BIS Paper Takes Aim at Crypto Miners “Front-Running”
Posted by Colin Lambert. Last updated: June 20, 2022
An article in the latest BIS Bulletin, published by the Bank for International Settlements, highlights the practice of MEV (miner extractable value) in crypto markets, suggesting it is akin to front-running in traditional markets and in need of study by regulatory authorities as cryptocurrencies go more mainstream.
The paper, Miners as Intermediaries: Extractable Value and Market Manipulation in Crypto and DeFi, argues that far from being “trustless”, cryptocurrencies and decentralised finance (DeFi) rely upon validators or miners to update the blockchain, many of whom decide how and when to add transactions to the blockchain to best benefit themselves economically.
The paper says the “intrinsic shortcomings of permissionless blockchain technology are well known in computer science and the cryptocurrency industry”, however the practice of miner extractable value (MEV) “can resemble illegal front-running by brokers in traditional markets”.
Because the miner has control over when and in what sequence transactions are placed on the blockchain for all to see, they are able to trade themselves in the market before (or after if they are countertrend) posting larger, potentially market moving transactions. The paper notes that by introducing its own transaction prior to the larger trade, the miner earns a profit in addition to the regular fees, thus forming, the paper says “an invisible tax on regular market participants.
The authors use recent academic data to calculate that total MEV since 2020 amounts to $550-650 million on just the Ethereum network. They add, however, that that estimate is based on just the large protocols and are hence likely to be understated. “In fact, MEV is so pervasive that, at times, one out of 30 transactions is added by miners for this purpose,” the paper states. “This share was even higher in early June 2022, due to a number of particularly large MEV transactions during the recent market stress. These extra transactions added by miners also work to limit the capacity of the entire Ethereum blockchain.”
The authors assert that regulators need to establish whether this activity by miners constitutes illegal activity. Noting that in most jurisdictions front-running is illegal due to best execution rules that govern intermediaries’ activities, by contrast in blockchain-based systems, miners are under no such obligation.
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The BIS paper tiptoes around the key points a little, as academics and central bankers often have to do, but there is no doubt in my mind that MEV constitutes front-running and should be banned – but can it? The challenge, as noted by the paper, is identifying who is actually engaging in the practice?
There has been, perhaps, a greater problem over the years, but one that may provide the solution. The protocols published by these venues have explicitly stated how things work – including MEV – but to date participants have rarely cared. That is likely to change, especially if we head into an extended crypto “winter”, because the fact of the matter is, historically in crypto, no-one has cared how things operate and who maybe doing something dodgy because everyone was making money.
That is changing by the day as crypto prices slide and the industry suffers a series of negative headlines, so perhaps now traders in these markets may start to pay more attention to how a particular blockchain is operated, and vote with their business to a chain that is not controlled by a miner or validator engaging in market manipulation?
The headline act of the dramatic decline in crypto prices has been the economic and employment impact, but there is likely to be another trend emerge – one where poor practices and unfair trading environments are “outed” by market participants and these venues suffer.
The only thing that will save them is another bull run in crypto, but the sense is confidence is damaged in the retail community and it will take some time before, if, another rally brings back the good times. This leaves the crypto industry looking even more longingly at the traditional institutional space for salvation – but those players are not going to come while practices such as MEV exist.
The path to reform for the crypto industry could, somewhat perversely given its trustless ethos, come in self-regulation a la traditional OTC financial markets.
“There are several open questions on whether current regulation on insider trading is directly transferable to MEV. In most jurisdictions, the legal status of these actions is ambiguous,” the authors observe. “To provide clarity, legal research would have to assess whether the activities permitted by the Ethereum protocol and other DeFi ecosystems should actually be prohibited. In contrast to traditional markets, anyone who participates in such an ecosystem essentially accepts the rules encoded in its protocol. It is therefore unclear whether a participant could object if someone exploits those rules to their advantage.
“On the other hand, it might be claimed that market regulations such as injunctions on insider trading will apply whether or not the potentially unlawful action is authorised under the blockchain’s rules,” the paper continues. “Importantly, the miners do not have an information advantage when it comes to the memory pool (which is public). Their ability to extract value arises from their control over the composition of the block they are adding to the blockchain. Whether this may constitute illegal insider trading has yet to be established.”
The paper acknowledges that the anonymous nature of the miners may make it difficult to enforce any regulatory interventions, notwithstanding that, however, it adds that MEV also poses a quintessential problem for the industry itself, as it stands at odds with the idea of decentralisation. “A range of new DeFi applications seeks to build financial services on permissionless blockchains,” the paper argues. “Yet MEV can directly limit the usefulness of these applications.
“A huge machinery requiring substantial investments is necessary to screen all the MEV possibilities,” it continues. “Bots that exploit MEV are now active on different decentralised exchanges. This imposes a fixed cost of mining, encouraging concentration. Solutions such as moving to dark venues, where transactions are only visible to miners, have not so far reduced front-running risk. The additional fees and unpredictability for users mean an additional form of insider rents in DeFi markets.”
The authors conclude by warning that MEV “could intensify”, partly because miners may be forced to engage in the practice to survive, and that miners who do engage in MEV are likely to be able to buy more computing power and crowd out those who are not engaged in the practice. “Thus, a form of rat race develops from the combination of the competitive and decentralised nature of updating and the fact that every miner can assemble their block any way they want,” the paper states, adding “It has been argued that MEV forms an existential risk to the integrity of the Ethereum ledger.”