Defining MEV Risk

Source: https://www.theblock.co/post/261536/a-uniswap-user-lost-700000-to-an-mev-bot-but-it-only-made-260

What is MEV ?

MEV stands for Maximal (or Miner) Extractable Value. It refers to the profits miners or validators can extract by ordering transactions in a certain way before including them in a block.

MEV risk - systematic or unsystematic risk ?

MEV risk arises from the actions that miners (or validators, in proof-of-stake systems) can take to reorder, insert, or censor transactions within blocks they produce. This can affect the entire network or protocol, influencing transaction ordering and potentially leading to front-running, back-running, and other forms of transaction order manipulation. These activities can impact the fairness and integrity of the DeFi ecosystem, leading to concerns over market efficiency and security for all participants.

Since MEV risk can influence the operation and security of blockchain networks and the broader DeFi market, it can be considered a form of systematic risk. It reflects broader vulnerabilities and challenges within the blockchain infrastructure and consensus mechanisms, rather than risks associated with individual investments or projects.

Example

A major blockchain network faces a vulnerability in its consensus mechanism that allows validators to consistently exploit transaction ordering for profit, it could lead to widespread trust issues, increased transaction costs, or loss for users engaging in DeFi protocols across the board. This risk would affect all users and protocols on the network uniformly, making it a systematic risk. An example of this could be if validators or miners use their position to consistently front-run large transactions across various decentralized exchanges (DEXes), impacting the market fairness and efficiency for all DeFi participants on that blockchain.

However, some reasons why MEV risk can be seen as an unsystematic risk:

1. It emerges from factors and behaviors tied to the unique architectures of particular smart contracts and protocols.

2. MEV vulnerabilities arise from specific design or coding limitations in the transaction logic of smart contracts of individual protocols.

3. Not all types of DeFi protocols face the same degree of MEV risks - for example, decentralized exchanges and lending protocols are more vulnerable compared to identity platforms.

4. The risk exposure comes from proprietary aspects of transaction ordering, sequencing or pricing logic - which differs vastly across decentralized applications.

Example:

A specific DEX might have a vulnerability in its smart contract that allows some traders to exploit transaction ordering within that DEX's pools. If attackers or certain users exploit this to consistently achieve better trading positions, manipulate token prices, or extract value at the expense of others, this risk is specific to that DEX and its users. This would not necessarily affect other protocols or the blockchain as a whole. Thus, the impact is limited to the users and liquidity of that particular protocol, classifying it as an unsystematic risk.

So while MEV exploits do influence trust in wider crypto/DeFi ecosystem to an extent, the risks ultimately stem from isolated vulnerabilities in unique protocols. Hence MEV risks remain largely uncorrelated with systemic market conditions in DeFi and are treated as idiosyncratic. Protocols have to individually address issues with architecture, randomization, fair sequencing etc. to mitigate MEV.