The Bank for International Settlements has released an update on ‘miner extractable value’ by intermediaries for cryptocurrency and decentralised finance transactions. In the BIS Bulletin, the authors describe the problems this poses.
We have written separately about the International Organisation of Securities Commission’s (IOSCO‘s) report on DeFi, which set out IOSCO’s general concerns about risks associated with DeFi, including ‘miner extractable value’ (MEV) risks.
What is the issue?
According to the BIS Bulletin, MEV is defined as:
‘[t]he profit that miners can take from other investors by manipulating the choice and sequencing of transactions added to the blockchain’.
MEV risk arises in DeFi markets as transactions are verified by intermediaries who are largely unregulated and free to select the order of the transactions they verify. DeFi generally refers to finance-related activities that utilise distributable ledger technology (such as blockchain) in an effort to operate in a decentralised manner. Users transact in DeFi products such as cryptocurrencies by submitting transactions to the pool of pending transactions (also called the ‘mempool’) to be verified by intermediaries. A transaction is verified when a miner includes the transaction in a block that they add to the blockchain.
As a miner is free to select and order which transactions to include in a block, the miner may choose and order the transactions in a way that maximises profits for the miner’s own gain. Such value is referred to as MEV, and is obtained at the expense of other market participants.
What are examples of MEV strategies?
In the BIS Bulletin and its appendix, the authors describe a number of different MEV strategies. Each strategy is briefly summarised below.
If a miner observes a large pending transaction in the mempool that is likely to impact the market price of the cryptocurrencies the subject of the transaction, within the block, the miner may add their own buy or sell transaction just before the large pending transaction. The miner pockets a profit by selling high before the price drops due to the large transaction, or buying low before the price rises due to the large transaction.
This strategy is similar to front-running, however, the miner instead adds their own transaction directly after the large transaction. According to the authors, this may entail buying new tokens just after they are listed, eg in automated strategies from multiple addresses, to manipulate prices.
In the BIS Bulletin, the authors provide an example of an MEV strategy known as a ‘sandwich attack’. This occurs where a miner ‘sandwiches’ a user’s transaction in a crypto-asset between two of the miner’s own transactions to buy and sell within a block, thus taking advantage of a change in market price of the crypto-asset caused by that user’s transaction.
Decentralised exchange (‘DEX’) arbitrage
A DEX strategy exploits the difference between the price for the same crypto-asset in different DEXs, and is implemented by buying the crypto-asset at a lower price on one DEX, and then selling it at a higher price on another DEX.
A lending arrangement may be constructed on the blockchain using smart contracts (known as a ‘lending protocol’). The types of lending protocols exploited by miners for MEV are arrangements where a borrower posts crypto-assets as collateral to borrow assets from a lender. If the value of the collateral dips below a minimum threshold, then the loan may be ‘liquidated’, meaning that an actor (known as a ‘liquidator’) may repay the loan and collect a substantial liquidation fee or the collateral from the defaulting borrower. A miner exploits a liquidation strategy by looking for unhealthy lending protocols and acting as the liquidator.
A miner may extract MEV by cloning and front-running a victim’s trade (broadly speaking, by observing a trade, submitting a cloned version of that trade and verifying the cloned version, and pocketing profits from the trade).
According to the authors, a time-bandit attack occurs when a miner rewrites blockchain history in order to steal funds that have already been allocated by smart contracts in the past. The authors note that such attacks may be especially damaging to the ledger’s integrity as they effectively reverse transactions that have already been recorded on the ledger.
The authors also note that there are other emerging strategies.
According to the authors, an estimated US$550 to 650 million worth of MEV has been extracted on the Ethereum network since 2020. MEV limits the usefulness of DeFi application as it is at odds with the idea of decentralisation, and results in negative outcomes for users including additional fees and higher unpredictability. Furthermore, miners who do not engage in MEV may be crowded out of the market as it becomes relatively uneconomical for them to operate.
According to the BIS Bulletin, that there are open questions as to whether the current regulations around insider trading that traditionally apply to financial markets are directly transferable to MEV, and that regulators around the world need to establish whether value extraction by miners constitutes illegal activity. The authors also note that MEV and related issues may be tackled in ‘permissioned’ distributed ledger technology which relies on a network of trusted intermediaries whose identifies are public, and whom therefore may be held accountable.