CryptoTalk – The Wacky World of MEVs

“True believers say crypto is more transparent than traditional finance. Yet that openness –combined with clunky infrastructure and an absence of regulation – lets crypto trading firms with lightning-fast bots prey on unsuspecting retail traders” — Forbes

Maximum Extractable Value (MEV), initially called ‘miner extractable value’ and used as a concept in proof-of-work on the Ethereum blockchain, is a relatively new concept in the world of cryptocurrencies, referring to the maximum value extractable from a block production in excess of the standard block reward and gas fees by ‘including, excluding, and changing the order of transactions in a block’.

Outside of calling the world of MEV ‘wacky’, Forbes calls it the place where ‘software-engineers-turned-traders try to outsmart (and sometimes even sabotage) each other and get rich off the unique and often inefficient structure of blockchain transactions.’

Predominant MEV strategies

There are mainly three predominant forms of MEV strategy. The most controversial of these, and particularly pernicious, is a front-running attack known as a sandwich attack. In this, an MEV bot spots intent to buy a coin and profits from the small price appreciation the price rise will cause. The bot, in this case, jumps first in line, purchasing the line at a fraction less, front-running the trade. After this, when the mark has purchased the coin, it sells automatically at the appreciated price, pocketing the profit.

Forbes writes, “front-running is not only lucrative for the MEV trader, but also for the “validators” running software to approve blockchain transactions. Just as big quant hedge funds engage in “payment for order flow” from brokers like Robinhood to purchase the right to execute retail traders’ orders, front running MEV traders essentially buy their way to the head of the line. The result is the validators end up with a bigger slice of the front-running profits than do the folks creating the bots.”

Arbitrage is another common, albeit less controversial MEV tactic exploited by price differences for the same token on about the roughly 500 loosely regulated exchanges. Given the thousands of cryptocurrencies in existence, there is much opportunity for profit. Many experts even consider this sort of MEV to be beneficial in establishing the true price of the currency as well.

Finally, we have something called a liquidation play, albeit this is limited to DeFi platforms with prevalent leverage. Consider the story of 33-year-old crypto bot developer Nathan Worsely.

A thousand liquidations and a $200,000 windfall

In 2021, Worsley homed in on decentralised finance platforms Abracadabra and Wonderland, promising an unbelievable 80,000% to people borrowing a coin called ‘Magic Internet Money’ (MIM) and staking it –i.e., placing it into a sort of crypto savings account.

Borrowers were then asked to pledge collateral equivalent to about 110% of the loan, where if the value of the collateral fell, they would get automatically liquidated by the smart contract underlying the loan. The most attractive part of the whole gambit for Worsely was the 12.5% reward paid to those willing to help liquidate borrowers whose collateral did not meet stipulated requirements.

In cryptocurrencies, unlike in traditional finance, liquidations are automatic. Seconds after collateral value goes down, it is seized and sold, often leaving borrowers with only the borrowed sum (this is far different from a stock investment, where brokers demand either shoring up on collateral or paying back the loan).

Forbes writes: “On Abracadabra, collateral for a loan denominated in “Magic Internet Money” need not be in the form of something as tangible as cash or Treasury bills. Any number of speculative cryptos will do. So, in the fall of 2021 as crypto prices started declining, Worsley built a software bot to pounce in the event that MIM investors suddenly had to be liquidated because some of the flimsy collateral tokens backing the loans swooned in value.”

In January 2022, two cryptocurrencies using MIM as collateral – Wonderland and Wmemo plunged 86% and 70% in value.

The bot immediately went to work. Prior to the plunge, it checked people’s balance and predicted who would be liquidated based on pending transactions and fluctuating crypto prices. When a likely liquidation candidate was found, a digital message telling Abracadabra’s DeFi software would quickly pay back the user’s original loan, receive an additional and equivalent amount in collateral, and collect up to 12.5% of the loan value.

The entire process took a thousandth of a second, earning Worsley a $200,000 windfall from a thousand liquidations.

“It’s somewhat of an art form. I liken it to being an engineer for a Formula One race car. You are tuning this machine every day, trying to squeeze every inch of performance out of the machine, and it’s racing against other people’s machines,” Worsely was quoted saying.

Experts estimate almost $700 million to have been realised in MEV profits on the Ethereum blockchain alone over the past two and a half years. Including other blockchains like Binance Smart Chain and Solana, profits exceed a billion dollars.

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