Why is the merger a watershed moment for Ethereum from an MEV perspective?

MEV arbitrage will no longer be the privilege of a few, but will become part of the income of ETH stakers.

From an MEV perspective, why is the merger a watershed moment for Ethereum?

By David Hoffman, Co-Founder of Bankless

Compilation: The Way of DeFi

In a merged Ethereum world, Ethereum transactions will go through a very specific and orderly process. A strong transaction supply and demand chain is being built, and a huge power structure is about to emerge.

The current state of the Ethereum transaction supply and demand chain is blunt and naive. We all submit transactions to the mempool, arbitrage bots show up and compete for every penny of value, and then miners sort through all these transactions to build a block.

After the merger, on Ethereum this process is coded and defined into the protocol. This essentially allows ETH stakers to utilize value capture at every step, ensuring that value is delivered to them at the end of the supply chain.

I have said before: the best perspective for a comprehensive understanding of cryptocurrencies is through biology.

Crypto is an emerging organic system that mimics the laws of nature. Although humans are building some structures, the “best structure” that has been found is one that mimics nature.

After years of research and development, Ethereum developers have built a transaction supply and demand chain that looks a lot like a “Watershed.” Watersheds are areas of land that direct rainfall or snowmelt to creeks and rivers, and ultimately to outflow points such as reservoirs, lakes, or oceans.

These raindrops (transactions) are all over Ethereum. Some went to Uniswap, some went to Aave, some went to OpenSea, NFT mints, DEX aggregators, bridges, token transfers, etc.

But it doesn’t matter where the raindrop (transaction) falls on Ethereum. They will eventually converge in the same place and go through the same process to get there. Every raindrop is unique and falls in a unique place, but the laws of nature soon take over, the droplets converge into a trickle, the trickle converges into a creek, the creek becomes a river, and the river ends up at the end of the watershed. The deepest pool: ETH stakers.

I call this…the Ethereum watershed.

From an MEV perspective, why is the merger a watershed moment for Ethereum?

Glossary

For those in the early stages of their Crypto journey, this glossary can help you better understand the rest of this article.

Priority Fee: All transactions on Ethereum are charged a priority fee. From the user’s point of view, this is basically synonymous with gas fees. The higher the fee you pay, the faster your transaction will be included in the blockchain, as you increase the incentive for the transaction to be selected.

Mempool: A mempool is a smaller database that contains unconfirmed or pending transactions held by each node. When a transaction is confirmed by being included in a block, it is removed from the mempool. Memory pools are not a canonical thing. Each blockchain node has its own version of the mempool. Sometimes, transactions are broadcast only to specific entities, making the mempool inconsistent with other entities.

MEV: Maximum extractable value (MEV) is the maximum amount that can be extracted from block production by including, excluding, and changing the order of transactions in a block, in addition to standard block rewards and gas fees. value. Anyone with access to transact in the block can transact in their favor, ensuring their transaction captures all available arbitrage opportunities.

MEV Searcher: The MEV Searcher is an automated and highly optimized algorithm that scans blockchains and mempools for potential arbitrage opportunities and submits transactions that attempt to capture the opportunity when it is found.

Transaction Bundle: The MEV searcher generates a “transaction bundle,” a complex set of transactions that are bundled together. Each “transaction pack” is organized as one transaction, but it contains many transactions. Just like a normal transaction, it also comes with a priority fee or bribe attached to incentivize nodes to include it in a block.

Block Builder: The block builder is responsible for fetching all the transaction packages it can, and the transaction with the highest priority fee in the mempool, for building an eligible block.

Block proposer: You may know a block proposer by another name: ETH staker, or validator. A block proposer proposes a block to be included in the blockchain. This is part of the normal ETH staking process and the final step in the transaction supply chain.

From an MEV perspective, why is the merger a watershed moment for Ethereum?

MEV: How big is it?

Every transaction on Ethereum has some kind of value associated with it. If not, then the sender will not pay the gas fee. Someone is willing to pay some price to change the state of Ethereum. People pay to change the price on Uniswap, or increase or decrease the liquidation level on Aave, or participate in some kind of financial transaction that changes the price and value of Ethereum.

Every transaction on Ethereum creates an arbitrage trail. When someone buys ETH on Uniswap, they confuse its price with every other market and create a small opportunity for arbitrageurs to rebalance. All financial transactions leave plenty of small opportunities for arbitrage bots.

Arbitrage bots emerge when you disturb the balance of the Uniswap pool, consuming the arbitrage, and exporting a more balanced and healthy ecosystem. The higher the usage of Ethereum, the greater the total amount of arbitrage that exists. Arbitrage bots are similar to high-frequency traders in TradFi, with millions of algorithms looking for the tiniest difference, all racing to capture that tiny opportunity.

If defined in US dollars, the value of MEV is very large, reaching 672 million US dollars. As shown below:

From an MEV perspective, why is the merger a watershed moment for Ethereum?

From an MEV perspective, why is the merger a watershed moment for Ethereum?

From an MEV perspective, why is the merger a watershed moment for Ethereum?

And this is just the early stages of MEV. MEV value capture is a very lucrative area that is bound to grow rapidly by orders of magnitude. No one thinks it won’t, especially when MEV is widely regarded as not a “solvable problem”.

At best, it can be exploited. But at worst, it will turn your blockchain into an oligarchic hell.

But don’t be afraid! Ethereum developers are working on this. They developed a system that leverages MEV and makes it downstream, and then distributes it to the widest range of market participants: ETH stakers.

Ethereum transaction supply and demand chain

Step 0丨Transaction origin: “memory pool”

Before transactions are embedded on the Ethereum blockchain, they exist in this “unborn” state called a “Mempool”. As mentioned above, the mempool is basically all user transactions that are not yet included in the blockchain.

When you make a transaction on Metamask, you broadcast it to the Ethereum node network. These nodes download this data and keep it in computer memory.

The transaction with the highest priority fee is pulled from the sea of ​​transactions and added to a block for inclusion in the blockchain network. This article will describe how transactions are selected for inclusion in the remaining steps below, as there are more variables to consider than “which transaction paid the highest priority fee”.

A word of caution: the mempool is a huge ocean of transactions. Every transaction has a bid associated with its inclusion, and they all do something on Ethereum.

All transactions have two underlying sources of value associated with them:

Priority Fees: Users can choose to pay an explicit bribe to get included

MEV: Second-Order Effects of Arbitrage Opportunities on Ethereum State

How a transaction eventually becomes part of the Ethereum blockchain depends on the size of the priority fee and all associated MEVs for the transaction.

For example, a transaction can be created with a fee of $0, basically asking miners to include the transaction for free. Miners or validators usually ignore this transaction. But if the transaction is something like “Pay 1,000,000 DAI for 1 ETH” or “Sell Cryptopunk #1118 for 1 ETH”, the transaction will be immediately taken by the first MEV bot to spot it.

Simply put, all transactions are rewarded, either with an explicit priority fee or with an implied MEV value. The value of each transaction is captured by the next participant in the supply and demand chain: MEV Searchers.

Step 1丨MEV Finder: “Micro Arbitrager”

MEV Finder is a highly optimized arbitrage bot.

Each MEV search bot is optimized for a specific type of MEV, and its creators spend a lot of time and labor improving the bot in order to generate better arbitrage and make more profits.

For example, there will be some searchers that are highly optimized to arbitrage the imbalance of various AMMs (Automated Market Makers; aka “decentralized exchanges”) in DeFi. If ETH is $1998 on Uniswap and $2002 on Sushiswap, a MEV bot optimized for DEX arbitrage will create a trade, grab the spread and get some gwei.

The same competition is happening inside lending apps like Aave, Maker or Compound. A lot of value is paid to liquidation bots, all of which are racing to liquidate DeFi loans. Over time, we have seen these DeFi liquidation bots compete on tighter spreads, ensuring loans are liquidated at the best rates the market allows, maximizing the value of loan retention.

There are thousands of MEV search bots scouring the mempool, competing with other MEV search bots for a tiny amount of arbitrage.

As these MEV searchers get better and more energy efficient, they will be able to compete for smaller and smaller arbitrage, organically ensuring that DeFi is an efficient market.

bundle

These MEV search bots create “bundle” trades, as it is usually a group of trades that needs to fully capture the available arbitrage. The bots need to include all these transactions in their operations in a specific order, so they bundle them up in a neat little package and ship it to the next player in the game: the Block Builders.

Just like regular traders, each MEV search bot submits a “bid” for each trading package they create. This is the price bots are willing to pay block builders to include their bundles. Due to the fierce competition in this MEV arbitrage game, the profits are extremely thin.

As these MEV bots are in a fast bidding escalation game, fighting for block inclusion, MEV searchers pay block builders nearly the full value of the arbitrage they extract, meaning block builders capture The amount of value is naturally close to 99.99% of what MEV searchers can extract.

Step 2丨Block Builder: “Macro Arbitragers”

The role of “block building” is straightforward. Block builders build the most valuable blocks possible and then bid for block proposers (ETH stakers) to accept their blocks.

It sounds simple, but in order to be as profitable as possible, the builder must be highly competitive.

There are two vectors for block construction competition:

  • hardware and network
  • Order Flow

hardware and network

Block builders have to go through a computationally intensive transaction simulation process.

Builders cannot blindly include every deal bundle without considering its content. Many deal bundles submitted by a searcher will pursue the same arbitrage opportunity, and if a lazy builder includes a conflicting deal bundle, the second deal bundle will be rejected and the builder will forfeit its associated bid.

The bad thing is that block space is at a premium, and the builder has to super-optimize the transactions it contains in a block.

Therefore, block builders go through an intensive transaction simulation process in which they play each transaction to check for conflicts. They will run through all possible bundles of transactions to find the most profitable combination, then populate the remaining blocks with basic mempool transactions and bid on block proposers for inclusion.

All of this is done in 12 seconds.

order flow

Going back to what I mentioned above about Ethereum’s mempool…

Memory pools are not a canonical thing. The “canonical thing” and “the only source of truth” is the Ethereum blockchain. Until the transaction “enters the blockchain”, it is in an indeterminate state.

Each Ethereum node has its own version of the mempool. When you transact through Metamask (or any wallet), you are broadcasting your transaction to every Ethereum node willing to listen. After all, you just want the transaction to be included in the block…but don’t care who does it.

However, this is not the case for every actor. Broadcast transactions are literally “show your cards” and tell the world what you want to do. If “what are you doing” means “I have a bunch of alpha that the market doesn’t know about”, broadcasting that transaction to all nodes willing to listen will surely cost you every penny of the alpha you’re trying to get.

OK, so you’re seeing a bunch of alphas on Ethereum…but if you broadcast your transactions, you’re revealing those alphas to some MEV bots, and they’re definitely going to preempt it because that’s what they do.

So what should be done? Private order flow.

Instead of broadcasting this transaction to everyone, you have an off-chain agreement with mining pools that agree to process your transaction without broadcasting it to everyone else.

Flashbots, for example, have developed “Flashbots Protect” to democratize access to this power.

Lesson to be learned here: not all memory pools are created equal. Entities with a better vision of mempools and access to private transaction order streams will be able to take advantage of arbitrage opportunities in other parts of the market.

These are the vehicles of competition for block builders: whether through improved hardware and networks, or private off-chain protocols for order flow.

Bid block

Block builders make money by collecting bids from all transaction bundles from MEV searchers, as well as all priority fees from individual transactions. For example, this would turn into a block that would give them 2.2 ETH. They will then bid 1.9 ETH for the block proposed by the block proposer in an attempt to get a 0.3 ETH difference.

Just like MEV searchers, block builders will be highly competitive. A really good block builder can generate a block worth 3 ETH and bid 2.2 ETH for it. But another block builder could construct a block worth only 2.4 ETH and bid 2.3 ETH for it.

Naturally, a rational block proposer would accept a bid block of 2.3 ETH, while a builder who accepted a smaller spread would pocket the cash.

Profit margins fell very fast.

Step 3丨Block proposer: “ETH pledger”

The final step is to actually add the block to the blockchain.

ETH stakers running validator nodes simply choose the highest bid block associated with them.

They don’t even have to do any work, just pick the most profitable block header and sign a message that they approve the block with full trust and credit in the 32 ETH bond.

Takeaway: Equality through Mechanism Design

Ethereum developers have spent a lot of time and R&D to make ETH staking as easy and democratic as possible, so that ETH can be staked on basic consumer hardware and using as little ETH as possible (i.e. 32 ETH).

These are the values ​​of Ethereum: to make home verification and participation in consensus as democratic and accessible as possible. Regardless of your background, all you need is basic consumer hardware and some ETH to participate in staking Ethereum. Application-layer innovations like Rocket Pool and Lido help lower the 32 ETH threshold, and in the future, 32 ETH has the potential to drop to 16 or even 8 for solo stakers.

We have found that MEV is a big problem in Ethereum, and it has the potential to centralize the supply of ETH to a few privileged parties who can withdraw MEV better than anyone else. This reality threatens all efforts to keep Ethereum decentralized and democratized.

So, what did the developers do? They leverage the mechanism design to take advantage of MEV and put it in the hands of ETH holders.

As an ETH staker, do you know how to run a MEV search bot? Do you know how to construct optimal blocks? With the above process, you don’t need to do this. The entire supply and demand chain is governed by the most decentralized and accessible part of the stack: ETH holders.

The profit margins of MEV searcher bots have been squeezed as much as possible in the process of being included by block builders. The block builder’s profit is minimized in the competition for inclusion by block proposers.

Block proposers are ETH stakers. All potential centralization threats from the best MEV search bots are passed to block builders and then to ETH stakers.

And this is very good for ETH.

So, will it really end here with ETH stakers?

uncertain.

Matt Culter of Blocknative believes that this competition will actually return to the point of origin of transactions: wallets.

Since every transaction has an associated value, the wallet becomes a very active place for consumer interaction. The wallet becomes the source of proprietary transaction flow. And block builders can take advantage of transaction flow.

Therefore, block builders may pay wallet fees for their transaction flow. For example, a dedicated block builder could pay Metamask a lot of money to only route transactions to them instead of broadcasting it to the world.

This sounds terrible! Metamask users’ transactions will be spoofed like Citadel and Robinhood.

But I don’t think that will be the case. Instead, I think it will generate things like credit card points or airline miles…rather than actual monetary rewards like ETH or DAI.

Wallets will pay you to use them. Logically, all the profits extracted through this process may be attributed to the transaction originator (aka you), and your wallet service provider will give you a rebate.

This is the cycle of the Ethereum transaction watershed.

After the value of the transaction is pooled in a central pool: ETH stakers evaporate into the air, it evaporates into the air, condenses into clouds, rains again onto the mountains, back to the top of the funnel, and feeds the Ethereum ecosystem constant nutrients.

From an MEV perspective, why is the merger a watershed moment for Ethereum?

In response, a self-perpetuating ecosystem is built and a thousand dapps bloom.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/why-is-the-merger-a-watershed-moment-for-ethereum-from-an-mev-perspective/
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.

Like (0)
Donate Buy me a coffee Buy me a coffee
Previous 2022-08-12 11:01
Next 2022-08-12 11:03

Related articles