Valid Points: The Problem With MEV on Ethereum
The new frontier of miner/maximal extractable value (MEV) on Ethereum may have negative consequences for network finality and immutability. Key to defending Ethereum against these MEV forces is the upcoming transition to Eth 2.0 and proof-of-stake (PoS). But will the transition come soon enough?
This article originally appeared in Valid Points, CoinDesk’s weekly newsletter breaking down Ethereum 2.0 and its sweeping impact on crypto markets. Subscribe to Valid Points here.
Pulse check
Bitcoin dominance tends to fall every crypto bull market cycle. As background, BTC dominance is a metric tracking the percentage of total cryptocurrency market capitalization made up by BTC.
Related: Bitcoin Is Already Incentivizing Renewable Energy
During the most recent bull market cycle, BTC dominance dropped from roughly 70% in January to as low as 40% in May. While the volatile crypto markets have since turned bearish over the latter half of Q2 2021, causing BTC dominance to pick back up again, the metric continues to trend between the range of 40% and 50%.
Among the alternative cryptocurrencies eating up the market share of BTC, the native cryptocurrency of Ethereum, ether, is the next largest coin, making up roughly 18% of total crypto market share. While ETH is the second-largest cryptocurrency next to BTC and has been since as early as 2016, it is not the fastest-growing altcoin on the market.
In 2021 Q2, the fastest-growing altcoin, excluding stablecoins, by monthly market cap growth, was the native token of Chiliz, a blockchain services network for sports and entertainment providers.
The chiliz token (CHZ) is the exclusive marketplace currency on Socios.com. Socios.com aims at decentralizing fanbase interaction with sports teams by leveraging blockchain infrastructure to facilitate payments for team merchandise, voting rights and other rewards. The marketplace has partnered with over 20 sporting and esports organizations including FC Barcelona, Juventus and Atletico de Madrid.
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Related: Ether Erases Early Losses, Faces Resistance Above $2K
Fans for each of these teams can purchase branded “Fan Tokens” on Socios.com that allow them to vote on certain team decisions such as renaming facilities or changing entrance songs. Since the CHZ is the exclusive means of exchange in the marketplace, the token accrues in value alongside demand for voting rights and rewards provided by the entertainers on the Socios.com platform.
The sports industry alone has a yearly value in the hundreds of billions of dollars and could gain further value through strong customer loyalty programs like the ones being experimented on through CHZ and Socios.com. The Chiliz token is one way to speculate on the use of Ethereum-based tokens for fan engagement and the continued growth of the Socios.com marketplace as the main platform to do this.
Teddy Oosterbaan
New frontiers: Does Ethereum need a stronger defense against MEV?
Block subsidies, transaction fees and miner/maximal extractable value (MEV): These are the three main revenue streams of Ethereum miners.
In efforts to combat currency inflation, protocol developers lowered block subsidies from 5 ETH to 3 ETH in 2017, and again from 3 ETH to 2 ETH in 2019. Starting in August 2021, transaction fees are also expected to decline as a result of Ethereum Improvement Proposal 1559 and its fee-burning mechanism. The only revenue stream that is expected to grow larger and more lucrative for miners in the months to come is MEV.
MEV refers to the income a miner receives as a direct result of their ability to insert, leave out and reorder transactions within a block. The order of transactions is of utmost importance in the context of high-frequency trading on decentralized exchanges (DEXs) where automated bots can identify buy or sell orders waiting for execution on Ethereum and front-run these trades before they get executed.
The higher the liquidity and value being moved on-chain through these DEXs, the greater the profit opportunity for miners to earn additional income through MEV.
*Missing values for daily extracted MEV appear in this chart as interpolated dotted lines that connects the plot points immediately preceding and succeeding the missing value
The larger MEV rewards become in comparison to block subsidies and transaction fees, the greater the financial incentive for miners to adjust not only the order of transactions but also the order of blocks themselves. In what is known as a “time bandit” attack, miners may begin to identify MEV opportunities in blocks that have already been finalized and reorganize the blockchain in their favor if potential rewards from frontrunning are larger than earnings from honest mining (i.e., block subsidies and transaction fees).
Speaking to the potential for miners to reorganize Ethereum blocks and disrupt chain finality, Georgios Konstantopoulos and Leo Zhang from Paradigm Research wrote in a blog post back in March, “This scenario is not obviously plausible: Miners are (for the most part) structurally long ETH, and such an action would directly negatively impact their ETH investment.”
Theory manifesting into reality
However, it would appear the tools for MEV extraction by way of block reorganization are actively being built and already being executed in primitive forms.
Edgar Aroutiounian of Flashbots tweeted on Thursday, July 8, that he had created a personal GitHub repository codifying how payments to miners can be facilitated in exchange for destabilizing blockchain consensus. Shortly thereafter, on Saturday, July 10, Twitter user “0xbunnygirl” announced their own code repository for MEV extraction through block reorgs called “Request for Reorg.”
While the possibility of MEV negatively impacting chain finality and immutability has been a long-running concern, discussed as early as November 2020 among Ethereum researchers, the reality of this happening appears to be manifesting today.
In light of this reality, there are a handful of defense mechanisms that researchers insist will protect the integrity of Ethereum’s blockchain. First, there is the collective will of the Ethereum community to censor this kind of behavior. Users can leave mining pools that are using their computational power, also called hashrate, to reorg blocks. Honest miners can resist accepting blocks they know to be from hostile miners engaging in these MEV practices.
Second, there is the forthcoming upgrade to a proof-of-stake (PoS) consensus protocol with Eth 2.0, after which miners will no longer have the ability to propose blocks or reorder transactions within blocks. These two responsibilities will fall into the hands of validator node operators, who are required to own a large investment of ETH, worth roughly $63,600 or 32 ETH, and have skin in the game in order to participate in blockchain consensus.
Weak lines of defense
Neither of these two defenses is convincing. The former assumes the collective will of the community is homogeneous and aligned on resisting MEV extraction through block reorgs despite clear evidence to the contrary. For some, such as Aroutiounian, if block reorgs can be done on Ethereum and there is a clear financial incentive for them to happen, they should – regardless of how it impacts public perception of the network.
The upgrade to Eth 2.0 and PoS as a defense against block reorgs for MEV extraction does not address the present reality and the impact these events can have on the value of Ethereum in the interim before the upgrade is ready for deployment. The readiness checklist which outlines all the tasks needed for PoS activation remains in large part unfinished. The earliest that developers estimate Ethereum’s transition to PoS will happen is the beginning of 2022.
Ethereum needs a stronger line of defense to combat the reality of MEV extraction through block reorgs.
Validated takes
Short-term profitability proves more important for decentralized exchange (DEX) users on Polygon than Ethereum. TAKEAWAY : Polygon’s DEX trading volume and liquidity came and went with a spike in rewards during the month of June, while remaining comparatively more stable on Ethereum over the same time period. (Data, Glassnode)
Sygnum Bank becomes the first banking institution to offer staking services for Ethereum 2.0. TAKEAWAY : The Swiss bank built for digital asset custody, brokerage and tokenization is expanding its offering of yield generating products by offering clients up to 7% per annum on their ETH through staking. In today’s low or negative interest rate environment, the bank wrote in a blog post, digital assets offer an alternative to yield generation. (Article, Yahoo)
Gas prices on Ethereum have been on a downward trend since late April, dropping from roughly 150 gwei to 15 gwei. TAKEAWAY : A higher block capacity, the rising popularity of layer 2 scaling solutions and increased use of alternative payment channels between DEX traders and miners are all likely factors contributing to lower gas prices on Ethereum. (Newsletter issue, Coin Metrics)
Circle, the co-creator of dollar-backed stablecoin USDC, is set to go public at a $4.5 billion valuation. TAKEAWAY : USDC is the second-largest stablecoin on Ethereum by circulating supply next to tether. In a presentation on Circle’s plans to go public, the company predicted sevenfold growth in USDC’s market capitalization by 2023. The predicted circulating supply would be $190 billion, much higher than leading stablecoin, USDT, which currently is sitting around $63 billion. (Article, CoinDesk)
Weekly volumes in dollar markets for BTC and ETH reached new all-time highs in 2021 Q2. Notably, notional volumes in ether-dollar pairs consistently surpassed bitcoin pairs for the first time ever in the month of May. TAKEAWAY: Surging interest in NFTs and DeFi since the beginning of this year are likely factors contributing to the growth of ether trading volumes. (Report, CoinDesk)
Teddy Oosterbaan
Factoid of the week
Open comms
Valid Points incorporates information and data directly from CoinDesk’s own Eth 2.0 validator node in weekly analysis. All profits made from this staking venture will be donated to a charity of our choosing once transfers are enabled on the network. For a full overview of the project, check out our announcement post.
You can verify the activity of the CoinDesk Eth 2.0 validator in real time through our public validator key, which is:
0xad7fef3b2350d220de3ae360c70d7f488926b6117e5f785a8995487c46d323ddad0f574fdcc50eeefec34ed9d2039ecb.
Search for it on any Eth 2.0 block explorer site.
New episodes of “Mapping Out Eth 2.0.” with Christine Kim and Consensys’ Ben Edgington air every Thursday. Listen and subscribe through the CoinDesk podcast feed on Apple Podcasts, Spotify, Pocketcasts, Google Podcasts, Castbox, Stitcher, RadioPublica, IHeartRadio or RSS.
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Ethereum Price Analysis: ETH Loses 1.8% as the Market Remains Choppy
Ethereum price opened the day in the green as bulls attempted to launch an upswing beyond the $2,000 resistance level. ETH lost 1.88% against the dollar over the last 24 hours with bears determined to stretch the bearish leg that started on July 07. This was after exploring levels around $2,400 and held support around $2,170. At the time of writing Ethereum was trading in the red at $1,922.
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Ethereum Price Stuck Between the 20-day SMA and the $1,860 Support
The four-hour chart shows that the Ethereum price has been struck between the 20-day SMA and the $1,860 support line. This points to a sideways price action amid as the market indecision becomes apparent. The appearance of three doji sticks over the last three trading sessions yesterday validate the indecision in the market as the Ethereum bulls and bears cancel out.
Note that on the same four-hour chart, Ethereum price presented a signal for an upward price action, suggesting that ETH uptrend could be seen in the near term. Moreover, the Moving Average Convergence Divergence (MACD) indicator validates Ethereum price consolidation by its sideways movement. In addition, the position of the MACD line (blue) above the signal line hints at a possible uptrend.
Ethereum Price (ETH/USD) Four-Hour Chart
Ethereum Price Uneventful as Bulls and Bears cancel
The market indecision displayed by the Ethereum price is validated by the Bulls and Bears Indicator by IntoTheBlocks. Generally, the 7-day difference between bulls and bears is negative pointing to more sellers than buyers. The chart indicates that the total volume of ETH tokens traded by the bulls and bears. Note that, the most important information here is the differences in trading volumes by the bulls and bears.
ETH Traded by Bulls and Bears Between June 22 and July 15
The chart indicates that bears traded approximately 190,000 million more ETH than bulls over the last 7-days. However, this difference, as shown by the blue line in the middle of the chart is neutral (at zero) pointing to a consolidating market as the pressure from bulls and bears cancels out. The indecision in the market yesterday is validated by the fact that bulls traded only 85,700 more ETH than bulls. In general, the equilibrium between the buyers and sellers points out to an indecision in the market.
What is Likely to Happen?
Note that if the market moves in favour of bulls, they should target overcoming the 20-day SMA towards the $2,000 psychological level. A daily close above this level could bolster bulls to push the price to $2,200 which corresponds to the 100-day SMA and even test the $2,400 two-week high.
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If the Ethereum price favours bears, ETH could retest the $1,860 crucial support level, before a further drop to $1,713 retesting the June 26 low.
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Capital at risk
What Is Proof-of-Stake, and Why Is Ethereum Adopting It?
Just looking at the headlines, cryptocurrencies are in a downturn.
The price of Bitcoin has dropped by around half since its peak. More speculative projects, such as Dogecoin, have fallen even further. While this may be discouraging to day traders and fast money types, for longer-term investors, there are exciting developments in cryptocurrency.
For one thing, the drive continues toward more exchange-listed funds and trusts in the sector. There’s also a key debate in a technical area: Is the future of cryptocurrencies found in proof-of-stake protocols?
The proof-of-work versus proof-of-stake issue comes down to this question: How to ensure the integrity of a cryptocurrency. Most legacy cryptocurrencies, such as Bitcoin, rely on a proof-of-work mechanism. When you see an image of thousands of computers in a mining facility, that’s a proof-of-work operation. The computers solve complicated algorithmic puzzles. In return, the miners receive tokens of the underlying cryptocurrency as reward.
What Is Proof-of-Stake?
Proof-of-stake, by contrast, relies on validators to maintain the cryptocurrency. In a proof-of-stake model, owners put up their tokens as collateral. In return, they get authority over the token in proportion to the amount they stake. Generally, these token stakers get additional ownership in the token over time via network fees, newly minted tokens or other such reward mechanisms.
In the beginning, proof-of-work was appealing because people just needed an ordinary computer to mine coins. Nowadays, however, specialized expensive gear is needed to mine leading proof-of-work tokens. Much of mining is now done by large, well-financed pools, which has cut out the general public from the equation.
In the debate proof-of-stake versus proof-of-work battle, the former could be more democratic. Anyone with tokens is able to participate as a validator or staker and tap into the decentralized finance (DeFi) ecosystem. More broadly, analysts have focused on the environmental burden from proof-of-work protocols. Bitcoin, in particular, has developed a large environmental footprint as it has gained wider adoption. Proof-of-stake, by cutting out the advanced cryptographic puzzles, reduces this environmental cost dramatically.
Proof-of-work advocates protest that proof-of-stake deviates from the original vision of cryptocurrency. Bitcoin differentiated itself from other financial assets because the database or blockchain record was inherently valuable. The mining process, while inefficient in terms of energy, created a distinct and tamper-proof record of all financial transactions. Proof-of-stake, at least in basic forms, has some vulnerabilities.
The nothing at stake problem, for example, is centered around the fact that when there is no cost to creating forks or putting bad information into the consensus, it encourages malicious behavior. Proof-of-work’s energy cost inherently limits manipulation; proof-of-stake, by contrast, must use more sophisticated methods to try to stop these security issues.
The proof-of-stake versus proof-of-work debate has largely stayed within the technical realm. Proof-of-stake has a notable leader in Cardano, but the biggest projects have stayed with proof-of-work. However, Ethereum’s plans to migrate from proof-of-work to proof-of-stake are bringing this subject into the spotlight. Ethereum’s move began in earnest in 2020, when Ethereum launched its proof-of-stake Beacon Chain. Development continues, with Phase 1 aiming to launch later in 2021 and the full merge into proof-of-stake for Ethereum happening over the next year.
It’s Complicated Switching to Proof-of-Stake
So, given the benefits of proof-of-stake, why has Ethereum taken so long to make the switch? “The main impediment for faster adoption of proof-of-stake has certainly been the difficulty of migrating the largest smart contract network Ethereum from proof-of-work to proof-of-stake,” says Justin Giudici, head of product at the Telos Foundation. “The challenge of changing the consensus mechanism on Ethereum has been compared to ‘fixing a plane while flying it.’ This is because with thousands of existing smart contracts on the Ethereum chain along with billions of dollars in assets at stake, the migration challenge is significant.”
Here are some numbers to put the challenge in perspective. “Development on Ethereum has far outpaced its ability to change and thus scale. It’s easy to understand why when you consider the DeFi phenomenon, which saw an industry go from zero to $76 billion in the last year. Then, during the first two quarters of 2021, non-fungible tokens exploded, bringing in $2.5 billion. Building on the Ethereum Network has been happening at an explosive rate, while the switch from proof-of-work to proof-of-stake is a long, arduous process,” says David Waslen, CEO of Rublix Development, a blockchain and smart contract software company.
It’s easy to migrate from one technology to another in a vacuum. However, as Ethereum’s decentralized finance system has already gained wide adoption, it’s vital to maintain continuous network stability. “There could be unexpected critical bugs or circumstances that are difficult to predict before the merge occurs. This is a good reason for not rushing the transition,” says Mattias Nystrom, community manager for the Golem Network.
“Ethereum’s timeline can be seen as a product of its strength: decentralization. It’s a complex project with lots of stakeholders and beyond that, it’s censorship resistant and permissionless socially. This means anyone can join the project and give their input on changes to the network. So you need consensus among developers creating the code and among the wider community for things to progress,” Nystrom says.
Proof-of-Stake and Transaction Costs
Another factor is the recent decline in cryptocurrency prices, and the ensuing amount of mining power devoted to proof-of-work protocols. Transaction fees on Bitcoin, Ethereum and other leading proof-of-work projects support the mining network. As crypto has dropped, transaction fees fell. But even if the average transaction fee drops from, say, $25 to $5, that can still be a huge cut of smaller decentralized finance transactions.
Also, as emerging markets such as El Salvador adopt cryptocurrency, fees will need to come down dramatically. El Salvador’s gross domestic product per capita works out to around just $11 per day. So if cryptocurrency will be the default money in that economy, it’s vital that user fees aren’t a large portion of a worker’s average daily wage.
Additionally, high transaction fees often found in proof-of-work protocols stifle progress for cryptocurrency adoption.
“There’s a huge impact to innovation in languishing on slower, more expensive consensus technology. Historically, the transition from proof-of-work to proof-of-stake and other high speed consensus models is comparable to the transition from dial-up internet to broadband,” Giudici says. “Quite simply, the number and types of use cases, level of adoption and impact of the technology go up orders of magnitude as entrepreneurs release products that couldn’t even be imagined using slower more limited technology.”
Ethereum is supposed to adopt proof-of-stake over the next year. But like the switch from dial-up to broadband, don’t be surprised if proof-of-stake still takes a while. “Even though the changeover from proof-of-work to proof-of-stake is beginning in 2021, the final result is a long way off. [Ethereum founder] Vitalik Buterin has even pointed to an extended process of ‘cleanup’ after the scheduled hard forks and the eventual chain merge before the Ethereum platform problems such as lack of scalability, costs and congestion can be aggressively addressed,” Waslen says.
Proof-of-Stake’s Broader User Impact
Proof-of-stake has one other widely discussed effect: the graphics card market. As Ethereum and other leading crypto projects adopt proof-of-stake systems, it should reduce the demand for graphics cards in for cryptographic mining. This could finally break the shortage in the area. That’s great news for gamers.
Jahon Jamali, co-founder of Sarson Funds, agrees that graphics card demand could free up with proof-of-stake adoption. However, the best proof-of-stake user benefit comes elsewhere. “The big positive effect is that consumers get to participate in the consensus mechanism. It’s more scalable and they can participate in the staking rewards. They will benefit greatly by being able to participate in a broader ecosystem,” Jamali says.