How DeFi protocols open the door for miners to grab new profits for themselves — at the risk of destabilizing Ethereum

In early September, a white-hat hacker who goes by the name “samczsun” noticed that nearly $10 million worth of ether (ETH) was tied up in a risky Ethereum smart contract. 

What samczsun saw was that the contract, which was a part of Lien Finance’s protocol for creating options and stablecoins, contained a “burn” function that could have allowed an attacker to mint tokens for free and then burn them in exchange for all the ETH in the contract. 

Samczsun took charge of an operation to protect the funds, enlisting the help of Ethereum mining pool SparkPool. SparkPool let samczsun use a new piece of infrastructure it has been developing, called Taichi Network, which let him keep the transaction private from the rest of the network so that he could recover the funds before anyone else caught wind of the opportunity. 

The private transaction network, which is supposed to launch this month, aims to prevent miners from “front-running.” In traditional finance, the term refers to when traders act on non-public information about future transactions that will affect a given asset’s price. In the context of cryptocurrency mining, front-running refers to something different: miners censoring or reordering transactions to make themselves first in line to take advantage of certain kinds of profit-generating opportunities.

Such opportunities have grown richer and more diverse lately, thanks in large part to the explosion of decentralized finance (DeFi) protocols, which has led to a corresponding increase in arbitrage opportunities for traders.

Since miners decide which transactions make it into blocks, they are at an advantage. If a miner sees a transaction in which someone is poised to profit via arbitrage, they can copy the transaction and prioritize it over the original in order to take the profit for themselves. 

In fact, the growing array of opportunities that miners have to front-run DeFi transactions is a newer form of an older phenomena called “miner extractable value,” or MEV. And it has profound implications for Ethereum’s future.

Flash Boys 2020

The term MEV first appeared in a now widely-recognized paper published in 2019 by Cornell researchers entitled “Flash Boys 2.0.” The title refers to a 2014 book by Michael Lewis, which is about how high-frequency trading operations exploit traditional financial markets. The paper defines MEV as “a value that is extractable by miners directly from smart contracts as cryptocurrency profits.” 

In a Twitter thread published earlier this week, pseudonymous cryptocurrency researcher @FrankResearcher shed light on a relatively sophisticated example of how miners — in this case mining pools — can profit from MEV.

Essentially, as @FrankResearcher illustrated using screenshots from a block explorer, mining pools were colluding to profit via a smart contract carrying out DEX arbitrage trades. As part of the scheme, they would combine trades from different mining pools and convert various tokens back and forth to extract value.

The total amount of MEV out there today is difficult to estimate, but it’s clear that thanks to the DeFi boom the opportunity is much bigger than it was when “Flash Boys 2.0” coined the term. According to The Block Research, total decentralized exchange volume has exploded from $281 million in September 2019 to $23.5 billion a year later.

A threat to Ethereum?

By giving samczun an inside track to recover the funds in the risky Lien Finance smart contract, SparkPool essentially gave the white-hat hacker the power to front-run potential front-runners. If mining pools have this ability, what’s to stop them from using it to capture Ethereum’s MEV, or from taking bribes to capture it for third parties? (SparkPool has not responded to The Block's questions about the Taichi Network.) 

Either way, the growing pot of MEV could spell trouble for Ethereum in the long-term, according to Philip Daian, a cryptocurrency researcher at Cornell who co-authored “Flash Boys 2.0.” Daian said in a recent interview that MEV could in the long term destabilize the blockchain, particularly when there are blocks in which MEV is greater than the block reward itself. 

According to Daian, miners that choose not to maximize their own MEV extraction could become uncompetitive and allow for certain kinds of traditional players to take over. “MEV extraction gives entities good at arbitrage and market manipulation, such as Wall Street’s hedge funds, a competitive advantage in mining,” Daian said.

“Long-term, this could centralize the network to the same set of parties that currently primarily profits from arbitrage in financial markets today, and could harm the long-term mission of Ethereum,” said Daian.