This article provides an overview of Maximal Extractable Value (MEV), explaining its impact on Ethereum’s network infrastructure and outlining strategies that Ethereum investors can use to protect their investments from potential losses resulting from MEV-related trade execution issues.
Introduction to MEV
Maximal Extractable Value (MEV) refers to the value that can be extracted from blockchain transactions by changing the order in which transactions are processed or by inserting new ones. It is a key concept in Ethereum and other blockchain ecosystems, influencing how blocks are created and transactions are executed. For investors, MEV can create hidden costs, affecting trade execution quality, leading to slippage and suboptimal outcomes, often without the investor’s awareness.
MEV has become particularly relevant since Ethereum’s shift to Proof of Stake (PoS) after the Merge in September 2022. Since then, it has been identified that 64% of MEV profits go to transaction searchers (who identify profitable opportunities), while 36% goes to Ethereum validators (who propose blocks).
While MEV extraction can be beneficial for validators and searchers, it has increasingly raised concerns for DeFi investors, especially during volatile market conditions.
MEV in DeFi and Its Effects
For those using DeFi applications, MEV can act like an invisible fee that doesn’t appear in the gas price but still impacts trade outcomes. This fee is the result of transaction manipulation, where searchers and validators reorder transactions within a block to capture value. This can be especially problematic during high-volatility events, such as large market swings or when significant liquidity events occur.
In fact, during extreme market conditions — like the FTX collapse in November 2022 or the USDC depeg in March 2023 — MEV accounted for over 60% of validator revenues. These periods, characterized by rapid liquidations or high trade volumes, highlight how vulnerable DeFi investors can be to MEV-induced losses.
Understanding MEV and Its Types
MEV occurs because blockchain networks, including Ethereum, do not have a reliable mechanism to track the exact order of transactions. Validators and miners have the ability to select transactions from the mempool (a list of unconfirmed transactions) and arrange them within a block in a way that benefits them the most.
While the concept of MEV is more visible in blockchain ecosystems than in traditional finance, many of the MEV types are familiar from traditional markets. The key MEV types include:
1. Arbitrage
Arbitrage occurs when there is a price discrepancy for the same asset across different platforms. In the DeFi space, this is common across decentralized exchanges (DEXs). A validator might exploit this price difference by buying an asset on one DEX and selling it for a higher price on another. For example, if Wrapped Ether (wETH) is priced at $1630 on Uniswap but only $1598 on SushiSwap, an MEV bot can insert a transaction to purchase wETH on SushiSwap and immediately sell it on Uniswap, pocketing the price difference.
Arbitrage accounts for 50% of all MEV activity and is generally seen as non-harmful unless it’s manipulated by other factors like sandwich trades.
2. Liquidations
Liquidation MEV arises in DeFi lending protocols when a borrower’s collateral becomes insufficient to cover their loan. If the collateral value drops below the required threshold, the loan triggers a liquidation event, where the collateral is sold to cover the debt. Validators have the unique position to insert liquidation transactions into a block and capture the associated liquidation fees.
Liquidations make up 25% of all MEV activities. While liquidations are necessary for the proper functioning of lending protocols, they can still be problematic if they result from manipulated prices or if certain users are strategically front-running liquidations.
3. Sandwich Trades
Sandwich trading is the most harmful form of MEV for regular users. In this scenario, a bot detects a large order that will likely impact the price of an asset and places two transactions: one before the large trade (to front-run it) and one after (to profit from the price impact). This manipulation forces the original trader to receive a worse execution price.
For instance, if a trader buys 500,000 wETH with a price impact of 2%, the bot might buy some wETH before the large order and sell it immediately afterward, making a risk-free profit. The victim trader is left with a worse price.
Sandwich trades are particularly damaging during periods of high volatility, such as the USDC depeg incident, where a trader experienced significant slippage due to these tactics.
MEV’s Impact on Ethereum’s Infrastructure
The rise of MEV has influenced Ethereum’s infrastructure in significant ways. Validators and block proposers, who control the order in which transactions are processed, can extract significant value by strategically including certain transactions. This has led to concerns about centralization in the Ethereum network, as corporate entities with more resources could gain an advantage in capturing MEV profits, further concentrating control over Ethereum’s consensus and transaction processing.
To address this concern, Flashbots, an independent research organization, has developed a solution that aims to democratize the MEV process. Flashbots have created MEV-relays that allow transaction searchers to bypass Ethereum’s main mempool and submit their transactions privately to validators. This system helps distribute MEV revenue more equitably and reduces the risk of monopolization.
Currently, 90% of Ethereum validators use MEV-boost relays, and Flashbots has successfully created a more transparent and fair marketplace for MEV extraction. The project has also contributed to ensuring that 11 MEV-relays are available, helping to mitigate the centralization risks associated with MEV.
How Investors Can Protect Themselves from MEV Losses
For DeFi investors, mitigating the impact of MEV is crucial, particularly during periods of high volatility. Here are some strategies to reduce the risk of MEV-induced losses:
- Use RPC Endpoints with MEV Protection
Some service providers offer RPC endpoints that guarantee your transactions won’t be front-run or sandwiched. By connecting to these relays, you can minimize your exposure to MEV bots. - Limit Slippage Tolerances
Setting stricter slippage limits can help protect your trades from excessive price impacts, particularly during periods of high volatility. - Use MEV-Boost Services
You can also use services like MEV-boost that route your transactions through relays that specifically protect against MEV manipulation, ensuring your transactions are processed in a way that minimizes front-running and other exploitative activities. - Avoid Large Trades During Market Volatility
Large transactions are more susceptible to sandwich attacks and slippage. If possible, try to execute large trades during periods of lower market volatility or break up large trades into smaller ones.
Conclusion
MEV has become an integral part of Ethereum’s ecosystem, offering significant revenue opportunities for validators and searchers. However, it also poses risks to DeFi investors, especially during volatile market events when MEV extraction becomes more aggressive. By understanding how MEV works and using tools to protect against it, investors can minimize the impact of MEV and improve the overall execution of their trades.
As always, while the Ethereum network continues to evolve, it is essential for investors to stay informed and adopt strategies that can mitigate MEV-related risks.