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IOSG Ventures: What has changed and what hasn’t changed at MEV after the merger

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We focus on the investment logic of finding and pursuing "change" in "unchange".

Original title: 《 IOSG Weekly Brief | What has changed and what hasn’t changed in MEV after the merger #155 》

Original author: Jiawei, IOSG Ventures

This article is original content from IOSG and is only used for industry learning and communication. It does not constitute any investment reference. If you need to quote, please indicate the source. For reprinting, please contact the IOSG team to obtain authorization and reprint instructions.

Introduction

Source: Flashbots

According to the definition given by the Ethereum community: MEV refers to the maximum value extracted from block production that exceeds the standard block reward and gas fee by including/excluding/and sorting transactions in blocks.

As on-chain financial activities become increasingly complex, MEV continues to accumulate. According to incomplete statistics, MEV is currently close to US$700 million. This is only in the context of Ethereum’s first layer during the PoW period. If The Merge is taken into account, as well as various Layer 2 and Alt-L1, the total amount of MEV is conservatively estimated to exceed 1 billion US dollars.

Source: Blocknative, Flashbots, IOSG Ventures

In the life cycle of an Ethereum transaction, we can abstract the MEV supply chain. This article mainly discusses the Builder and Validator (Proposer) parts.

Proposer and Builder Separation (PBS)

In the current Ethereum protocol layer design, block builders (Builders) and block proposers (Proposers) are the same entity-under PoS, they are first a subset of Validators. This entity is pseudo-randomly selected from a broad Validator Set to build blocks and propose blocks to the PoS network.

Source: Blocknative, IOSG Ventures

The above figure basically explains the process of block construction. There are three main sources for Builder to obtain transactions: public transaction pool (mempool), private transaction channel (such as Flashbots Protect), and Bundles submitted by MEV searchers. Builder builds these transactions into a block and submits it to Relay together with the bid to participate in the auction.

With the growing trend of MEV, the design of Builder and Proposer as the same entity gradually showed its drawbacks: compared with ordinary Validators, large Validator Pools have more opportunities to achieve MEV; in addition, they obviously have stronger MEV capture capabilities than ordinary Validators, which leads to serious centralization problems. Therefore, PBS (Proposer-Builder Separation) proposed to separate Builder and Proposer.

After the separation, both ordinary Validators and large Validator Pools outsource the blocks to professional Builders for construction to maximize profits, and they only need to do one thing, "propose".

The current PBS is divided into protocol layer and non-protocol layer implementations. The difference between the two is that the former is embedded in Ethereum itself and is technically mandatory; while the latter means that PBS is optional and non-mandatory.

Protocol Layer PBS (Danksharding)

The protocol layer PBS (In-protocol PBS or Enshrined PBS) will be introduced in the Ethereum Danksharding implementation, making PBS a protocol layer design. At that time, in addition to building blocks, the Builder will also need to calculate the KZG polynomial commitment of 32MB of data in about 1 second and distribute it in the P2P network.

Non-protocol Layer PBS (MEV-Boost)

Flashbots proposed an open source software MEV-Boost as a non-protocol layer implementation of PBS. This is an open market, where the Builder focuses on building blocks and maximizing the benefits of each block as much as possible. After participating in the auction, the most profitable blocks are submitted to the Proposer. The latter only needs to simply propose this block, which is equivalent to selling its block space. In return, the Proposer of the block can receive the fees paid by the block builder. It is estimated that after running MEV-Boost, the staking income of the validator will increase by more than 60%.

Source: Flashbots

The above is the general workflow of MEV-Boost.

First, in addition to running the three softwares of the validator client, consensus client and execution client, the Validator also needs to run MEV-Boost.

Builder gets transactions and Bundles from the transaction order flow and builds blocks according to their respective strategies.

Source: Flashbots

Relay serves as a two-way communication channel between Builder and Proposer. It can connect to one or more Builders, verify the validity and bid of the blocks submitted by the Builder, and submit the valid highest bid to the Proposer.

Proposer can gather one or more Relays, select the most profitable blocks from them, and make proposals.

Regarding the non-protocol layer PBS and block construction, some interesting topics are derived, which will be discussed one by one below.

Market supply and demand and transformation

In terms of supply and demand, Proposer and Builder have actually achieved a certain degree of separation in the early stage.

Complex on-chain activities make MEV opportunities increasingly apparent. In PoW, miners with strong computing power have the right to generate blocks, but their ability to search for MEV is average, and most of them simply choose transactions with high gas fees to generate blocks; on the other hand, searchers have a strong ability to capture MEV opportunities, but the right to generate blocks is not in their hands.

Initially, there was no definite way for miners to include transactions submitted by these searchers; searchers could only raise the gas fee as high as possible in the hope that their submitted transactions would be included. But this is a public "auction", equivalent to a Gas War, and bidders must pay fees even if they ultimately fail, which will cause network load and push up gas prices, resulting in serious negative externalities.

So, in response to the above supply and demand and pain points, Flashbots proposed Flashbots Auction, which introduced auctions and communication channels between miners and searchers. Searchers send transactions to miners through Flashbots Auction and pay additional fees.

In summary, supply and demand create an open market.

This is the scenario in PoW. When Ethereum transitions to PoS, you only need to stake 32 ETH and meet simple hardware requirements to participate in the verification network, which means that the distribution of block rights has become wider, that is, more people can participate in block production. However, compared with miners, these Validators lack the ability to build blocks.

The open market of supply and demand still exists, but there are some changes: in the past, miners could choose to build blocks themselves, or outsource block building - Flashbots Relay sends transactions or blocks to miners, and miners can choose to receive them; now, for Validators, block construction will incur additional computational overhead, and most of them do not have enough ability to capture MEV, so Validators need to request blocks from Flashbots Relay.

Regulation, anti-censorship and decentralization

Regulation and censorship are, to some extent, the same thing. Anti-censorship and decentralization are the narrative pillars of blockchain, and the relationship between the two is inseparable.

Source: mevwatch.io

First, at the regulatory level, after the merger, centralized trading platforms, pledge service providers, and actual operators account for a large proportion of the entire network Validator. These entities are in specific legal jurisdictions, so they need to weigh the compliance risks brought by their business. Ethereum faces invisible regulatory pressure.

From the data point of view, the number of blocks that meet OFAC compliance requirements every day has reached 67%; 74 out of every 100 blocks meet OFAC compliance requirements. This data is on an upward trend while remaining high. If this value is close to 100%, it will be difficult for transactions from addresses sanctioned by OFAC to be included in the block.

Of course, the addresses sanctioned by OFAC so far are all hacker addresses, which seems to be reasonable in terms of morality and ethics; but whether this regulatory scope will be expanded is probably unpredictable. Faced with high regulatory pressure, how should large validator pools choose between economic interests and the spirit of decentralization? Instead of trying to answer this question, we should perhaps solve the review problem directly from a technical perspective.

In addition to regulatory review, there is also the issue of Builder review in MEV-Boost. In the above workflow, we can see that the Proposer can only passively receive the complete block submitted by the Builder, and cannot include the transactions he wants in it. That is, either accept all or do not participate in MEV-Boost at all. In this case, the Builder can actually unite to intentionally not include certain transactions and blackmail the initiator of their transactions.

In Danksharding's protocol PBS, crList (anti-censorship list) is introduced to solve the censorship problem, that is, the Proposer has the right to specify a transaction list, which must be included by the Builder; after winning the auction, the Builder needs to prove that all transactions in the crList have been included (or the block is full), otherwise the block will be deemed invalid.

Source: EigenLayer

The Proposer Part is introduced in MEV-Boost++ proposed by EigenLayer, which is similar to crList. Proposer has the right to participate in building part of the block.

Further decentralization

Source: relayscan.io

Through the implementation of the non-protocol layer of PBS, the problem of Validator centralization is alleviated. In the previous discussion, we found that the Builder also has the problem of centralization at this stage. In the past week, the top five Builders built 84.64% of the MEV-Boost blocks.

Flashbots recently open-sourced its Builder API, hoping that multiple Builders will collaborate to build blocks, rather than a single entity currently building a complete block.

At a glance, because different Builders can cover different coverage of MEV searchers and private transaction channels, some Builders may have advantages in the former or the latter. Now, the block submitted by the Builders is a complete block. If you want the block you build to be selected, you must maximize the overall benefits of the built block.

If multiple Builders collaborate, the Builder with the former advantage can submit part of the block, and the Builder with the latter advantage can submit the other part, which will make the Builder as a whole more decentralized, and in theory, the Validator will eventually benefit more. However, at the same time, this has also significantly intensified competition among Builders.

Flashbots proposes that all teams develop their Builders publicly, and the community only trusts those Builders whose behavior conforms to the transparent and free software specifications. If each Builder follows this standard, the role of the Builder and the construction of the block will be more decentralized and transparent.

Thinking about Endgame from the perspective of MEV

Source: IOSG Ventures

Vitalik described the final vision of Ethereum in his article "Endgame": block production is centralized, but block verification is trustless and highly decentralized, and ensures censorship resistance.

Personally, I guess that the logic of the first half of the sentence is based on the following three points:

From the perspective of decentralization, Ethereum needs to make the hardware requirements or computing resources of becoming a Validator as low as possible. If the Validator only needs to simply propose a constructed block with the highest bid without building the block itself, this can reduce some of the computing overhead.

From the perspective of economic incentives, the participants of this system are all Economically Rational. If running MEV-Boost can increase the staking income by as much as 60%, then apart from other objective factors such as supervision, rational Validators will outsource the work of block construction to Builders, which makes block production centralized.

If Danksharding is implemented in the future, the hardware and bandwidth requirements for Builders will increase significantly, which will inevitably point to the result of Builder centralization.

Although block production is centralized, Ethereum has achieved further decentralization of the Validator Set by lowering the threshold and PBS for participating in network verification, and has ensured that block verification is trustless and highly decentralized based on a wide range of Validator Sets and a pseudo-random voting process. This is certain.

Of course, centralization and decentralization are Spectrum, not a "yes" or "no" question.

Closing Thoughts

Block construction is a vast market, and MEV is happening all the time, involving algorithm competition and competitor games, and cash flow is flowing day and night. MEV is a rare pure chain-native business model in the current crypto world, and it is stable enough.

The current PBS is a non-protocol layer, and Validator can still choose to build blocks by himself instead of outsourcing to professional Builders. In the future, after Ethereum introduces Danksharding, PBS will become a mandatory implementation in protocol design, and we will see that the market for block construction will become larger.

We focus on the investment logic of finding "change" and seeking "change" in "unchanged":

Considering the future large-scale adoption and the increasing complexity of on-chain financial activities, we believe that MEV is the "unchanged" trend in the medium and long term.

What has "changed" after the merger? First, the supply and demand relationship between block proposals and block construction has changed. Secondly, the demand for anti-censorship and decentralization has begun to emerge. Finally, the trend of block construction becoming a professional market is also slowly emerging. These changes will lead us to the end of Ethereum.

There is a two to three-year time window between non-protocol layer PBS (MEV-Boost) and protocol layer PBS (Dankshading). Furthermore, if we jump out of the perspective of Ethereum Layer1, there are also broad cross-domain MEV opportunities in the multi-chain ecosystem and multi-Rollup ecosystem.

IOSG will continue to conduct a series of directional and predictive research and explore implicit investment opportunities from it. Stay tuned!