Compilation of the original text: The Way of DeFi
Original source:Bankless
Compilation of the original text: The Way of DeFi
In this article, we will introduce the merged Ethereum transaction lifecycle.
You'll learn how blocks are built on Ethereum, and which actors capture value along the way
You will learn about the mechanism design behind each step
You will see how ETH is the ultimate winner at the end of the process
Image credit: Logan Craig
Image credit: Logan Craig
In the merged world, Ethereum transactions will go through a very specific and orderly process. A powerful trading supply chain is being built, and a huge power structure is about to emerge.
The current state of the Ethereum transaction supply chain is blunt and naive. We all submit transactions to a mempool, arbitrage bots come along and compete for every penny of value, and then miners collate all of these transactions to build a block.
After the merger, this process was codified and defined into the protocol on Ethereum. 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 before: the best lens to fully understand cryptocurrencies is through biology.
Cryptography is an emerging organic system that mimics the laws of nature. Although humans are building some 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 Watershed. Watersheds are areas of land that channel rainfall or snowmelt into streams and rivers, and eventually to outflow points such as reservoirs, lakes or oceans.
These raindrops (transactions) are all over Ethereum. Some went to Uniswap, some to Aave, some to OpenSea, NFT foundries, DEX aggregators, bridges, token transfers, etc.
But it doesn't matter where the raindrops (transactions) land on Ethereum. It will eventually converge to the same place and go through the same process to get there. Every drop of rain is unique and falls in a unique place, but soon the laws of nature take over and the drops converge into trickles, which converge into creeks, which become rivers, which eventually converge in deepest part of the basin.
ETH Stakers (pledgers).
I call this the...Ethereum Watershed.
Glossary of terms
For those of you who are in the early stages of your crypto journey, this glossary can help you better understand the rest of this article.
Priority Fee:All transactions on Ethereum have priority fees. From a user perspective, this is basically synonymous with gas fees. The more fees you pay, the faster your transaction gets included in the blockchain, because you increase the incentive for your transaction to be selected.
Memory pool (Mempool):The mempool is a smaller database of unconfirmed or pending transactions kept by each node. When a transaction is confirmed by being included 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 Finder:The MEV Searcher (MEV Searcher) is an automated and highly optimized algorithm that scans the blockchain and mempools for potential arbitrage opportunities, and when one is found, submits a transaction attempting to capture it.
Transaction Bundle:The MEV searcher generates "transaction bundles", which are a group of complex transactions bundled into a package, which is a single transaction but contains many transactions. Just like a normal transaction, it comes with a priority fee or bribe to be included in a block.
Block Builder:The block builder bundles all transactions together, along with the highest priority mempool transactions, and constructs a block eligible for inclusion.
Block Proposer:You may know block proposers by another name: ETH Staker. Validating nodes, 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 kind 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, or to increase or decrease the liquidation level on Aave, or to participate in some kind of financial transaction that changes the price and value of Ethereum.
Every transaction on Ethereum creates an arbitrage trail. When someone buys ETH on Uniswap, they confuse its price with every other market 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 appear, consume the arbitrage, and output a more balanced and healthy ecosystem. The higher the usage of Ethereum, the greater the total amount of arbitrage that exists. Arbitrage bots are similar to high frequency traders in TradFi, there are millions of algorithms looking for the tiniest difference, all racing to capture that tiny opportunity.
If defined in US dollars, the value of MEV is very large, reaching 672 million US dollars. The following figure:
And this is just the early days of MEV. MEV value capture is a very lucrative field that is bound to grow rapidly and by orders of magnitude. Nobody thinks it won't, especially when it's widely believed that MEV is not a "solvable problem".
At best, it can be exploited. But at worst, it can turn your blockchain into an oligarchy of hell.
Watch: The existential crisis of cryptocurrencies
But fear not! Ethereum developers are working on this issue. They have developed a system that utilizes MEVs and streams them downstream for distribution to the widest range of market participants:ETH stakers.
Ethereum transaction supply chain
Step 0丨Transaction Origin: "Memory Pool"
Before transactions are embedded in the Ethereum blockchain, they exist in this "unborn" state called the "mempool". As mentioned above, the mempool is basically all user transactions not yet 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 pulled from the ocean of transactions and added to a block into the blockchain network. This article describes how transactions are selected for inclusion in the remaining steps below, as there are more variables to consider than "which transaction paid the highest priority fee".
Note: the mempool is a huge ocean of transactions. Every transaction has a bid associated with its inclusion, and they all do something on Ethereum.
All transactions have two underlying sources of value associated with them:
Priority fee:Users can choose to pay an explicit bribe for inclusion
MEV ：Second-order effects that create arbitrage opportunities on the state of Ethereum
How a transaction ends up being part of the Ethereum blockchain depends on the size of the preferred fee and all associated MEV for the transaction.
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 this transaction. 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 picked up by the first MEV bot that spots it.
Simply put, all transactions are rewarded, either an explicit priority fee or an implicit MEV value. The value of each transaction is captured by the next players in the supply chain: MEV Searchers.
Step 1丨MEV Searcher: “Arbitrager”
MEV Finder is a highly optimized arbitrage bot.
Every MEV search bot is optimized for a 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 search engines that are highly optimized to arbitrage the imbalance of various AMMs (automated market makers; aka “decentralized exchanges”) in DeFi. If ETH is $1998 on Uniswap and $2002 on Sushiswap, a MEV bot optimized for DEX arbitrage will create a trade that captures the spread and earns 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 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 search bots scouring the mempool, competing with other MEV search bots for arbitrage of minimal value.
As these MEV seekers get better and more energy efficient, they will be able to compete for smaller and smaller arbitrage, organically ensuring that DeFi is an efficient market.
tie up
These MEV search bots create "bundles" of deals, as it is usually a group of deals that need 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 and ship it to the next players in the game: the Block Builders.
Just like regular traders, each MEV search bot submits a "bid" for each trading package they create. This is the price a bot is willing to pay a block builder to include their bundle. As this MEV arbitrage game is highly competitive, margins are extremely thin.
Since these MEV bots are in a rapid bidding escalation game, fighting for inclusion in blocks, MEV Seekers pay block builders nearly the full value of the arbitrage they extract, meaning block builders capture The amount of value is naturally close to 99.99% of what MEV searchers can extract.
Step 2丨Block builders: "macro arbitrageurs"
The role of "block building" is straightforward. Block builders build the most valuable blocks possible and then bid for block proposers (ETH stakers) to accept their blocks.
It sounds simple, but in order to be as profitable as possible, builders must be highly competitive.
There are two vectors for block building 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 considering its content. Many deal bundles submitted by a searcher will pursue the same arbitrage opportunity, and if a lazy builder includes conflicting deal bundles, the second deal bundle will be rejected and the builder will forfeit its associated bid.
Too bad block space is at a premium and builders have to hyper-optimize the transactions it includes in a block.
Therefore, block builders go through an intensive transaction simulation process where they broadcast each transaction to check for conflicts. They will run through all possible bundles of transactions to find the most profitable combination, then fill the remaining blocks with basic mempool transactions and bid to block proposers for inclusion.
All of this is done in 12 seconds.
Check out Blocknative's Trading Simulation Platform
order flow
Going back to what I said above about the Ethereum mempool...
Memory pools are not a canonical thing. The "canonical thing" and "single source of truth" is the Ethereum blockchain. Before a transaction "enters the blockchain", it is in an indeterminate state.
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 is willing to listen. After all, you just want transactions to be included in blocks...but don't care who does it.
However, this is not true for every actor. Broadcasting deals is really "showing your cards", telling the world what you want to do. If "what are you doing" means "I have a bunch of alpha that the market doesn't know about", then broadcasting that transaction to all nodes that will listen is sure to cost you every penny of the alpha you're trying to gain.
Watch a very old Bankless episode: "Ethereum Is a Dark Forest"
Okay, so you're seeing a bunch of alpha on Ethereum...but if you broadcast your transaction, you're revealing that alpha to some MEV bot, and they're bound to pre-empt it, because that's what they do.
So what should be done?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.
Flashbots, for example, have developed "Flashbots Protect" to democratize access to this power. you canview here。
Lesson to be learned here: Not all memory pools 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 vehicles for competition among block builders: whether through improved hardware and networks, or private off-chain protocols for order flow.
bidding block
Block builders make money by collecting bids for bundles of all transactions from MEV Seekers, and all prioritized fees from individual transactions. For example, this would turn into a block that would give them 2.2 ETH. They will then bid 1.9 ETH on the block proposed by the block proposer in an attempt to get a 0.3 ETH difference.
Just like MEV searchers, block builders will be highly competitive. A really good block builder can generate a block worth 3 ETH and bid 2.2 ETH for it. But another block builder could build a block worth only 2.4 ETH and bid 2.3 ETH for it.
Naturally, rational block proposers will accept bid blocks at 2.3 ETH, while builders who accept the smaller difference pocket the cash.
Profit margins are falling very fast.
Step 3丨Block proposer: "ETH Stakers"
The last 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, just choose the most profitable block header and sign a message that they approve this block with the full trust and credit of a 32 ETH bond.
Key takeaway: 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, to make ETH stakeable on basic consumer hardware, and toUse as little ETH as possible (32 ETH, read this thread to understand why it is the current theoretical minimum number)。
These are the Ethereum values:Make family validation and consensus participation as democratic and accessible as possible. Regardless of your background, all you need is basic consumer hardware and some ETH to participate in staking on Ethereum. Application-layer innovations like Rocket Pool and Lido help lower the 32 ETH threshold, and in the future, 32 ETH could be lowered to 16 or even 8 for a single staker.
We've found MEV to be a big problem in Ethereum, with the potential to centralize the supply of ETH to a few privileged parties who can extract MEV better than anyone else. This reality threatens all efforts to keep Ethereum decentralized and democratized.
So, what did the developers do? They utilize mechanism design to leverage MEV and place it in the hands of ETH holders.
As an ETH staker, do you know how to run the MEV search bot? Do you know how to build optimal blocks? With the above process, you don't need to do this. The entire supply chain is subject to the most decentralized and accessible part of the stack:ETH holders.
Profit margins for MEV searcher bots are squeezed to the max as block builders fight for inclusion. The profits of block builders are minimized in the competition of block proposers for inclusion.
Block proposers are ETH stakers. All potential centralization threats from the best MEV search bots are passed on to block builders and then to ETH stakers.
And this is very good for ETH.
So, does it really end here with ETH stakers?
uncertain.
Matt Culter of Blocknativeargues that this competition actually goes back to the point of origin of the transaction:wallet.
Since each transaction has an associated value, the wallet becomes a very active place for consumer interaction. Wallets become sources of proprietary transaction streams. And block builders can take advantage of the transaction flow.
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! Transactions of Metamask users will be spoofed like Citadel and Robinhood.
But I don't think that will be the case. Instead, I think it yields things like credit card points or airline miles...not actual monetary rewards like ETH or DAI.
Wallets 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.
This is the cycle of the Ethereum transaction stream.
After the value of the transaction is pooled in a central pool: ETH stakers evaporate into the air, it evaporates into the air, condenses into a cloud, rains down the mountain again, returns to the top of the funnel, and feeds the Ethereum ecosystem Constant nourishment.
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