A detailed analysis of the merged Ethereum transaction supply chain: which participants can capture value?

Author: David Hoffman, Bankless

Translated by: The Path of DeFi

• You will learn how to build blocks on Ethereum and which participants capture value in the process.

• You will understand the mechanism design behind each step.

• You will see how ETH ultimately becomes the winner at the end of this process.

Ethereum "Watershed"

Image Source: Logan Craig

In a post-merge world, Ethereum transactions will go through a very specific and orderly process. A powerful transaction supply chain is being built, and a massive power structure is about to emerge.

The current state of the Ethereum transaction supply chain is rigid and immature. We all submit transactions to the mempool, arbitrage bots emerge and compete for every penny of value, and then miners organize all these transactions to build a block.

After the merge, this process on Ethereum is encoded and defined into the protocol. This fundamentally allows ETH stakers to capture value at every step, ensuring that value is passed to them at the end of the supply chain.

I have said before: the best perspective to fully understand cryptocurrency is through biology.

Crypto is an emerging organic system that mimics natural laws. Although humans are building some structures, the "best structures" discovered are those that mimic nature.

After years of research and development, Ethereum developers have established a transaction supply chain that looks very much like a "watershed." A watershed is a land area that directs rainfall or snowmelt to streams and rivers, ultimately flowing to outlets such as reservoirs, lakes, or oceans.

These raindrops (transactions) are scattered across Ethereum. Some go to Uniswap, some to Aave, some to OpenSea, NFT minting factories, DEX aggregators, bridges, token transfers, and more.

But it doesn't matter where the raindrops (transactions) fall on Ethereum. They will eventually converge to the same place and arrive there through the same process. Each raindrop is unique, falling in a one-of-a-kind location, but natural laws will soon take over, and the droplets will converge into trickles, trickles into streams, streams into rivers, and rivers will ultimately gather at the deepest part of the watershed.

ETH Stakers.

I call this… the Ethereum watershed.

Glossary

For those in the early stages of their crypto journey, this glossary can help you better understand the rest of this article.

• Priority Fee: All transactions on Ethereum incur a priority fee. From the user's perspective, this is essentially synonymous with gas fees. The higher the fee you pay, the faster your transaction will be included in the blockchain, as you increase the incentive for your transaction to be selected.

• Mempool: The mempool is a smaller database that contains unconfirmed or pending transactions held by each node. When a transaction is confirmed by being included in a block, it is removed from the mempool. The mempool is not a standardized entity. Each blockchain node has its own version of the mempool. Sometimes, transactions are only broadcast to specific entities, causing the mempool to be inconsistent across different entities.

• MEV: Maximal Extractable Value (MEV) refers to the maximum value that can be extracted from block production beyond standard block rewards and gas fees by including, excluding, and changing the order of transactions in a block. Anyone with the authority to transact in a block can trade in a way that benefits themselves, ensuring their transactions capture all available arbitrage opportunities.

• MEV Searcher: An MEV Searcher is an automated and highly optimized algorithm that scans the blockchain and mempool for potential arbitrage opportunities and submits transactions attempting to capture those opportunities when found.

• Transaction Bundle: MEV Searchers generate "transaction bundles," which are a set of complex transactions bundled into a single package, but containing many transactions. Like regular transactions, it also carries a priority fee or bribe to be included in a block.

• Block Builder: Block builders bundle all transaction bundles together, along with the highest priority mempool transactions, and construct a block that meets inclusion criteria.

• Block Proposer: You may know another name for block proposers: ETH Stakers. Validator nodes, block proposers propose blocks to be included in the blockchain. This is part of the normal ETH staking process and is the final step in the transaction supply chain.

MEV: How Big Is It?

Every transaction on Ethereum has some value associated with it. If it didn't, the sender wouldn't pay gas fees. Someone is willing to pay something to change the state of Ethereum. People pay to change prices on Uniswap, or to raise or lower liquidation levels on Aave, or to participate in some financial transaction that alters Ethereum's price and value.

Every transaction on Ethereum leaves traces of arbitrage. When someone buys ETH on Uniswap, they confuse its price with all other markets, creating a small opportunity for arbitrageurs to rebalance. All financial transactions leave numerous small opportunities for arbitrage bots.

When you disrupt the balance of a Uniswap pool, arbitrage bots emerge, consuming the arbitrage and outputting a more balanced and healthy ecosystem. The higher the usage of Ethereum, the more total arbitrage opportunities exist. Arbitrage bots are similar to high-frequency traders in TradFi, with millions of algorithms searching for the tiniest discrepancies, all competing to capture that small opportunity.

In dollar terms, the value of MEV is enormous, reaching $672 million. The chart below:

And this is just the early stage of MEV. The value extraction of MEV is a highly lucrative field that will inevitably grow rapidly by orders of magnitude. No one thinks it won't, especially when people generally believe that MEV is not a "solvable problem."

On the bright side, it can be exploited. But on the downside, it could turn your blockchain into an oligarchic hell.

But fear not! Ethereum developers are working on this issue. They have developed a system that harnesses MEV and directs it downstream, then distributes it to the broadest market participants: ETH Stakers.

Ethereum Transaction Supply Chain

Step 0 | Transaction Origin: "Mempool"

Before transactions are embedded into the Ethereum blockchain, they exist in a "unborn" state called the "mempool." As mentioned above, the mempool is essentially all user transactions that have not yet been included in the blockchain.

When you make a transaction on Metamask, you broadcast it to the Ethereum node network. These nodes download this data and store it in their computer memory.

Transactions with the highest priority fees are pulled from the ocean of transactions and added to a block to be included in the blockchain network. This article will describe below how transactions are selected for inclusion, as there are more variables to consider beyond "which transaction paid the highest priority fee."

It is important to note: the mempool is a vast ocean of transactions. Each transaction has a bid associated with its inclusion, and they are all doing something on Ethereum.

All transactions have two potential sources of value associated with them:

• Priority Fee: Users can choose to pay an explicit bribe to gain inclusion.

• MEV: The second-order effects that create arbitrage opportunities on the Ethereum state.

How transactions ultimately become part of the Ethereum blockchain depends on the size of the priority fee and all relevant MEV associated with the transaction.

For example, a transaction with a fee of $0 can be created, essentially asking miners to include the transaction for free. Miners or validators will typically 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," then the transaction will be immediately taken by the first MEV bot that discovers it.

Simply put, all transactions are rewarded, either with explicit priority fees or implicit MEV value. The value of each transaction is captured by the next participant in the supply chain: MEV Searchers.

Step 1 | MEV Searcher: "Micro Arbitrager"

MEV Searchers are highly optimized arbitrage bots.

Each MEV search bot is optimized for a specific type of MEV, with its creators spending significant time and effort to improve the bot to generate better arbitrage and earn more profit.

For example, there will be some searchers highly optimized to exploit imbalances in various AMMs (Automated Market Makers; also known as "decentralized exchanges") in DeFi. If the price of ETH on Uniswap is $1998, while on Sushiswap it is $2002, an MEV bot optimized for DEX arbitrage will create a transaction to capture that price difference and earn some gwei.

The same competition occurs within lending applications like Aave, Maker, or Compound. A significant amount of value is paid to liquidation bots, all competing to liquidate DeFi loans. Over time, we have seen these DeFi liquidation bots compete on smaller margins, ensuring loans are liquidated at the best rates allowed by the market, maximizing the value retained in loans.

There are thousands of MEV search bots scouring the mempool, competing with other MEV search bots for tiny arbitrage opportunities.

As these MEV searchers become better and more energy-efficient, they will be able to chase increasingly smaller arbitrages, organically ensuring that DeFi is an efficient market.

Bundling

These MEV search bots create "bundled" transactions because it typically involves a set of transactions that need to be fully captured to exploit available arbitrage. The bots need to include all these transactions in their operations in a specific order, so they bundle them into a neat little package and then deliver it to the next player in the game: Block Builders.

Like regular traders, each MEV search bot submits a "bid" for each transaction bundle they create. This is the price the bot is willing to pay the block builders to include their bundle. Due to the fierce competition in this MEV arbitrage game, profits become extremely thin.

As these MEV bots are in a fast-paced bidding escalation game, competing for inclusion in blocks, the bids that MEV searchers pay to block builders are nearly equal to the total value of the arbitrage they extract, meaning the amount of value captured by block builders is naturally close to 99.99% of what MEV searchers can extract.

Step 2 | Block Builder: "Macro Arbitrager"

The role of "block building" is straightforward. Block builders aim to construct the most valuable blocks possible and then bid for block proposers (ETH stakers) to accept their blocks.

This sounds simple, but to be as profitable as possible, builders must be highly competitive.

Block building competition has two vectors:

• Hardware and Network

• Order Flow

Hardware and Network

Block builders must undergo a computationally intensive transaction simulation process.

Builders cannot blindly include every transaction bundle without considering its content. Many transaction bundles submitted by searchers will pursue the same arbitrage opportunity, and if a lazy builder includes conflicting transaction bundles, the second transaction bundle will be rejected, and the builder will lose its relevant bid.

Worse yet, block space is precious, and builders must super-optimize the transactions they include in a block.

Thus, block builders undergo an intensive transaction simulation process, during which they play out each transaction to check for conflicts. They will run all possible transaction bundles to find the most profitable combinations, then fill the remaining block with basic mempool transactions and bid to the block proposers to include it.

All of this is done within 12 seconds.

Order Flow

Returning to the earlier mention of the Ethereum mempool…

The mempool is not a standardized entity. The "standardized entity" and "single source of truth" is the Ethereum blockchain. Before a transaction "enters the blockchain," it is in an uncertain 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 willing to listen. After all, you just want your transaction included in a block… but don't care who does it.

However, this is not the case for every actor. Broadcasting a transaction is essentially "showing your cards," telling the world what you want to do. If "what you are doing" represents "I have a bunch of alpha that the market doesn't know," then broadcasting that transaction to all willing nodes will surely cost you every penny of alpha you are trying to gain.

Okay, so you see a bunch of alpha on Ethereum… but if you broadcast your transaction, you will reveal that alpha to some MEV bots, which will definitely front-run you because that's their job.

So what should be done? Private Order Flow.

You don't need to broadcast this transaction to everyone; instead, you reach an off-chain agreement with a mining pool that agrees to process your transaction without broadcasting it to everyone else.

For example, Flashbots has developed "Flashbots Protect" to democratize access to this power. You can check it out here.

The lesson to be learned here: not all mempools are equal. Entities with better mempool visions and access to private transaction order flows will be able to exploit arbitrage opportunities in the rest of the market.

These are the vehicles through which block builders compete: whether through improved hardware and networks or private off-chain agreements for order flow.

Bidding for Blocks

Block builders make money by collecting bids from all transaction bundles from MEV searchers, as well as all priority fees from individual transactions. For example, this could turn into a block that provides them with 2.2 ETH. They will then bid 1.9 ETH for that block proposed by the block proposer in an attempt to capture a 0.3 ETH spread.

Like MEV searchers, block builders will be highly competitive. A truly excellent block builder can generate a block worth 3 ETH and bid 2.2 ETH for it. But another block builder might build a block worth only 2.4 ETH and bid 2.3 ETH for it.

Naturally, rational block proposers will accept the 2.3 ETH bid block, while the builder with the smaller spread will pocket the cash.

Profit margins decline very quickly.

Step 3 | Block Proposer: "ETH Stakers"

The final step is to actually add the block to the blockchain.

ETH stakers running validator nodes simply choose the block with the highest associated bid.

They don't even need to do any work; they just select the most profitable block header and sign a message indicating they approve this block with the full trust and credit of their 32 ETH bond.

Key Points: Achieving Equality Through Mechanism Design

Ethereum developers have spent significant time and research to make ETH staking as easy and democratic as possible, allowing ETH to be staked on basic consumer hardware and using as little ETH as possible (32 ETH; read this thread to understand why it is currently the theoretical minimum).

These are Ethereum's values: making home validation and participation in consensus as democratic and accessible as possible. Regardless of your background, you only need basic consumer hardware and some ETH to participate in Ethereum staking. Applications like Rocket Pool and Lido help lower the barrier of 32 ETH, and in the future, the 32 ETH requirement for individual stakers could potentially be reduced to 16 or even 8 ETH.

We have found that MEV is a significant issue in Ethereum, with the potential to concentrate the supply of ETH in the hands of a few privileged parties who can extract MEV better than anyone else. This reality threatens all efforts to maintain Ethereum's decentralization and democratization.

So, what did the developers do? They leveraged mechanism design to harness MEV and place it in the hands of ETH holders.

As an ETH staker, do you know how to run an MEV search bot? Do you know how to build the most optimized block? Through the above process, you don't need to. The entire supply chain is constrained by the most decentralized and accessible part of the stack: ETH holders.

The profit margins of MEV search bots are maximally compressed in the process of being competed for inclusion by block builders. And the profits of block builders are maximally compressed in the competition for inclusion by block proposers.

Block proposers are ETH stakers. All potential centralization threats from the best MEV search bots are passed to block builders and then to ETH stakers.

And this is very favorable for ETH.

So, will it really end with ETH stakers?

Not necessarily.

Matt Culter from Blocknative believes that this competition will actually return to the origin point of transactions: wallets.

Since every transaction has associated value, wallets become a very active place for consumer interaction. Wallets become sources of proprietary transaction flows. And block builders can leverage transaction flows.

Thus, block builders might pay wallet fees for their transaction flows. For example, a dedicated block builder could pay a lot of money to Metamask to route transactions only to them, rather than broadcasting them to the whole world.

This sounds terrible! Metamask users' transactions will be deceived like Citadel and Robinhood.

But I don't think it will be like that. Instead, I think it will produce something like credit card points or airline miles… rather than actual monetary rewards like ETH or DAI.

Wallets will pay you to use them. Logically, all profits extracted through this process may ultimately revert to the transaction initiators (i.e., you), and your wallet service provider will give you a rebate.

This is the cyclical nature of the Ethereum transaction watershed.

Once the value of transactions converges to a central pool: ETH stakers will evaporate into thin air, it evaporates into the air, condenses into clouds, rains down on the mountains again, returns to the top of the funnel, and provides a continuous source of nourishment for the Ethereum ecosystem.

Thus, a self-sustaining ecosystem is established, allowing a thousand dapps to bloom.