MEV
Maximal extractable value (MEV) refers to the maximum value that can be extracted from block production in excess of the standard block reward and gas fees by including, excluding, and changing the order of transactions in a block.
MEV Extraction
In theory MEV accrues entirely to miners/validators because they are the only party that can guarantee the execution of a profitable MEV opportunity. In practice, however, a large portion of MEV is extracted by independent network participants referred to as "searchers." Searchers run complex algorithms on blockchain data to detect profitable MEV opportunities and have bots to automatically submit those profitable transactions to the network.
Miners/validators will get a portion of the full MEV amount because searchers are willing to pay high gas fees (which go to the miner/validator) in exchange for higher likelihood of inclusion of their profitable transactions in a block. Assuming searchers are economically rational, the gas fee that a searcher is willing to pay will be an amount up to 100% of the searcher's MEV (because if the gas fee was higher, the searcher would lose money).
With that, for some highly competitive MEV opportunities, such as DEX arbitrage, searchers may have to pay 90% or even more of their total MEV revenue in gas fees to the miner/validator because so many people want to run the same profitable arbitrage trade. This is because the only way to guarantee that their arbitrage transaction runs is if they submit the transaction with the highest gas price.
Frontrunning
Rather than programming complex algorithms to detect profitable MEV opportunities, some searchers run generalized frontrunners. Generalized frontrunners are bots that watch the mempool to detect profitable transactions. The frontrunner will copy the potentially profitable transaction's code, replace addresses with the frontrunner's address, and run the transaction locally to double-check that the modified transaction results in a profit to the frontrunner's address. If the transaction is indeed profitable, the frontrunner will submit the modified transaction with the replaced address and a higher gas price, "frontrunning" the original transaction and getting the original searcher's MEV.
Flashbots
Flashbots is an independent project which extends the go-ethereum client with a service that allows searchers to submit MEV transactions to miners without revealing them to the public mempool. This prevents transactions from being frontrun by generalized frontrunners.
As of this writing, a significant portion of MEV transactions is routed through Flashbots, meaning generalized frontrunners aren't as effective as they used to be.
Types of MEV
DEX Arbitrage
If two DEXes are offering a token at two different prices, someone can buy the token on the lower-priced DEX and sell it on the higher-priced DEX in a single, atomic transaction. Thanks to the mechanics of the blockchain, this is true, riskless arbitrage.
Liquidations
Lending protocols require users to deposit some collateral (e.g. ETH). This deposited collateral is then used to then lend out to other users.
Users can then borrow assets and tokens from others depending on what they need, up to a certain percentage of their deposited collateral. For example, if the borrowing amount is a maximum of 30%, a user who deposits 100 DAI into the protocol can borrow up to 30 DAI worth of another asset. The protocol determines the exact borrowing power percentage.
As the value of a borrower's collateral fluctuates, so too does their borrowing power. If, due to market fluctuations, the value of borrowed assets exceeds say, 30% of the value of their collateral (again, the exact percentage is determined by the protocol), the protocol typically allows anyone to liquidate the collateral, instantly paying off the lenders. If liquidated, the borrower usually has to pay a hefty liquidation fee, some of which goes to the liquidator — which is where the MEV opportunity comes in.
Searchers compete to parse blockchain data as fast as possible to determine which borrowers can be liquidated and be the first to submit a liquidation transaction and collect the liquidation fee for themselves.
Sandwich Attacks
To sandwich, a searcher will watch the mempool for large DEX trades. For instance, suppose someone wants to buy 10,000 UNI with DAI on Uniswap. A trade of this magnitude will have a meaningful effect on the UNI/DAI pair, potentially significantly raising the price of UNI relative to DAI.
A searcher can calculate the approximate price effect of this large trade on the UNI/DAI pair and execute an optimal buy order immediately before the large trade, buying UNI cheaply, then execute a sell order immediately after the large trade, selling it for the higher price caused by the large order.
Sandwiching, however, is riskier as it isn't atomic (unlike DEX arbitrage, as described above) and is prone to a salmonella attack.
References:
https://mirror.xyz/smolthots.eth/gaf-6VD43x84RVZhSA5aQwKDYs8lhSEI1CcQ2S_I89M
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