Decentralized Finance (DeFi) is a profound paradigm shift, redefining how the world engages with financial services. At its center, open liquidity provisioning allows for seamless decentralized trading,lending, and more complex financial strategies. In contrast to traditional finance, centralized intermediaries are not required as liquidity providers, instead, users are empowered to bootstrap liquidity.
Automated Market Makers (AMMs) - see e.g. Uniswap - allow anyone to contribute assets to pools and thus facilitate trading. Users are compensated with a share of trading fees, and potentially,idiosyncratic incentives added by parties benefiting from liquidity (e.g. a project issuing a token). AMMs are simple - users may provide liquidity over the entire price range, or for a specific pricing interval.
DeFi composability and the absence of asset custody by intermediaries push market participants to opt for AMMs over centralized exchanges (CEXs). AMMs have the potential to outperform centralized exchanges in terms of liquidity provision (G. Liao and D. Robinson).
Conversely, Decentralized Exchanges (DEXs) driven by a Central Limit Order Book (CLOB) - see e.g. dYdX v4 - demand a substantial pool of assets and ample order book depth for smooth operation. A CLOB is adept at consolidating liquidity around the market price and has the flexibility to adjust quotes as needed.
However, the process of actively matching buy and sell orders to connect traders is complex and rewards sophistication. Market makers in CLOB-based DEXs must consistently update their positions to prevent their orders from becoming stagnant. This dynamic nature of CLOBs, while offering powerful tools for price discovery, also renders liquidity provision a more intricate endeavor. This complexity is particularly pronounced for those traders who may not have access to real-time market data, as remaining profitable in such an environment requires a deep understanding of market dynamics and order flow.
AMMs and decentralized CLOBs are the dynamic engines driving the DeFi ecosystem. For Liquidity Providers (LPs) navigating the DeFi landscape, a central challenge looms – adverse selection, as extensively explored in J. Milionis et al for AMMs and U. Natale et al for CLOBs. This article delves deep into these mechanisms, highlighting challenges and opportunities facing LPs. We’ll zoom in on Uniswap v3, the most widely used AMM, to explore the complexities and potential solutions in this dynamic landscape. In the final section, we argue that staking, specifically with a validator optimizing for MEV, is a way of recouping potential losses.
Uniswap is the leading DEX by volume with $1.5 trillion in lifetime volume since its 2018 debut (cfr. DefiLlama), and over $1 trillion alone processed by Uniswap v3 (H. Adams et al). Central to its operation is the concept of concentrated liquidity (CL), empowering LPs to offer assets within specific price ranges. LPs facilitate the smooth flow of assets and liquidity, making the success of these AMMs critically dependent on LPs participation, who provide liquidity in exchange for trading fees.
For LPs participating in AMMs, the primary challenge is adverse selection, cfr. J. Milionis et al. This issue arises because parties with access to real-time market prices can exploit price discrepancies between AMMs and other platforms. These transactions often involve arbitrage between CEXs and DEXs. To succeed in capitalizing on price disparities, individuals need not only priority access to the first few on-chain transactions in a block (T. Gupta et al) but also the ability to execute high-quality trades on CEX. This transaction flow between different venues forms the backbone of efficient AMM trading, however, it can have adverse effects on LPs via adverse selection.
In U. Natale et al, we evaluate how pricing on dYdX v4 could be impacted by the presence of another CLOB with higher liquidity, for a given asset - e.g. on a CEX. However, it's important to note that this platform is not live at the moment. This means that making an exact comparison of the profitability of professional Market Makers in a decentralized order book like dYdX v4 is currently unfeasible. Consequently, for the remainder of our analysis, our primary focus will be on Uniswap v3, where Concentrated Liquidity presents opportunities and challenges worth exploring.
Estimating the effective profit & loss (PNL) for a LP has been a subject of extensive study in literature. One widely debated estimator, frequently discussed in the context of the profitability of ETH/USDC LPs on Uniswap v3, revolves around markouts, as outlined in a series of medium articles by Ambient finance, formerly known as CrocSwap. However, it's crucial to highlight that markouts, as an estimator, may not present a holistic view of LP profitability on Uniswap v3.
This is because markouts typically overlook the genuine liquidity and the precise price range within the pool. Consequently, they may overlook changes in the value of the numéraire within the pool, focusing solely on the risky asset's fluctuations. The omission of these critical factors can significantly impact the accuracy of LP profitability assessments.
In order to avoid possible biases in the analysis, we decided to use an estimator that is dependent on the actual variation in pool value, see here for the description of the mathematical framework.
To estimate the PNL, we built a Dune Analytics dashboard, where we consider the USDC/ETH pool with 0.05% fees.
The picture above shows the final Pool’s PNL since the beginning of the year, which corresponds to a general gain of around $35M. Let’s observe that, to achieve this figure, we need to consider the total TVL as capital deployed for the strategy. At current TVL of $206.59M, this corresponds to a 16.9% gain, instead, by considering the maximum historical TVL (~$320M) the total gain since the beginning of the year is around 10% of the capital deployed.
If we focus on the PNL from pool value variation, i.e. no fees, we can see how the overall gain is primarily driven by accrued fees. Indeed, the adversarial selection produced - at time of writing - a loss of $400k, with a maximum loss of ~$1M in May.
If we compare with the ETH price movement during the same time period, we can see that this effect is primarily driven by the movement in ETH price.
More precisely, this is an effect related to price volatility, as shown in Milionis et al. Indeed, when price volatility sharply increases, the price discrepancy between Uniswap v3 and other venues also increases, amplifying the MEV size. The two plots below show the pool value variation due to Toxic Flow and the correlation between pool value from toxic flow and spikes in volatility (24h Moving Average). Here by Toxic Flow we indicate all the transactions coming from informed traders that generate a negative PNL for the LPs. Given the nature of DEXs, informed traders aim to include their transactions in the top part of the block (we used the first 10 txs in the block) to avoid price movements due to market activity.
Before concluding this section, it's worth mentioning that, despite the PNL of $35M due to the accrued fees, being competitive and effectively implementing a strategy that generates a positive PNL is a complex undertaking. This is because there are sophisticated LPs, and the accrued fees need to be divided among all participants. Barriers to entry include access to highly performant price feeds and pricing models, as well as optimized execution. Furthermore, the previous estimator considers the PNL from the pool value, inherently assuming that the entity deploying the strategy has infinite capital that can be allocated each time the price moves. If we utilize the estimator defined in Eq. (8) of this document, we can illustrate how an LP with a fixed initial amount deployed in the liquidity provision strategy experiences a PNL of -30% (without accounting for the fees), as demonstrated below.
Additionally, by updating the positions every minute, the LP accumulates a total gas cost of $2M since the beginning of the year. It's important to note that this cost can be hedged with solutions like Alkymia, in which Chorus One has invested.
We have seen how LPs, who diligently provide liquidity, may face losses as arbitrageurs exploit price differences between centralized and decentralized platforms. Staking represents a strategic approach for LPs to recapture a portion of the extracted MEV. This is particularly advantageous when LPs choose validators that are actively working to optimize MEV yields, like Chorus One (see previous chapter). By aligning their staked assets with validators who specialize in maximizing MEV yields, LPs can amplify their returns while bolstering their resilience against the challenges of adverse selection.
This endeavor is not about exploiting MEV at the expense of the ecosystem but rather about recapturing it for the benefit of those who contribute to the DeFi landscape. Maximizing MEV yields is a way to ensure that the value generated from the MEV ultimately flows back to the stakers, aligning incentives and fostering a fairer and more rewarding DeFi ecosystem. Moreover, the staked amount can be thoughtfully hedged against price fluctuations using external sources, creating a comprehensive strategy to safeguard LPs' investments and enhance their gains.
In summary, LPs, who play a pivotal role in DeFi liquidity provision, can employ a multifaceted strategy combining liquidity provision, staking, and hedging to mitigate the impacts of adverse selection and recapture a portion of the extracted MEV. By making strategic choices in validator selection and actively managing their positions, LPs can navigate the complexities of the DeFi landscape and emerge as resilient and profitable participants.
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 45+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
Chorus One is proud to introduce our new research effort, fueled by a grant from dYdX, that examines the implications of Maximum Extractable Value (MEV) within the context of dYdX v4 from a validator's perspective. This comprehensive analysis presents the first-ever exploration of mitigating negative MEV externalities in a fully decentralized, validator-driven order book. Additionally, it delves into the uncharted territory of cross-domain arbitrage involving a fully decentralized in-validator order book and other venues.
This paper, marking a significant milestone in exploring MEV dynamics, identifies factors that influence undesirable MEV extraction, and proposes concrete strategies to level the playing field in derivative trading by counteracting such behavior.
dYdX v4 signifies a transformative phase in the evolution of the dYdX protocol. It embraces a fully decentralized derivatives exchange built on a central limit order book (CLOB). Unlike previous iterations, which combined smart contracts with centralized services, v4 employs a decentralized off-chain order book and a high-performance matching engine. This architecture, powered by the CometBFT consensus and Cosmos SDK, strives to achieve scalability alongside decentralization while allowing community-driven protocol development.
This transition signifies a substantial shift, as v4 introduces the industry's first truly decentralized perpetual futures exchange. Validators will manage the order books, with meticulous steps taken to ensure fair and trustless trading through effective negative MEV mitigation.
Set against the backdrop of this pivotal upgrade, our paper serves a crucial purpose by shedding light on the complexities of mitigating bad MEV on dYdX v4, thus equipping the community with the resources needed to navigate the upcoming transition. By providing comprehensive insights, our analysis aids in anticipating the impact of MEV on the new chain and trading experience, as well as the wider Cosmos ecosystem, ultimately fostering informed decision-making.
Our analysis uncovers pivotal insights that reverberate across the ecosystem:
Finally, our research extends beyond insights to practical solutions for mitigating validator-driven MEV risks. We propose that such MEV might manifest through partnerships between trading firms and market makers, favoring those with established advantages. We underscore the risks associated with harmful MEV, including asymmetric risk for delegators. Even in optimistic scenarios, potential revenue from partnerships may not fully offset these risks. To address this, we suggest a combination of measures including potential penalties and flexible unbonding periods for re-delegation to ethical actors, aiming to effectively manage validator-driven MEV risks.
At Chorus One, we leverage a sophisticated and ethical set of MEV strategies to optimize our validators' performance and continuously monitor progress. Backed by in-house experts and extensive research, we deploy various infrastructural solutions such as relay optimization, latency games, and investing in robust machines to improve our MEV performance. Learn more about Chorus One's winning MEV strategies by reading our recent blog.
For a comprehensive exploration of our research on MEV implications within dYdX v4, we invite you to read the full research paper here.
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 40+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
The staking economy is a thriving industry, offering over $12 billion in rewards, with $600 million attributed to Maximal Extractable Value (MEV). At Chorus One, we deeply recognize the significance of MEV for both validators and investors, which has fueled our commitment to continuously optimize our infrastructure to ideally integrate with the Ethereum MEV pipeline.
MEV serves as a gateway for validators to maximize the value extracted from transactions within a block. As early as 2019, the research paper "Flash Boys 2.0," authored by Ari Juels and Lorenz Breidenbach, shed light on its real-world impact, particularly in decentralized exchanges and user experiences. The cumulative value of MEV extracted on Ethereum alone surpassed $78 million in early 2021 and has skyrocketed to an astonishing $600 million in 2023.
MEV has become a cornerstone of Chorus One's research efforts. As one of the earliest and most influential contributors to MEV research, we conduct in-house studies and experiments to optimize MEV yield. Notably, we were commissioned by dYdX to produce an in-depth report on MEV within dYdX v4, and released the first public tracker of (pre-protorev) MEV on Osmosis (@chorusonemev). Furthermore, we have developed a customized version of the Solana client to capture MEV opportunities on the Solana network.
To achieve the highest possible MEV yield, employing effective infrastructure strategies is paramount. At Chorus One, we conduct a series of experiments to identify the most efficient combination of strategies, aiming to optimize our MEV performance. Below, we delve into the fundamentals of MEV extraction, exploring the solutions we implement to improve our performance.
In general, MEV empowers block producers to rearrange, include, or exclude transactions, providing advantages that can impact users. However, there is a subtle distinction in how MEV operates on Ethereum compared to other blockchain networks.
On Ethereum, the process involves a 'block builder' constructing the block, which is then passed on to a 'relay' before being proposed by a validator. This Proposer-Builder Separation (PBS) introduces a separation between the block producer and the proposer. As an Ethereum validator, Chorus One focuses on optimizing MEV rewards by fine-tuning our interaction with relays.
Conversely, on most other chains, validators themselves build the block and have the freedom to prioritize transaction sorting to maximize MEV rewards.
We continuously optimize our infrastructure to capture the highest possible MEV rewards.
The following graph illustrates our performance over a 60-day period. Over this time period, Chorus One nodes have captured close to 14% more MEV rewards per validator (ETH) when compared to the weighted industry average, observed on Lido.
*Please note that this is a snapshot, and that MEV rewards fluctuate as a function of variance and market conditions. Please visit Rated Network to view the latest figures.
This process of continuous infrastructure optimization highlights the significance of employing a combination of well-established best practices to achieve higher MEV rewards. By utilizing specific methods in tandem, validators can effectively maximize their MEV yield. More on this below.
Before diving into Chorus One's approach, we briefly explore the process of extracting MEV. It involves key players with distinct roles:
Block Producers: They create blocks of transactions on the blockchain, deciding which transactions to include and their order.
Relays: A relayer is an entity responsible for checking blocks before passing them to the block producers. The relay confirms the builder blocks for validity and estimate the MEV-related value of each block. By tweaking how block producers/validators interface with relays, they can add value by optimizing MEV rewards.
Searchers: These individuals or automated bots constantly monitor the blockchain, searching for profitable opportunities to manipulate transaction order and earn additional profits through MEV.
DApps and Protocol Developers: Decentralized applications (DApps) and the developers who create rules for block producers support MEV extraction. DApps create opportunities for MEV extraction through their design, while protocol developers establish rules that enable block producers to capture MEV.
In simpler terms, block producers create blocks,relays check the blocks, searchers seek ways to profit by manipulating transaction order, and DApps and protocol developers provide the framework and incentives for MEV extraction.
Validators often employ similar solutions to increase rewards and actively seek optimization opportunities. For instance, MEV-Boost, an implementation of proposer-builder separation (PBS) developed by Flashbots for Ethereum, enables validators to maximize staking rewards by selling block space to builders in an open market.
MEV-Boost is free, open-source, and neutral software designed to democratize MEV while minimizing associated negative implications, such as consensus-layer security risks, centralization, or the risk of searchers going rogue. For more information on MEV-Boost software, visit https://boost.flashbots.net.
MEV plays a significant role in yield generation on networks like Ethereum, and as a result, our nodes are MEV-boost enabled by default.
With a team of in-house experts, we continuously adjust our infrastructure to optimally integrate with the Ethereum MEV pipeline.
1. Relay Selection
Relays are crucial intermediaries in the MEV extraction process, acting as trusted connectors between block builders and validators. Their primary role is to facilitate seamless data exchange and ensure the selection of the most lucrative bids for validators. We continuously conduct experiments to identify the optimal combination of relays (as shown in the relay market dashboard below) , aiming to establish efficient communication and achieve the highest valid bid submission to validators.
Our approach: By carefully selecting the best relays, we enable our validators to receive winning bids from all connected relays.
2. Latency Games
Exploring the dynamics between builders, relays, and validators is even more interesting with a new dimension: time.
Latency, the delay in data transmission, has gained significant importance for relays and the entire MEV supply chain, leading to notable consequences. It acts as a centralizing force within the MEV supply chain, with relays having shorter latency likely to be more successful in auctions. This preference encourages builders to prioritize sending their blocks to those relays.
Our approach: We optimize our connection to relays when requesting blocks by prioritizing payoff and minimizing the probability of a missed slot.
3. Infrastructure Optimization
On the infrastructure and hardware front, we prioritize optimizing the performance of our validators. Through the strategic selection of hardware, geographical distribution, and client implementation, we ensure that our infrastructure operates at its peak efficiency. This optimization enhances the rewards generated for our customers.
Our approach: We are actively investing in and expanding our infrastructure to further elevate performance and rewards.
TL;DR: More rewards, more revenue.
Through our unique solutions and ongoing research, we continuously push the boundaries to enhance the rewards obtained through MEV. Today, our MEV-boost enabled nodes capture significantly higher APR on staked ETH, surpassing the yield of the average validator.
To learn more about our approach to MEV, visit: https://chorus.one/mev-maximum-extractable-value
To stake with Chorus One, reach out to staking@chorus.one and we'll get back to you.
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 45+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
MEV has become a much-discussed topic in recent years, progressing from a niche area of research to a full-fledged ecosystem and a lucrative source of validator revenue. In the article below, we’ll explore how we leverage MEV to boost staking rewards in Ethereum, what are its implications for stakers, and even understand what exactly is MEV.
First things first, MEV generally stands for “maximum extractable value” and refers to the total amount of economic value that can be gained as a function of the ordering of transactions in a block.
For example, a user may swap a large amount of token A for token B on a decentralized exchange (DEX), affecting the exchange rate between these two assets.
If this rate is then inconsistent with the pricing in the wider market, traders (“searchers”) can take advantage of the imbalance through arbitrage. Intuitively, a trader would be rewarded for committing capital to re-establish efficient pricing.
It is easy to intuit that there are desirable and less desirable forms of MEV.
For example, arbitrages and loan liquidations serve to increase and preserve the integrity of on-chain capital markets. These types of transactions take place after an opportunity has been created, i.e. these are often referred to as “back-running”.
On the flip side, there is a class of transactions characterized as “front-running”. These strategies involve creating or compounding a profit opportunity by submitting a trade before a user transaction hits the chain.
While there are some counter-arguments, most people agree that front-running increases transaction costs for ordinary users, and it is, therefore, less desirable than back-running, which can in theory decrease user transaction costs (e.g. through efficient pricing).
The upshot is that the feasibility of any MEV-type trade is dependent on the ordering of transactions in the block.
Ideally, a searcher would like to trade directly after the opportunity has been created. There are some exceptions to this (i.e. where the opportunity will compound with other transactions), but in any case, there is always an ideal timing for a trade when there’s money on the table. And there are sophisticated actors waiting to exploit these opportunities.
Validators ultimately control the ordering of transactions in a block. As there is always an ideal timing to trade (or the best estimate thereof), searchers are incentivized to bargain with validators to ensure their transactions are placed well.
On Ethereum, this process has been automated via an auction system, spearheaded by the Flashbots team. In this post-Merge, Proof-of-Stake Ethereum world, the main tool to perform these auctions is called “mev-boost”. This is a private communication channel between searchers and validators, which allows the efficient pricing of a block. As a result of this, validators receive “tips” for proposing the most price-efficient block, on a secure commit-reveal scheme.
We have created some tools to decode MEV and ‘mev-boost’ transactions under Proof-of-Stake Ethereum, check our Dune Analytics dashboard.
The higher the network penetration score of an individual validator or group of validators (known or unknown), the more chances it will get to propose blocks, and consequently benefit from a block price auction, which is often a matter of luck. Validators under these conditions are also more likely to be present when particularly lucrative opportunities occur, and so luck turns into opportunity.
This means that a large validator set working together is more likely to generate smooth staking returns, versus a small validator with more irregular windfalls.
For stakers, this process results in additional rewards that are immediately accessible on the Execution Layer of the network — responsible validators share a portion of MEV rewards with stakers.
Volatile markets generate more MEV opportunities through collective price discovery, and various inefficiencies which reveal themselves in unusual conditions. For example, more liquidations if the ETH price drops significantly below what market participants expect.
Therefore, you can expect your staking rewards to go up in conditions of uncertainty.
Profits from on-chain trading can be enormous. For example, the all-time largest MEV arbitrage on Ethereum in June 2022 yielded a gross profit of 2518.5 ETH; of this sum, 74.52 ETH went to the block proposer.
A well-thought-out MEV strategy can boost your staking returns significantly. For example, in March 2023, up to 15% of validator revenues have been derived from MEV so far. At Chorus One, we have experimented with different mev-boost setups and relayers, always working on tweaking our strategy to reach higher levels of efficiency. Moreover, we only charge a small staking commission on all returns, allowing you to keep the vast majority of MEV rewards your validator generates. We wrote about how we view MEV and our policies here: Chorus One’s MEV Policy: Transparency, Sustainability, Reward Optimization.
Optimization of MEV rewards coupled with our performant infrastructure and round-the-clock supervision allows us to deliver highly competitive returns to our delegators, sometimes exceeding other validators by up to 30%. Don’t take our word for it, real-time statistics can be accessed via Rated.
Chorus One is a leading advocate for MEV transparency and efficiency. Our team has been at the forefront of MEV research, actively developing solutions to support the nascent yet rapidly evolving MEV landscape. We have executed MEV-type transactions on both Solana and Cosmos, and our recent release of an open-source MEV-client on Solana demonstrates our commitment to advancing the space. Additionally, our expertise in the MEV domain has been recognized with a grant from dYdX to produce a comprehensive report on MEV for their v4 platform.
Reach out to us at sales@chorus.one to understand more about how our MEV-enabled infrastructure can help you earn superior returns.
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 35+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures. We are a team of over 50 passionate individuals spread throughout the globe who believe in the transformative power of blockchain technology.
For more information, please visit chorus.one
