CoinEx Introduction: Can Retail Investors Benefit from the Huge Profits of MEV Arbitrage?

During the DeFi boom in 2021, crypto users started to discuss MEV arbitrage, a shortcut to digital wealth. Traders and arbitrage bots have been making a fortune from this seemingly unremarkable profit channel. MEV arbitrage has been highly controversial because it made the ETH network more congested and less fair. Though there have been extensive discussions on how to solve and prevent MEV arbitrage, so far, most people find it impossible to stop MEV arbitrage. As such, more tools have been developed to make MEV arbitrage more convenient and transparent. That said, what is MEV? How is arbitrage achieved? Can the average investor benefit from MEV arbitrage?

What is MEV?

Many people may think that MEV (Miner Extractable Value) is only relevant to miners or that only miners can benefit from it. However, in reality, most of the MEV profits are taken by traders and arbitrage bots, rather than miners. Instead of “miner extractable value”, what MEV produces is the value that users generate therefrom.

The story behind MEV starts from centralized exchanges. Anyone who had experienced crypto investments and trades in the early days of the market must be familiar with the term “arbitrage”. Back then, centralized exchange was still a new concept. Most of the centralized exchanges were in their infancy, and the market-making systems were far from mature. These platforms significantly differed in terms of user base and liquidity. Furthermore, the price difference for fiat-based trading was huge. For instance, while ETH was sold on platform A at $100, the ETH price on platform B might be $110 at the same time. If you moved fast, then you might be able to purchase ETH at $100 on platform A and sell it on platform B for $110. In this ideal scenario, one ETH translated to a profit of $10. Sounds appealing, right? Indeed, the profits from arbitrage were extremely high in the early stage of the crypto market.

Apart from this, centralized exchanges also feature an arbitrage opportunity for market makers. Let us assume that the best bid price of a token is $100, the best ask price is $105, and the latest trade price is $102.5. In this case, it may seem that there is a great arbitrage opportunity. However, if retail investors start to buy and sell the token for arbitrage, they often end up buying the token at $105 and selling it at $100, and the market maker would profit from the $5 spread.

The reason for this is: To provide liquidity, market makers need to place both ask and bid orders. Moreover, market makers are also responsible for creating market depth, which is why they often sell at, for example, 105, 110, and 115 and buy at 100, 95, and 90 (the actual spread between the price gradients of market makers is not as significant). Ordinary users tend to conclude the deal at the market price for fast trades because they do not have the patience to keep track of the trade records all the time. As a result, retail investors often buy high and sell low, with the spread earned by market makers. Despite this, most market makers profit from arbitrage through low fees and frequent trades. It should be noted that not every market maker can make a profit. For laymen, arbitrage through market-making is likely to bring losses, rather than profits.

Is arbitrage possible on decentralized exchanges? The answer is yes. Arbitrage on DEX is known as “miner extractable value”. So, what does it have to do with miners?

To engage in arbitrage, given that the opportunity may disappear at any moment, the most important requirement is that the transaction must be fast. However, in the case of DEX, all transactions are conducted on the blockchain, and it is the miner, rather than the exchange, who determines the transaction speed. To be more specific, miners can freely choose which transaction to pack because, on blockchains, the space of each block and the number of transactions that can be confirmed are all limited. Generally speaking, when multiple transactions need to be confirmed, miners will prioritize transactions with higher fees. Of course, if a miner and an arbitrageur are working together, the miner may prioritize the transaction at lower fees for a share in the arbitrage profit. This is why arbitrage on DEXs is called miner extractable value.

What methods are there to benefit from MEV arbitrage?

The first and most common type of MEV arbitrage taps into the price spread of different DEXs. In other words, the different token prices on DEXs give rise to arbitrage. More specifically, those who found an arbitrage opportunity can purchase a token at low prices on one exchange and sell it on another where the token price is higher.

The second type of MEV arbitrage is more complicated and encompasses three scenarios: “front-running”, “back-running”, and “sandwich attack”. Although market makers on centralized exchanges are well-established, market-making on decentralized exchanges is automatic and driven by algorithms. On DEXs, since liquidity pools are provided by users, there is no guarantee on the scale of funds, which means there is a lack of liquidity and market depth. Therefore, external players can tap into the arbitrage opportunity created by the fluctuations of big buy/sell orders. In front-running, once a big purchase order is discovered, the trader or arbitrage robot can pay a substantial transaction fee for purchase at a lower price ahead of a buyer, and then sell it to the target victim at a higher price. This process creates a front-running arbitrage. When there is a big sell order, the arbitrager can back-run the order to obtain arbitrage profits through a short. This process is referred to as MEV back-running arbitrage. Combining the above two strategies, a sandwich attack places the target in between for arbitrage profits. On DEXs, every trade incurs certain costs (even if the trade is not executed). That said, how do arbitragers achieve their targets with precision? The answer is that they can quickly confirm a transaction and engage in arbitrage relying on miners’ confirmation priority or by collaborating with miners in a joint arbitrage action.

Another question is: How can arbitragers identify these big orders? The answer is that the pending transactions in the memory pool of blockchains are open to all. Therefore, traders, arbitrage bots, and miners can trace the opportunities for arbitrage like a hunter after his prey.

Can the average person engage in this type of arbitrage? According to statistics from MEV-Explore, from January 2020 to now, total MEV profits in the crypto market have exceeded $750 million in 21 months. In the last 30 days, total MEV profits generated by blockchain users were approximately $15.6 million. In theory, the above arbitrage strategies can be applied by anyone. However, in reality, the average user faces more challenges than expected.

First of all, in the race against professional traders and arbitrage bots, the regular user’s chance of winning is close to zero. Secondly, arbitrageurs do seek cooperation with miners to lower the probability of failures, yet the miner responsible for packaging the relevant transaction is selected randomly. As such, an arbitrageur needs to work with a large number of miners to significantly increase the chances of prioritized confirmation, which means the arbitrageur must be a giant investor or institution. In any case, such capacities are beyond the reach of retail investors, which is why it is very challenging for them to engage in MEV arbitrage.