Original article by George Kaloudis , CoinDesk
Original translation: Felix, PANews
Key points:
Arbitrage opportunities exist in both traditional finance and crypto, but are more pronounced in the latter due to the longer visibility and settlement times for pending transactions.
Although MEV on Bitcoin is not as prominent as Ethereum, it is emerging through “sniping” Ordinal inscriptions, hollowing out blocks, and miner cartelization.
The emergence of MEV on Bitcoin could lead to market pressure to “privatize” the memory pool, which would undermine the founding principles of cryptocurrency.
One of the so-called “killer apps” of cryptocurrencies and blockchains is the ability to trade all kinds of assets without centralized financial intermediaries. Never mind that most of these assets do nothing, or purportedly do nothing. People are getting huge returns from trading them. Just like everyone got rich from SHIB in 2020, and then again in 2023 trading WIF and PEPE.
When early capital poured into these tokens, it was first purchased on DEXs through automated market makers (AMMs) before the tokens were listed on CEXs. AMMs are decentralized applications that match buyers and sellers of crypto tokens without going through regulated exchanges and without requiring KYC (like passport photos, drivers license photos, or multiple selfies). All you have to do is connect your crypto wallet, enter which asset you want to buy through the AMM, and click buy.
What’s interesting about these AMMs (besides the convenience and privacy of avoiding identity checks) is that while crypto influencers promote cryptocurrencies and blockchain as the “next iteration” of the stock market, in some ways the stock market is more real-time than AMMs.
Lets take a simple example: A wants to buy stock XYZ for $100, and B wants to sell stock XYZ for $99. Because financial markets are so interconnected today, C somehow knows this (there are legal and illegal ways to find and process this information) and buys XYZ stock from B for $99, and then immediately sells it to A for $100. Everyone is happy: A gets XYZ stock, B gets $99, and C gets $1 from the arbitrage trade.
Now, that profitable trade has been completed, and as the trade closed, arbitrageur C ate up the trade, and the market for stock XYZ was inefficient (a $1 difference between As bid and Bs ask). This all happened in real time, which means it was linear, C had to step in between A and B at the right time to execute the trade, and it had to happen in that order (from A to C to B).
This type of arbitrage can also be seen in AMMs, albeit in a slightly different form. Lets say you heard about SHIB a long time ago and wanted to buy some before it was listed on a CEX. Since its not on an exchange, you call up an Ethereum-based AMM and click a button to buy SHIB tokens. When you place your order, it gets thrown into a large pool of pending Ethereum transactions. Some of those transactions might be people buying things online with USDC, but many of them are trades for tokens like SHIB or WIF or PEPE.
These trades are visible to everyone before they are completed and executed because they are all in something called the mempool. If the AMM used for trading misprices SHIB due to market inefficiencies (like stock XYZ in the example), someone on the network can construct an Ethereum transaction to buy SHIB before you use another AMM and then sell it to you for a profit.
To take the example further, lets say you buy a significant amount of SHIB. In this case, everyone can see that a large buy and market-moving trade is waiting and can trade around your trade to take advantage of market inefficiencies and your order to move the market.
Trades like these can be classified as sandwich trades. Some have chosen the term “sandwich attack” because the AMM is unable to match buyers with intended sellers and can cause the original buyer to lose money before the trade is completed (imagine if you wanted to buy 1 billion SHIB tokens and you only got 800 million because the AMM was inefficient and the sandwich trade was not possible).
Sandwiches and other types of “inefficiency discovery” are more broadly known as Maximizing (or Miner) Extractable Value, or MEV for short. MEV means that the people validating transactions choose to order them in a way that is most beneficial to themselves, rather than the people who transacted with them. Since block times (the time it takes to validate a transaction) are not real-time (in Ethereum, transactions are validated every 12 seconds or so), there is plenty of time for arbitrage trading, especially by trading bots.
With this in mind, it is not difficult to imagine that MEV has expanded beyond AMM. A reasonable conclusion to the previous technical debate is that the more complex you want to do, the more likely MEV will appear.
MEV: Pros, Cons, and Existence on Bitcoin
There is a lot of discussion around MEV. Is it good or bad? Is it illegal?
It depends on who you ask.
On the positive side, MEV is a free market that calculates the real cost of things on the blockchain by eliminating inefficiencies that will be exploited until the inefficiency is close to zero. On the negative side, MEV may allow uninformed laymen and new users to be exploited by professionals and advanced users.
Only Ethereum has been mentioned so far because, despite MEV’s first-mover advantage, MEV has not historically existed for Bitcoin. While it exists in theory, it is not economically feasible in practice (except in very specific circumstances).
You might be thinking: “No MEV? If Ethereum-based AMMs have MEV, then surely Bitcoin-based AMMs must also have MEV, right?”
You are right, its just that there is no AMM based on Bitcoin yet. This is because Ethereum is more expressive than Bitcoin, which means you can do more with it, such as creating tokens with Doge or other memes, trading them on AMMs and getting rich.
And because Bitcoin is not very expressive, there is not a thriving market or AMM for new tokens on Bitcoin. How can AMM-related MEV opportunities emerge if there are no new non-Bitcoin assets on Bitcoin? Trading Bitcoin for other Bitcoin?
Yes. This is exactly where Bitcoin’s MEV begins to emerge.
MEV on Bitcoin
MEV is far less robust on Bitcoin than on Ethereum, and when experts discuss the topic, it is always with a note of caution.
“This is more like a game you can play than MEV,” said Colin Harper, head of research and content at bitcoin mining firm Luxor Technology.
Three years ago, Bitcoin went through an update called Taproot that made the network more expressive. Through the Ordinals protocol, it was accidentally possible to exchange Bitcoin for NFTs. This is what I meant by trading Bitcoin for other Bitcoins before: NFTs can work on Bitcoin because the Ordinals protocol is able to see which satoshis (the smallest unit of Bitcoin, one 100 millionth) are engraved with arbitrary data, which can be pictures, text, or something else. These collectibles are called inscriptions, which are different from NFTs (separate tokens). If you buy an inscription, instead of a brand new token like you would on Ethereum, you are just buying some Bitcoins that are special only from the perspective of the Ordinals protocol.
This is essentially buying Bitcoin with Bitcoin (of course, more for less). Just like buying SHIB with ETH or buying USDC with USDT, buying Bitcoin with Bitcoin is an activity that can be preempted.
Colin Harper explains: “When you sell an inscription on Magic Eden or other similar marketplaces, you use a PSBT (Partially Signed Bitcoin Transaction). The seller signs their half, and when the buyer buys, they complete the transaction with their signature, and the buyer pays the transaction fee. Therefore, if an NFT trader sees the transaction in the mempool, they can replace the original buyer’s payment and address (steal) by broadcasting their own transaction. To do this, they broadcast a RBF (Replace by Fee) transaction with a higher fee to ensure that their transaction is confirmed before the original transaction.”
While this is not quite the same as the pure MEV discussed in the first section of this article, it still looks like MEV: the intended buyers and sellers are mismatched because a third party steps in and offers the miner more compensation in exchange for the inscription, and the miner maximizes his own value in the transaction by accepting the third party deal.
Other things like MEV on Bitcoin
Bitcoin still has miners, and within the mining operation, there are things happening regularly that look like MEV.
A common example is the mining of empty blocks. Bitcoin will periodically mine an empty block. This block is of no use to anyone except the miner who mined the block, because no other transactions waiting to be confirmed have been verified except the coinbase (lowercase c, not the company) transaction that rewards the miner for the block. There are technical reasons why this happens, and the appearance of empty blocks is actually accidental, but it is difficult to say whether this is MEV and whether it is good for Bitcoin.
There is also the cartelization of miners (PANews Note: A cartel is a monopoly group that can easily occur when a few resources are completely controlled by several companies). Many Bitcoin miners now use mining pools to balance their income, mining collectively and getting a corresponding share. This can create a problem, especially as mining pools become larger and larger. As Walt Smith of the venture capital firm Cyber Fund wrote in a long article titled Bitcoins MEV:
“…pooled mining creates systemic risk by enabling smart multi-block MEV by increasing the odds of consecutive block wins. Mining pools and other mining cartels abuse pool economics to enforce common block templates, blacklisting small miners who perform non-standard block construction. Sustained excess fees coupled with economies of scale induce consolidation, creating a morbid cycle.”
Currently, a few mining pools control a significant portion of the network’s computing power, and even two or three of them can combine to control more than half of the computing power. If a mining pool cartel wins enough blocks in a row, it can exercise monopoly power to maximize profits.
Another real-world example of Bitcoin miner behavior might be MEV: out-of-band payments. Bitcoin miners are paid (either off-chain or through separate and seemingly unrelated Bitcoin transfers) for accepting transactions that are considered non-standard. Again, this is not pure MEV, as the value extracted does not appear on the blockchain as a result of savvy programmatic decisions. Instead, value is extracted by miners receiving more rewards than they would otherwise have received.
Some researchers worry that out-of-band payments are the first step down a slippery slope that could obscure incentives. But miners are seizing the opportunity. Marathon, a publicly traded mining giant, has launched a service called Slipstream that accepts nonstandard transactions.
The worry is that this kind of shady dealings could lead to mempool privatization, which is unsettling on any blockchain. As CoinDesk’s Sam Kessler wrote: “Most pressingly, there are concerns that mempool privatization could entrench new middlemen in a critical area of ethereum’s transaction plumbing.”
If most transactions were submitted to a private mempool for confirmation, a small number of people (a designated minority) would be able to influence Bitcoin transactions. This would centralize power in the blockchain, which is obviously an unacceptable situation for anyone who values censorship resistance.
There are other examples like MEV on Bitcoin that inevitably exist in some form or another, and network participants need to take note.
