Regulating Maximal Extractable Value in Public Blockchains

In the February 2023 issue of the legal journal ZdiW Dr. Frederik von Essen and I analysed Maximal Extractable Value or “MEV” activities (e.g., frontrunning or sandwiching) in blockchains with publicly accessible mempools under European as well as German regulatory law.

According to estimates by the Bank for International Settlements (BIS), MEV totaling approximately 550-650 million euros has been extracted since 2020 and additional 70-120 million euros – solely in the Ethereum network .

While there is still no consensus on which on-chain revenue sources should be considered as MEV, the BIS refers to a aribitrary inclusion of transactions in blocks at the expense of other network participants. These forms of MEV include “frontrunning” or “sandwiching,” where network participants with so-called arbitrage or search bots discover and initiate profitable transactions of others in the mempool (more or less an order book of a blockchain). Such activities result in profits, for example, by exploiting price differences between decentralized exchanges (“DEX”) or by taking advantage of liquidation fees from lending protocols.

In a nutshell, our conclusions are as follows:

(1) MEV activities are spreading as the market capitalization of DeFi applications grows.

(2) Specific MEV activities are systemically relevant, such as those connected to protocol-based lending liquidations.

(3) Specific MEV activities, such as frontrunning or sandwiching, can lead to the exploitation of other network participants.

(4) Specific MEV activities result in integrity risks for individual DEXs, as well as for DLT systems as a whole (such as capacity issues and extremely high transaction fees).

(5) Technical solutions like Flashbots Auction mitigate integrity risks and protect the interests of network participants.

(6) Existing laws (MAR, CRIM-MAD, and WpHG) largely fall short in addressing harmful MEV activities (transactions with security tokens are covered, but currency tokens are mostly beyond the scope of application).

(7) Part VI of MICAR applies to crypto-assets, thus encompassing not only security tokens but also currency tokens like ETH or BTC. Therefore, the prohibition of insider trading and market manipulation generally applies, especially when network participants use private communication channels outside of mempools, such as Flashbots Auction.”

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