New Flashbots upgrade might revolutionize the crypto markets
It is challenging to compare Flashbots to conventional finance. And the reason for that is that they mark a fundamental change from Wall Street’s financial practices and culture. They are not the leading whistleblowers or high-frequency traders (HFT).
The technological innovation that concealed the rigged cat and mouse game ensured that high frequency trading was always one step ahead of regulators and whistleblowers.
The designers of Flashbots noticed a resemblance in the way traders took advantage of Maximum Extractable Value (MEV). However, they turned on the light rather than naming specific performers. The front-running “shenanigans,” as co-founder Phil Daian calls them, won’t necessarily halt as a result of this, but the community will gain from this trading activity.
The MEV Boost upgrade is expected to enhance validator incentives by up to 50% after the Merge, according to Figment, a top provider of institutional staking services. However, we must first comprehend where the previous model fell short before we can explain how the new one functions.
The traditional view: a culture of concealment
The Wall Street front-running of 2009 was cited by Robert Ellison, director of stake marketing at Figment, as an analogous example of some of the methods now used. The old worldview was incorrect, as can be seen by carefully examining the conflict between those front-runners and their whistleblowers.
Richard Gates revealed the HFT firms’ front-running strategy to the Wall Street Journal in 2009 and the SEC in official form in 2010. Companies at the time were using Spread Network’s carefully positioned fiber optic lines and deploying servers adjacent to exchanges to complete deals as quickly as possible. Traders were able to manipulate the market thanks to this competitive edge significantly. Only 2% of businesses employed the strategy, yet it was responsible for 73% of stock order volume.
Gates admitted to being a victim of this technique to the SEC in 2010. He asserted that Credit Suisse, the owner of the dark pool Crossfinder, was purposefully giving HFT traders an unfair advantage over regular traders like himself.
He mentioned in his complaint that Credit Suisse allegedly told these dealers that they had “sheep in the corral” in order to advertise their pool to them. To kill them, all you need to do is show up.
In 2015, Gates submitted an application for a whistleblower reward that would have given him 10% to 30% of the SEC settlement with Credit Suisse. In addition, Credit Suisse consented to pay $84.3 million in fines later that year.
High-frequency exchanges and dealers, however, had already switched to new tactics by that point. The NYSE, for instance, used secret order types that allowed a select few corporations to place trades ahead of other dealers. There were more complaints made, and new whistleblowers like Haim Bodek emerged.
In addition, Gates’ own business, Powhatan Energy, was dealing with accusations of its own at the time he applied for the whistleblower prize, resulting in fines of $26 million. They claimed that the business knowingly abused a weakness in the PJM Interconnection LLC markets.
This incident demonstrates how the SEC’s whistleblower incentives are too open to abuse, and its bureaucracy is too slow to implement significant reform. The system for obtaining the greatest amount of value (MEV) from Ethereum transactions exposes the network to very similar kinds of front-running operations, and like the traders on Wall Street, they are continuously coming up with new strategies. You’ll see, though, that Flashbots presents a solution that logically conflicts with the previous way of thinking.
Explained: the leading MEV
All deals in Ethereum, unlike conventional exchanges, must settle on-chain rather than through a clearing house, just like regular transactions. But before they are settled on-chain, practically all trades enter a mempool where, according to the proof-of-work (PoW) protocol, miners favor transactions with greater gas fees over those with lower fees. After the Merge, validators will take on this duty.
Maximum extractable value (MEV) is defined as “the maximum value that can be retrieved from block creation by including, omitting, and modifying the order of transactions in a block” on Ethereum.org.
Algorithms created by third parties known as MEV searchers scan the pool of transactions for MEV chances. A portion of the profit is subsequently divided among the miners who choose their opportunities. Leaders have created their own algorithms that leverage information from order books and mempools available to the public to reduce lines.
In a decentralized exchange (DEX) like Uniswap, the trade that executes first gains an edge over other trades. In a transaction known as a sandwich trade, the front-runner first determines the profitability of the price action of the queued trade, performs a trade with a higher gas cost to leap ahead, and then sells right away after the prior trade is completed. They only make money if the price movement exceeds the cost of gas.
Another common strategy is generalized front running. In order to move ahead of the pack, it scans the mempool for successful trades or transactions, replicates them, and raises the gas price. Unlike sandwich trades, this strategy makes money via MEV rather than price movement on a DEX.
However, these strategies are unpredictable and inconsistent.
“People have discovered there are several methods to interact with Ethereum. The typical user might wish to send ETH. However, people participating in MEV respond more to what is happening on the network. The process is reflective and iterative”. According to Clayton Menzel, Figment’s head of protocols and opportunities, “they are keeping an eye on what others are doing and observing the pending transaction pool”.
A new paradigm
In order to lessen the harmful network impacts of MEV, Flashbots conducts research and development.
They developed an open-source technology that enables POW protocol miners and POS protocol validators to collaborate with MEV searches more effectively. Separate from the mempool, it runs a private auction. Although this solution doesn’t entirely ban front running on Flashbots, it does stop the broader strategy by concealing pending transactions from the wider public.
By including a third party called the builder in the new MEV Boost update, Flashbots will increase the effectiveness of this auction. The block production process in this version would no longer involve direct interaction between MEV searchers and validators. Builders will instead collaborate with MEV searchers to construct and auction prospective blocks to validators. For their contributions, each side would profit. Additionally, it increases the process’ efficiency and fairness by relieving the burden on validators and allowing more participants to gain from it.
The genius of this new paradigm is that it seeks to address inefficiencies rather than penalize undesirable conduct. On the Ethereum network, there will very certainly always be front-running strategies. However, by providing the appropriate incentives, they can direct that behavior into an open and democratic structure that encourages greater market participation for MEVs.
It restructures the incentives to lessen adverse network effects and make MEV more decentralized rather than depending on slow bureaucratic officials to punish poor behavior. After the Merge, not every validator is certain to go over to Flashbots. However, if it raises stake yields and lowers MEV’s harmful network effects, validators that don’t use Flashbots or another MEV solution run the danger of losing stakers.
Recently, Figment declared that MEV-Boost would be incorporated into its Ethereum validators. On Goerli, the last testnet used before the Ethereum Merge, they have so far tested MEV-Boost successfully. Their research has thus far indicated that the improvement will significantly increase stake revenue. However, it will also enable Figment’s ETH users to take part in MEV.
Education remains essential
Education is crucial. Flashbots develops open solutions so you can see MEV extraction and make research public. It gives you a clear picture of what’s happening and a balanced perspective that takes into account both the good and the bad. Education and free discourse are also crucial, according to Ellison.
In this area, there is a lot of noise but little signal. People should choose better infrastructure providers to deal with as ETH transitions to PoS. As a holder of an ETH token, you can now choose your own actions after seeing the drawbacks of MEV. Figment is making a lot of effort to assist customers in making wise staking selections. Prior to the Merge, they not only publicized their MEV policy but also ran a Twitter chat to help their audience better grasp the changes.
At this time, miners are not under any obligation to split MEV payouts. On the other hand, validators can be at more reputational risk. Due to competition, MEV rewards are therefore expected to be distributed more fairly than they are now once validators replace miners following the merging.