Original: https://newsletter.banklesshq.com/p/the-ethereum-watershed?utm_source=%2Fprofile%2F6431556-david-hoffman&utm_medium=reader2&triedSigningIn=true
In the merged world, Ethereum transactions will go through a very specific and orderly process. A powerful trading supply chain is being built before our eyes, and a huge power structure is about to emerge.
The current state of the Ethereum transaction supply chain is blunt and naive. We all commit our trades to the mempool, arbitrage bots descend and compete for every penny of value,
Miners then collate all these transactions to build a block.
In the merged Ethereum, this process is codified and defined into the protocol. This essentially allows ETH stakers to leverage 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, and I can't say enough: the best lens to fully understand cryptocurrencies is through biology.
Cryptocurrency is an emerging organic system that mimics the laws of nature. Although humans are building these structures, the "best structure" that has been found is one that mimics nature.
After years of research and development, ethereum developers have built a supply chain of transactions that looks a lot like a watershed. Watersheds are areas of land that channel rainfall or snowmelt into creeks, streams, and rivers and eventually to outflow points such as reservoirs, lakes, or oceans.
Transactions (raindrops) spread across Ethereum. Some go to Uniswap, some to Aave, others to OpenSea, NFT minting, DEX aggregators, bridges, token transfers, etc.
However, it doesn't matter where the raindrop (transaction) lands on Ethereum; it always converges to the same place and goes through the same process to get there.
Every raindrop is unique and lands in a unique place, but soon the laws of nature take over. The drops become trickles, the trickles become creeks, the creeks become rivers, and the rivers eventually converge in the deepest part of the watershed.
ETH stakers, I call it the...Ethereum watershed.
Glossary
For those early in their crypto journey, this glossary can help prepare you for the rest of this post.
Priority Fees: All transactions on Ethereum are subject to priority fees. From a user perspective, this is basically synonymous with gas fees. The higher the fee you pay, the sooner your transaction will be included in the blockchain because you are increasing the incentive to choose your transaction.
Mempool: A mempool (memory pool) is a smaller database containing unconfirmed or pending transactions kept by each node. When a transaction is confirmed for inclusion in a block, it is removed from the mempool. Memory pools are 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 by including, excluding, and changing the order of transactions in a block, in addition to standard block rewards and gas fees. Anyone with the right to transact in a block can transact in their own favor, ensuring their trades capture all available arbitrage opportunities.
MEV Searcher: The MEV Searcher is an automated, highly optimized algorithm that scans the blockchain and mempools for potential arbitrage opportunities, and when an opportunity is found, submits transactions that attempt to capture it.
Transaction bundles: MEV Searcher produces "transaction bundles", which are complex sets of transactions that are all bundled into a single bundle. It's a single transaction with many transactions inside it. Just like a normal transaction, it also comes with a priority fee to qualify for a block.
Block Builder: The Block Builder takes all the transaction packages it can get, as well as the highest priority mempool transactions, and builds a block that meets the conditions for inclusion.
Block Proposer: You may know a block proposer by a different name: ETH staker. validator node. Block proposers propose blocks for inclusion in the blockchain. This is part of the normal ETH staking process and the final step in the transaction supply chain.
MEV: How big is it?
Every transaction on Ethereum has some sort of value associated with it. If not, then the sender will not pay the gas fee. Someone is willing to pay some price to change the state of Ethereum. People pay to change the price on Uniswap, they pay to increase or decrease the liquidation level on Aave, or participate in some kind of financial transaction that changes the price and value of Ethereum.
Every transaction on Ethereum generates a series of arbitrage actions. When someone buys ETH on Uniswap, they confuse its price with that of other markets and create a small rebalancing opportunity for arbitrageurs. All financial transactions leave plenty of small opportunities for arbitrage bots.
When you disturb the balance of the Uniswap pool, arbitrage bots will come, arbitrage, and export a more balanced and healthy ecosystem. The more Ethereum is used, the greater the total amount of arbitrage. Arbitrage bots are similar to high-frequency traders in TradFi; there are millions of algorithms looking for the tiniest of differences, all racing to capture that tiny opportunity.
And this is just the early days of MEV. MEV value capture is such a lucrative industry that it is bound to grow orders of magnitude fast. Nobody thinks it won't, especially when it's widely believed that MEV is not a "solvable problem".
At best it can be exploited, at worst it can turn your blockchain into an oligarchy hell.
But fear not! Ethereum developers are working on this issue. They developed a system that leverages MEV and sends it downstream, then distributes it to the widest range of market participants: ETH stakers.
Ethereum transaction supply chain
Step 0 | Transaction Source: "Memory Pool"
Before transactions are embedded on the Ethereum blockchain, they exist in this "unborn" state called the "mempool". Mempool stands for "memory pool", which is basically all broadcast user transactions that have not yet been included in the blockchain.
When you make a transaction on Metamask, you broadcast it to the network of Ethereum nodes. These nodes download this data and keep it in computer memory.
Transactions with the highest priority fees are plucked from the ocean of transactions and added to blocks for inclusion in the blockchain. I describe how transactions are selected for inclusion in the remaining steps below, since there are more variables to consider than "which transaction paid the highest priority fee".
An important thing to note: the mempool is one giant ocean of transactions. Everyone has a bid associated with their inclusion, and everyone does something on Ethereum.
All transactions have two underlying sources of value associated with them:
- Priority fees: Explicitly bribed users can choose to pay for inclusion in blocks
- MEV: second-order effects on Ethereum state generating arbitrage opportunities
How a transaction ends up being part of the Ethereum blockchain is a function of the priority fee and the size of all associated transaction MEV.
For example, it is possible to create a transaction with a fee of $0, basically asking miners to include the transaction for free. Miners or validators usually ignore transactions that don't pay them money, but if the transaction is something like "Pay 1,000,000 DAI for 1 ETH" or "Sell Cryptopunk #1118 for 1 ETH", the transaction will be immediately recognized by the first A MEV robot discovers it.
In short, all transactions are rewarded for including it, whether it is an explicit priority fee, or implicitly earning an implied MEV value. The value of each transaction is captured by the next players in the supply chain: MEV Searchers.
Step 1 | MEV Searchers: "Micro Arbitrageurs"
MEV Searchers are highly optimized arbitrage bots.
Each MEV Searchers bot is optimized for one specific type of MEV, and its creators spend a lot of time and manpower improving the bots in order to generate better arbitrage and make more profits.
For example, there will be highly optimized Searchers that can arbitrage between various AMMs (automated market makers; aka “decentralized exchanges”) in DeFi. If ETH is priced at $1998 on Uniswap and $2002 on Sushiswap, a MEV bot optimized for DEX arbitrage will create a trade to capture that spread and earn some gwei.
The same competition happens inside lending apps like Aave, Maker or Compound. A lot of value was paid to liquidation bots, all racing to liquidate underwater DeFi loans. Over time, we’ve seen these DeFi liquidation bots compete on tighter spreads, ensuring loans are liquidated at the best rate the market allows, maximizing the value retained on the loan.
There are thousands of MEV Searchers bots, searching in the mempool, competing with other MEV Searchers bots for tiny value arbitrage.
As these MEV Searchers get better and more energy efficient, they will be able to compete for less and less arbitrage, organically ensuring that DeFi is an efficient market.
tie up
These MEV Searchers bots create "bundles" of trades; as it is usually the set of trades needed to fully capture the available arbitrage. Bots need to include all of these transactions in a specific order in their operations, so they bundle them up in a neat little package, tie a bow on it, and send it to the next player in the game: block building By.
Just like regular traders, each MEV Searchers bot submits a "bid" for each trading package they create. This is what bots are willing to pay block builders to include in their bundles. As this MEV arbitrage game is highly competitive, margins are extremely thin.
As these MEV bots are in a fast game of bid escalation, fighting for inclusion, the bids that MEV Searchers pay to block builders rapidly approach the full value of the arbitrage they extract, meaning that the value captured by block builders is naturally close to MEV Searchers can extract more than 99.99%.
✨Perfect Competition✨
Step 2 | Block Builders: "Macro Arbitrageurs"
The role of "block building" is simple. Block builders build the most valuable blocks possible and then bid to have their blocks accepted by block proposers.
It sounds simple, but in order to be as profitable as possible, builders must be highly competitive.
There are two aspects to block builder competition:
- hardware and network
- order flow
hardware and network
Block builders must go through a computationally intensive transaction simulation process.
Builders cannot blindly include every transaction bundle without regard to its content. Many bundles submitted by Searchers will seek the same arbitrage opportunity, and if a lazy builder includes a conflicting bundle, the second deal bundle will be rejected and the builder will forfeit its associated bid.
Block space is precious, and builders must hyper-optimize the transactions it includes in a block.
Therefore, the block builder goes through an intensive transaction simulation process where it simulates every transaction to check for conflicts. They will iterate through all possible permutations of transaction packages to find the most profitable combination, then fill the remaining blocks with basic mempool transactions and bid to block proposers for their inclusion.
All within 12 seconds.
order flow
Going back to what I said above about the Ethereum mempool...
Memory pools are not a canonical thing. The "canonical stuff", the "single source of truth" is the Ethereum blockchain. Until a transaction is "in the blockchain", it is in limbo.
Each Ethereum node has its own version of the mempool. When you make a transaction through Metamask (or any wallet), you are broadcasting your transaction to every Ethereum node that will listen to you; after all, you only want your transaction to be included...you don't care how trade.
This is not the case for every actor. Broadcast trading is all about "showing your cards." You are telling the world what you want to do. If "what you're doing" equates to "I have a bunch of alpha the market doesn't know about", then spreading the word about this trade to everyone who will listen is sure to cost you every penny of the alpha you were trying to gain.
Ok, so you're seeing a bunch of alpha on Ethereum...but if you broadcast your transaction, you reveal that alpha to some MEV bot, they're sure to beat you...because that's what they do.
Private order flow.
Instead of broadcasting this transaction to everyone, you make an off-chain agreement with a mining pool that agrees to process your transaction without broadcasting it to everyone else.
The lesson to be learned here is: not all mempools are created equal. Entities with better mempool vision and access to private transaction order flow will be able to take advantage of arbitrage opportunities in other parts of the market.
These are the vehicles of competition among Block Builders: who can best see the mempool, whether through improved hardware and networking, or a private off-chain protocol for order flow.
bid for a block
Block builders make money by collecting all bids from all transaction bundles from MEV Searchers and all priority fees from individual transactions. For example, this would turn into a block that would net them 2.2 ETH. They will then make a bid of 1.9 ETH for this block, proposed by the block proposer, in an attempt to pocket the 0.3 ETH spread.
Just like MEV Searchers, block builders will be highly competitive. A really good block builder could generate a block worth 3 ETH and bid 2.2 ETH to include it.
Naturally, rational block proposers will accept bid blocks at 2.3 ETH, and builders who take the smaller spread pocket the cash.
Profits plummeted.
Step 3 | Block Proposer: "ETH Staker"
The final step is to actually add the block to the blockchain!
ETH stakers running validators simply choose the block with the highest bid associated with it.
They don't even have to do any work. They simply choose the most profitable block header and sign a message that they approve the block with the full trust and credit of a 32 ETH bond.
Conclusion: Achieving equality through mechanism design
Ethereum developers have spent a lot of time and R&D to make ETH staking as easy and democratic as possible. Significant effort has been put into making ETH staking staking on basic consumer hardware, using as little ETH as possible.
These are Ethereum's values: making family verification and participation in consensus as democratic and accessible as possible. Regardless of your background, all you need is basic consumer hardware and some ETH, and you can participate in Ethereum staking. Application layer innovations like Rocket Pool and Lido help lower the threshold of 32 ETH. In the future, 32 ETH may be reduced to 16 or even 8.
We found that MEV is a big problem in Ethereum, which has the potential to centralize the supply of ETH to a few privileged parties who can extract MEV better than anyone else. This reality threatens the entire effort to keep Ethereum decentralized and democratic.
So what did the developers do? They use mechanism design to leverage MEV and get it into the hands of ETH holders.
As an individual staking ETH, ask yourself...do you know how to run the MEV Searchers bot? Do you know how to build optimal blocks? With the above process, you don't have to. The entire supply chain is at the mercy of the most decentralized and accessible part of the stack: ETH holders.
The profits of MEV Searcher bots are maximally squeezed by block builders. Block builders' profits are maximally squeezed by block proposers.
Block proposers are ETH stakers.
All potential centralization threats from the best MEV Searcher bots are passed downstream to block builders and then to ETH stakers.
Really, really bullish on ETH.
Will it really end up with ETH stakers?
uncertain.
Matt Culter of Blocknative believes that the race will actually come back to where transactions originate: wallets.
Since every transaction has value associated with it, wallets become a very powerful place for consumer interaction. The wallet becomes a source of proprietary transaction flow; a transaction flow that block builders can leverage.
Therefore, block builders may pay wallet fees for their transaction flow. For example, a dedicated block builder could pay Metamask a lot of money to only route transactions to them, rather than broadcasting them to the world.
This sounds terrible! Metamask users' transactions will be stolen like Citadel and Robinhood.
I don't think that will be the case. Instead, I think this yields things like credit card points or airline miles...not actual monetary rewards like ETH or DAI.
The wallet will pay you to use them. Logically, all profits extracted through this process may go to the transaction originator (aka you!), and your wallet service provider will give you a kickback.
Of course, this ends the Ethereum transaction watershed cycle.
After the transaction value is gathered into a central pool: ETH pledgers, evaporate into the air, condense into clouds, rain down the mountain again, return to the top of the funnel, and provide a steady stream of nutrients for the Ethereum ecosystem.
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