High Seas Traders
Hello DeFi People,
The Oiler team is working on delivering blockchain native derivatives — oracleless instruments that allow you to trade blockchain parameters like the hashrate, EIP-1559 BASEFEE (gas prices), block sizes. It is aiming at providing miners, validators, on-chain wallet providers, protocols, hedge funds, market makers and other big on-chain gas price spenders with tools to better manage their exposure to dramatic shifts in the protocol behaviour.
In case you might want a deeper refresher on what we’re building, don’t hesitate to do so and read our previous articles:
From the Oiler perspective, we need to track all the major developments within the Ethereum blockchain. Any of such protocol changes shapes the types of strategies that may be relevant for people managing their risk exposure on hashrate or gas prices (or other blockchain parameters).
One of such changes is rapidly becoming the new normal and looking like it will become the mainstay. MEV, that we talk about, and the fair MEV solutions like Flashbots attracted the majority of the Ethereum hashrate and deeply influenced the way the mempool and the blockspace look. Later we will show an intuition on why some say that the Flashbots lead to lower gas prices.
MEV stands for the miner extractable value (although the correctness of this term has been disputed). MEV, more or less, is the same thing as an arbitrage opportunity in traditional finance. It is also called a free lunch by many. In the end it is just making money off the market inefficiencies, inconsistencies, and mistimings and by doing that leading to markets that are ready to trade at fair prices with much higher liquidity available for everyone. If you’re interested in what MEV is, we highly recommend looking into the data provided by Flashbots.
In their March transparency report, Flashbots shared that 12 mining pools accounting for over 58% of ethereum network hashrate are mining on flashbots.
The most widely discussed paper on the topic The Flash Boys 2.0 provides a deep analysis of what leads to an advent of MEV, the threats to consensus, methods of MEV extraction and the game-theoretical explanation of its impact on mempool and gas prices.
Arbitrage opportunities have existed since the beginning of trading interactions between humans — we can assume that the smart prehistoric people were comparing the prices of seashells on different beaches. They were Flash Boys Alpha (The Beach Boys?). They would take a lazy day off, just to visit neighbours and learn that the seashells that are particularly common and cheap at their island are very sought after at one just a few hours away.
When you start frantically buying tons of local seashells then the locals will soon find out that there is a business to make. And then you end up with professional beach-runners and hyperfast prehistoric seashell delivery boats.
Our seashell traders must have been quite relaxed about their trade initially, but then they realized that the latency matters and started running very fast between the different beaches just to deliver as many seashells before others would realize how to make the fortune. In the end, there are just so many seashells that you can sell elsewhere before the market prices become the same at both islands.
Similarly, Ethereum miners nowadays started realizing that the MEV opportunities are there and if they move fast, they will be able to extract it before other miners do. Luckily in order to do that they had to team up with a community of MEV opportunities searchers.
What happened in the years between the seashells and now was a history of travel where merchants were competing for knowledge of arbitrage opportunities and the speed of delivery (think of the times of tea clippers running across the oceans to arrive first at the London tea markets).
And so the arbitrage has always been the same thing → discovering the mispricings, analyzing the cost of trade execution (whether it is the gas price or the cost of sending caravans) and winning the race against the others. And it has always been a fascinating story of risk taking, exploration and trade pacts. One of the most famous arbitrageurs of the old times was Marco Polo ;)
Old days arbitrage:
Clipper times arbitrage:
Modern days arbitrage:
Let us think of the old times of merchants and high seas traders and how we can use their story as a metaphor for the Ethereum arbitrage. Think of the mempool as an ocean, smart contracts being continents and transactions being the ships being sent across the oceans to move tokens and value between the different smart contracts.
Imagine that a particularly valuable trade was discovered in the old times in Asia and the European traders became aware of it. They knew that the opportunity was limited in amount (let us say 10 shiploads) and time (had to be picked up within a month or it would perish). Sending a ship from Europe to Asia was dangerous and had an unpredictable timing (depending on the luck the winds could be favourable or a storm could wreck the ships) and the potential profit was enormous.
What would happen?
Many ships were sent (far more than the 10 that were necessary) just for this venture and the prices of delivering less profitable merchandise rose because of the lack of cargo ships available. And if such opportunities were arising over and over again then a lot of money was spent (wasted?) on building faster and faster ships and trying to beat others even by one wei, I mean one day (Great Tea Race of 1866). Can you see how nothing changed?
In the Flash Boys 2.0 paper, the authors present examples of the PGA (priority gas auction) on Ethereum network with competing transactions (ships) spending more and more money to be the first ones to pick up the valuable MEV (cargo). Many of them get canceled (give up mid way to Asia) but still take away from others the gas limit (cargo space), causing the average gas prices (transport cost) to rise.
PGA leading to average gas price increase
Source: https://pdaian.com/flashboys2.pdf
So these wild MEV tactics with bidding wars lead to the average gas prices rising (and are potentially one of the reasons for high gas prices in the late 2020 and Q1 2021).
Why could we say that the solutions like Flashbots lead to lower average gas prices?
Let us continue with our metaphor.
Imagine that the European merchants work with a reliable courier then can deliver their sealed bids directly to the cargo owners in Asia. After that they receive information about who gave the best offer and got a guarantee that if they sent a ship they will be the ones to pick up cargo. The losers learn that there is no need for them to send ships at all. On top of that, building the fastest ship possible may not be so important any more (it is still important to discover the trading opportunities fast). Suddenly all the ships that used to compete and were forced to give up mid-way are available to carry other cargo.
The average prices fall.
So, it is possible that with the advance of solutions like Flashbots we entered the era of secret bids (carried by reliable couriers in the envelopes) and lower gas prices.
Now, let us get back to why MEV and Flashbots (and similar big gas price market movers) are something that we pay close attention to at Oiler.
MEV has such a profound impact on the mempool behaviour that is being closely scrutinised by both Eth1 and Eth2 researchers and developers. Since we are rooted in protocol engineers and the protocol risks, MEV could not go unnoticed by our team.
How an event like that could be incorporated into risk management strategies?
First of all, at the early days of MEV, miners could have planned for the incoming increased revenue which at that time was uncertain. If a new entrant mining pool decided to take a big bet on MEV and invested a lot of resources into new equipment, they may have wanted to protect themselves from lower gas prices by buying put options. This way their very risky venture with lots of capital invested upfront could be protected from adversary market conditions. This would be an interesting strategy to follow as MEV initially raised the gas prices and then lowered them while at the same allowing some of the mining pools to capture most of the value that was previously locked in transaction fees.
A sophisticated mining pool would be able to buy put options at the very low prices at the time of the rising gas prices just to exercise them after the Flashbots style solution has been implemented leading to the gas prices falling while still receiving the rewards from the fast lane MEV payments from Flashbots.
On the other hand, an on-chain wallet operator that was subsidising gas payments to their users could buy call options after reading the Flash Boys 2.0 paper thinking that the prices will soon go up and it will be too expensive to subsidise users further or even to deliver on past promises.
Legal Notice:
This article and any information contained in it is subject to the Oiler Legal Notice available at https://docs.oiler.network/oiler-network/token/legal-notice-and-risk-disclosure-statement. Please carefully review the Legal Notice as it contains important legal information, risk disclosure statement, limitations and restrictions relating to the information that we provide, third-party resources and forward-looking statements.
Links
Oiler’s Website: oiler.network
Oiler GitBook: https://docs.oiler.network/oiler-network/
Oiler’s Medium: https://medium.com/oiler-network
Oiler’s Twitter: https://twitter.com/OilerNetwork
Oiler’s Discord: https://discord.gg/bxMsvVTgJp
Oiler’s Telegram: https://t.me/oilernetwork
