In a merged world, Ethereum transactions will flow through a very specific and orderly process. A robust transactional supply chain is being built before our eyes, and massive power structures are on the horizon.
The current state of the Ethereum transaction supply chain is sluggish and immature. We all submit our transactions to the mempool, arbitrage bots come and compete for pennies’ worth, and then miners sort through all these transactions to build a block.
In a merged Ethereum, this process is codified and defined. This essentially allows ETH subscribers to harness value capture at every step, ensuring that value is delivered to them at the end of the supply chain.
I’ve said it many times before, but I still haven’t said enough. The best way to gain a comprehensive understanding of cryptocurrencies is through biology.
Crypto is an emerging organic system that mimics the laws of nature. Even though humans are building these structures, the “best structures” that have been found are those that mimic nature.
After years of research and development, Ethereum developers have built a transaction supply chain that looks a lot like a watershed. A watershed is an area of ​​land that conducts rainfall or snowmelt into creeks, creeks, and rivers, and ultimately into outflow points such as reservoirs, lakes, or oceans.
Transactions (raindrops) are falling all over Ethereum. Some went to Uniswap , some went to Aave, some went to OpenSea, NFT mining farms, DEX aggregators, bridges, token transfers, etc.
However, it doesn’t matter where the raindrop (transaction) falls on Ethereum; it always converges in the same place and gets there through the same process.
Each raindrop is its own, unique raindrop, falling in a unique location, but soon the laws of nature take over. The droplets converge into a trickle, the trickle becomes a stream, the stream becomes a river, and the river eventually converges in the deepest part of the watershed.
Ethereum stakers
I call it the Ethereum watershed.
Encryption Glossary
For those early on the cryptocurrency journey, this glossary can help you prepare for the rest of this article.
Priority Fee: All transactions on Ethereum have a priority fee. From the user’s point of view, this is basically synonymous with gas fees (handling/gas fees). The higher the fee you pay, the faster your transaction will be included in the blockchain, because you are increasing the fee, you are increasing your transaction to be picked faster by miners and then packed faster.
memory pool. The mempool is a smaller database of 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. The mempool is not a canonical thing; each blockchain node has its own version of the mempool. Sometimes, transactions are only broadcast to specific entities, making the mempool inconsistent with other entities.
MEV: Maximum Extractable Value (MEV) is the maximum value that can be extracted from block production, in addition to standard block rewards and gas fees, by including, excluding, and changing the order of transactions in a block. Whoever has the power to front-run a block will be able to seize all available arbitrage opportunities by securing their transactions in their favor.
MEV Searcher: The MEV Searche (MEV Searche) is an automated, highly optimized algorithm that scans the blockchain and the Mempool for potential arbitrage opportunities, and when it finds an opportunity, submits transactions in an attempt to seize that opportunity.
Transaction bundles: MEV Searchers produce “transaction bundles”, which are complex sets of transactions, all bundled into one bundle. It is a transaction, which contains many transactions. Just like a normal transaction, it also charges a priority fee, or bribe, to qualify for a block.
Block generator: The block generator can take all transaction transaction packets, and the highest priority fee mempool transactions, and build a block that qualifies for inclusion.
Block proposer: You may know the block proposer by another name: ETH Staker (Ethereum Staking), the validator, the block proposer proposes the block to be included in the blockchain. This is part of the normal ETH investment process and is the last step in the transaction supply chain.
MEV: How big is the scale?
Every transaction on Ethereum has some kind of value associated with it. If it doesn’t, then the sender doesn’t pay for the gas. Someone is willing to pay something to change the state of Ethereum. People pay to change the price of Uniswap, they pay to raise or lower the liquidation level on Aave, or to engage in some kind of financial transaction that changes the price and value of Ethereum.
Every transaction on Ethereum generates a series of arbitrage behaviors. When someone buys ETH on Uniswap, they confuse its price with the price in other markets and create a small opportunity for arbitrageurs to rebalance, all financial transactions leave plenty of small opportunities for arbitrage bots.
When you disturb the balance of the Uniswap pool, arbitrage bots will come, consume the arbitrage, and export 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 (traditional finance); there are millions of algorithms looking for the tiniest difference, all racing to capture this micro opportunity.
Guys let’s take a look at the size of MEV, the total market value is $670 million, and look at the chart below:
And this is just the early stages of MEV. Value capture in MEV is such a lucrative industry that it is bound to increase 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; at worst, it can turn your blockchain into an oligarchic hellscape.
But don’t worry! The developers of Ethereum are already on the move. They’ve made a system that takes the MEV and makes it flow downstream, where it can be distributed to the widest range of market participants. ETH Stakers (Ethereum stakers).
Ethereum Transaction Supply Chain
Step 0 | Transaction Source: The Mempool
Before transactions are embedded in the Ethereum blockchain, they exist in this “unborn” state, known as the “Mempool”. Mempool means ‘mempool’, which is basically all broadcast user transactions that have not yet been incorporated into the blockchain.
When you make a transaction on Metamask, you broadcast it to Ethereum’s network of nodes. These nodes download this data and keep it in their computer memory.
The transaction that pays the highest fee is selected first from the vast ocean (because there will be many transactions that need to be packaged in the blockchain, paying a high fee, and having the right to be packaged by miners first), and added into a block and incorporated into the blockchain. I describe how transactions are selected for inclusion in the remaining steps below, because there are more variables to consider than “which transaction paid the highest priority fee”.
All transactions have two potential sources of value:
- Priority Fee: Users can choose to pay explicit bribes (outrageous fees) to gain priority to be selected for packaging.
- MEV: A second-order effect that creates an arbitrage opportunity on the state of Ethereum.
How transactions end up becoming part of the Ethereum blockchain is both the size of the priority fee and the ability of the trading platform to have an associated MEV.
For example, one could create a transaction with a $0 fee associated with it, essentially asking miners to include that transaction for free, which is usually ignored by miners or validators. Instead, it’s a transaction that actually gives them money, but if the transaction is to buy 100,000 DAI and pay 1ETH as a fee, or to sell Cryptopunk #1118, pay 1ETH as a fee, both transactions will immediately be MEV Bots find and package deals for them.
Simply put, all transactions come with a reward that includes it, either an explicit priority fee or an implied MEV value. The value of each transaction is picked up by the next participant in the supply chain: the MEV searcher (usually an algorithmic bot searching automatically).
Step 1 | MEV Finder: “Micro Arbitrage”
MEV Finder is a highly optimized arbitrage bot.
Each MEV Finder bot is optimized for a specific type of MEV, and its creators spend a lot of time and labor improving the bot so that it can generate better arbitrage and make more profits.
For example, there will be highly optimized searchers that trade on various AMMs (Automated Market Makers; aka “Decentralized Exchanges”). If ETH were priced at $1998 on Uniswap and $2002 on Sushiswap , a MEV bot optimized for DEX arbitrage would create a trade, grab that spread, and pocket some gwei.
This competition also occurs inside borrowing/loan apps like Aave, Maker or Compound. A lot of value is paid to liquidation bots, and they are all competing with each other to liquidate DeFi loans. Over time, we’ve seen these DeFi liquidation bots compete on tighter spreads, ensuring loans are liquidated at the most favorable rates the market allows, maximizing the value of the loan’s retention.
There are thousands of MEV searcher bots, searching in memory, competing with other MEV searcher bots for very small value arbitrage.
As these MEV searchers get better and cheaper, they will be able to compete for smaller and smaller arbitrage amounts, organically ensuring that DeFi is an efficient market.
bundle deal
These MEV searcher bots create ‘bundled’ deals; since it is usually a group of deals, the available arbitrage needs to be fully captured. The bots need to include all of these deals together in a specific order for their operations to work, so they bundle these deals in a neat little package, tie a bow, and ship it to the next one in the game Players: Block Builders.
Just like a normal trader, each MEV searcher bot submits a “bid” in each trade bundle they create. This is the price the bot is willing to pay Block Builders, including their bundle deal. Since this MEV arbitrage game is highly competitive, profit margins become very thin.
Since these MEV bots are in a fast bidding escalation game, vying for inclusion, the bids MEV searchers pay Block Builders are quickly approaching the full value of the arbitrage they extract, meaning that Block Builders naturally capture close to the amount of value that MEV searchers do. Can extract >99.99%.
Step 2 | Block Builder: “Macro Arbitrage”
The role of the block builder is simple, the block builder builds the most valuable block possible, then bids on the block proposer and accepts their block.
It sounds simple, but in order to make as much money as possible, builders must be highly competitive.
There are two aspects to the block builder competition:
- Hardware and Network
- Order Process
hardware and network
Block builders have to go through a computationally intensive transaction simulation process.
Block builders cannot blindly bundle every transaction package without regard for the rest. Many bundles submitted by searchers for the same arbitrage opportunity, if a lazy block builder includes a conflicting bundle, the second bundle will be rejected and the block builder will give up its related bids.
Block space is precious, and builders must super-optimize transactions in blocks to ensure they don’t leave money on the table.
Therefore, the block builder goes through an intensive transaction simulation process in which it simulates each transaction to check for conflicts. They will run through all possible combinations of transactions to find the most profitable one, then populate the remaining block with basic mempool transactions, tie it with a bow, and bid on block proposers for inclusion (these transactions all within 12 seconds).
Order Process
Going back to what I said above about the Ethereum mempool…
The mempool (memory pool) is not a canonical thing, the only source of truth “is the Ethereum blockchain. Before a transaction is not packaged “before it enters the blockchain”, it is in a disordered state.
Each Ethereum node has its own version of the mempool. When you transact through Metamask (or any wallet), you will broadcast your transaction to every Ethereum node; after all, you just want your transaction to be included, you don’t really care how the transaction flows.
This is not the case for every user, and broadcasting transactions is about “showing your cards” and telling the world what you’re doing. What you are doing is equivalent to: I have a bunch of alpha gains that no one knows about. If you broadcast this deal to everyone, you’re sure to lose every alpha you can think of.
You see a bunch of alphas on ethereum…but if you broadcast your transaction, you’re exposing those alphas to some MEV bots and they’re sure to beat you…because of these Robots specialize in MEV arbitrage.
Private order flow
You can have an off-chain agreement with a mining pool that agrees to process your transactions without disclosing it to others.
Flashbots, God bless them, have made Flashbots to democratize access to this opportunity.
block unicorn note: Flashbots is an R&D organization that aims to mitigate the negative externalities and existential risks that Maximum Extractable Value (MEV) brings to smart contract blockchains.
The lesson to be learned here is: not all mempools are created equal. Entities with better mempool views and access to private trade order flow will be able to take advantage of arbitrage opportunities in other parts of the market.
These are the vehicles of competition for block builders: who can best see the mempool, either improving hardware and networking, or order flow for private off-chain protocols.
Auction Blockchain
Block builders make money by collecting all bids from all transaction bundles from MEV searchers, as well as all priority fees from individual transactions. This will turn into a block and will bring them 2.2 ETH. For example, they will bid 1.9 ETH for the block proposed by the block proposer, trying to pocket the 0.3 ETH difference.
Like MEV searchers, block builders will be highly competitive. A really good block builder can build a block worth 3 ETH and bid 2.2 ETH… but another block builder can build a block worth only 2.4 ETH, And bid 2.3 ETH to join.
Of course, rational block proposers will accept the 2.3 ETH bid block, and block builders with smaller bids will pocket the cash.
Profits plummeted.
Step 3 | Block Proposers: ETH Stakers
The final step is to actually add the block to the blockchain!
ETH Stakers, those who are running validator nodes, simply choose the highest bid block associated with it.
They don’t even have to do any work, they just choose the most profitable block header and sign a message that they approve the block with their 32 ETH bond, full trust and credit.
Finally, we come to the part of this article, which has always been the focus.
Conclusion: Equality through Mechanism Design
Ethereum developers have spent a lot of time developing to make staking on Ethereum as easy and democratic as possible. There has been a lot of effort to make it possible to use underlying hardware to spend staking Ethereum with as little ETH staking as possible (read this article, staking 32 ETH, why it is currently the theoretical lowest number).
These are the values ​​of Ethereum: to make family verification and participation in consensus as democratic and convenient as possible. Your background should not matter, you only need basic hardware consumption and some ETH to participate in the node staking of Ethereum. Application-layer innovations like Rocket Pool and Lido help lower the threshold of 32 ETH, and in the future, 32 ETH may be reduced to 16, or even 8, for a single user.
We have found that MEV is a huge problem with Ethereum, it has the potential to concentrate the supply of ETH to a few privileged parties who can withdraw MEV better than others, a reality that threatens to keep Ethereum decentralized and democratic all efforts to transform.
So, what did the developers do? They leveraged mechanism design to harness MEV and put it in the hands of ETH holders.
As an ETH staker, ask yourself… do you know how to run a MEV searcher bot? Do you know how to build the most ideal block? With the above process, you don’t need to. The entire supply chain is responsible for the most decentralized and accessible part of the stack: ETH holders.
The profit margin of the MEV searcher bot is maximized by the block builder’s struggle for inclusion, and the block builder’s profit is maximized by the block proposer’s struggle for inclusion.
Block proposers are ETH Stakers.
All potential centralization threats of the best MEV search bots are passed downstream to block builders, which in turn are passed downstream to ETH stakeholders.
This is very, very good for ETH.
Will it really end with ETH Stakers? Not necessarily.
Matt Culter from Blocknative believes that this competition will actually return to the point where transactions are initiated: wallets.
Since every transaction has an associated value, the wallet becomes a very powerful place for consumer interaction. Wallets become the source of proprietary transaction streams; transactions are available to blockchain builders.
Therefore, block builders are likely to pay for transactions in their wallets. For example, a dedicated block builder could pay Metamask a lot of money to only route transactions to them without broadcasting to the world.
Sounds bad! Metamask users will be scammed like Citadel and Robinhood.
I don’t think so. Instead, I think it will generate something like credit card points or airline miles rather than an actual monetary reward like ETH or DAI.
Wallets will pay you to use them. All profits withdrawn through this process may logically end up in a rebate or rebate from the originator of the transaction (aka you!), provided by your wallet service provider.
Naturally, this also ends the cycle of Ethereum transaction watersheds.
After the value of the transaction is gathered in a central pool, it evaporates into the air, condenses into a cloud, rains down again, and returns to the top of the funnel, providing a steady stream of nutrients for the Ethereum ecosystem to enjoy.
Congratulations, we’ve built a self-perpetuating ecosystem where a thousand dapps bloom.