $60, it will be $120

Given that Validator A is economically sound – it sets the profit at $60, this will yield a total profit of $120.

B. For Validator A, if Validator B sets her profit at $60, then Validator A has two profit options (boxes 3 and 4):

  • $0 if validator A sets profit at $100
  • $60 if validator A sets profit to $60

Given that Validator A is economically sound – it sets the profit at $60, this will yield a total profit of $60.

Note that in both cases above, setting the profit to $60 instead of $100 is Validator A’s dominant strategy. Validator A setting the profit to $100 is never the best response.

Validator B:

C. Box 1 and Box 3:

Given that Validator B is economically sound – it sets the profit at $60, this will yield a total profit of $120.

D. Boxes 2 and 4:

Given that Validator B is economically sound – it sets the profit at $60, this will yield a total profit of $60.

Nash Equilibrium: For Validator A and Validator B, there is only one potential outcome where both validators respond optimally, and that is if both validators set the profit to $60 (yellow box in the image above ). This will be the only Nash Equilibrium, and they will each receive a total profit of $60.

Therefore, we have shown above that if users are able to transfer their staked assets between validators fluidly, a Nash equilibrium occurs when validators provide the most attractive profit sharing distribution in the user’s favor, something like How a perfectly competitive market works:

This is what generates MPSV = MEV profit sharing validators.

MPSV flywheel

Understanding MEV2.0: How can users become MEV beneficiaries?

Proof of Stake (PoS) enables users to decide where they want to stake their assets. Other things being equal, having more staking weight allows you as a validator to become a leader in the PoS model. For a rational economic player, deciding where to wager depends on where you can earn the highest APY with the lowest fees/commissions.

Using MEV’s earnings, MPSV with lower staking weights may be able to return a portion of MEV’s profits to users to raise the rate of return above the standard inflation rate. Also, if smaller MPSVs pool their MEV profits together – it gives users more room for staking earnings. Over time, new users will switch to the MPSV model (i.e. provide MEV profits to users), so that validator will be able to earn additional stakes from other validators. This in turn results in MPSV being selected as Leader more frequently.

in conclusion

Summing it all up, we can see that there is a proof-of-stake MEV scenario where everyone is actually better off, including users. In a proof-of-work system – miners act independently of users when confirming blocks. In a proof-of-stake system, there is a dependency between validators and users.

That’s what I mean by “fully democratizing MEV.” We have shown above that the Nash Equilibrium of MPSV occurs when different validators share the most attractive profits with users. In the long run, just one validator can provide users with a better share of MEV profits, driving the validator market.

We believe MPSV can do the following:

  1. Create new shifts in MEVs where users can passively benefit from MEVs
  2. For smaller MPSVs, if they can share more profit with users than the top 10 or the largest validators, this can be used as a way to compete with larger validators – and even with other small MPSVs Unite and share MEV profits.
  3. In a highly competitive scenario where all validators transfer 100% of the MEV profit share to users, users ultimately benefit as a whole. [Note: Validators can still earn revenue from transactions and priority fees].
  4. In this world, everyone is better off, including MEV searchers, validators, and users in this model.

What breaks the oligopoly of the MEV market is user choice!

Maybe, just maybe, we’ll transform the MEV market into a perfectly competitive market structure.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/understanding-mev2-0-how-can-users-become-mev-beneficiaries/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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