This is the second in a series of articles we plan to write to educate and talk about all things “Blockchain”.

Years ago, when we started talking about Digital Assets and Blockchain, one of the early criticisms among sceptics was the lack of “real-life”, practical use-cases.  Well, one is playing out in “real time” with regard to the Russian invasion of Ukraine, leading some to describe it as the “first crypto war”.  Digital assets have taken on an unprecedented role in the war in Ukraine, helping the government raise hundreds of millions of dollars to fight against the Russian invasion. 

At the early outset of the conflict, Ukrainian officials posted the addresses of crypto wallets on their Twitter accounts, giving donors a direct method of sending financial aid and contributions (see example below).  Since then, more than $100m worth of crypto has been raised by the “Crypto Fund for Ukraine” run by Michael Chobanian, the founder of the Ukrainian crypt exchange Kuna.

For the Ukraine, crypto was supposed to be a launchpad into the future.  Ukraine’s deputy minister for digital transformation Alexander Bornyakov hoped that digital assets and blockchain technology would help revitalize the Ukrainian economy and bring all government processes online. But now, it has become an important lifeline for defense in a country being ravaged by war. 

Much of the crypto, spread across assets such as bitcoin, ether, polkadot, solana, dogecoin, tether and more, have gone to help fund humanitarian agencies distributing aid in the country.  Other funds have helped supply soldiers with food, uniforms, and other military equipment and supplies.  These funds are also being used to fight the cyber war, reportedly defaced Russian government websites, provided intelligence, and taken down military systems. 

Using crypto in the middle of a crisis is not always easy, after all it requires an internet connection and a working device.  Furthermore, not everyone is adept at transacting and transferring of crypto assets, making it ripe for fraud. 

And blockchain does not pick sides. Crypto and blockchain have also likely helped Russia avoid some financial and economic sanctions.  Crypto assets cannot be frozen, censored, and can be used without ID, making them both an important humanitarian tool AND a tool to subvert illegal actions.  Iran, for example, has used bitcoin mining to bypass trade embargoes in the past, according to research from the blockchain analytics firm Elliptic.  Indeed, the New York Times reports that the Russian government has been developing a digital ruble and other tools to help avoid sanctions. 

So, while the current use cases that have emerged in this first “Crypto War” were not necessarily the ones first conceived by blockchain futurists, they are important nonetheless and have further legitimized and helped make the case for blockchain.  Indeed President Biden just issued an executive order, “Ensuring Responsible Development of Digital Assets” giving further recognition to the fact that blockchain and crypto assets are investment themes that are here to stay!

Disclosure

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The modern world is full of acronyms, but one acronym relevant to the Blockchain is MEV or miner extractable value.  MEV is the measure of profit a blockchain miner can make through their ability to include, exclude or reorder transactions. 

Crypto miners (and validators) process and validate transactions in order to receive compensation.  Because they have full visibility of all transactions, one aspect of mining is the ability to reorganize or reprioritize transactions in order to front-run other users’ transactions and effectively arbitrage. In essence, miners can leverage their discretionary power to sequence transactions within blocks to maximize their profits.

MEV, also known as maximal extractable value, is the maximum or optimal value that can be extracted from block production in excess of the standard block reward and gas fees by including, excluding, or changing the order of transactions in a block.  MEV is also relevant in a proof of work context, given that miners can also control the transaction inclusion, exclusion, and ordering. 

If you are feeling lost, let’s review some transaction terms. 

The standard block reward is the number of Bitcoin, Ethereum, or other crypto currency you receive for successfully mining a block of currency.

Gas is the unit of measure that pertains to the computational effort required to execute specific operations on the Blockchain.  Since each transaction requires computational resources to execute, there is an associated fee.  

Gas fees are paid for Ethereum are paid in ether, and so on.  Everything on the network costs gas.  The cost of gas is determined by demand for resources on the network.  How much gas you need depends on how large and complex the contract or transaction and how fast you want it executed.  Just like the fuel economy in your car, if you are willing to go slower, you can pay less gas.  If you want the transaction or contract executed faster, you pay more gas!  These decisions result in more efficient use of the Blockchain network. 

While it might be difficult for individual miners to figure out the most profitable MEV opportunity, a large portion of MEV is extracted by independent network participants called “searchers”.  Searchers can run complex algorithms on blockchain data to detect profitable MEV opportunities and use bots to automatically submit those profitable transactions to the network. 

Miners also get a portion of the full MEV amount because searchers are willing to pay high gas fees (which go to the miner) in exchange for a higher likelihood of inclusion in profitable transactions in a block. Assuming searchers are economically rational, the gas fee that a searcher is willing to pay will be an amount up to 100% of the searcher’s MEV (because if the gas fee was higher, the searcher would lose money).

For some highly competitive MEV opportunities, searchers may have to pay up to 90% or even more of their total MEV revenue in gas fees to the miner because so many others want to participate in the profitable arbitrage trade. 

This supply-demand dynamic means that those that are good at “gas golfing” – programming transactions that use the least amount of gas, have a competitive advantage, allowing searchers to set higher gas prices while keeping total gas fees constant. 

There are many other methods used to “game” the decentralized system to extract maximum profits. These are the same methods that traders have been using to “game” the market for decades, since computing power became available. 

In the financial markets, this system of arbitrage creates market efficiency and greater robustness.  This is also the case on the Blockchain.  Decentralized finance relies on economically rational actors to ensure the stability and utility of their protocols.  Rational players are taking advantage of economic incentives and arbitrage opportunities. 

That being said, there are downsides to MEV practices which can slow down the network with congestion and end up raising gas prices for all.  MEV extraction ballooned in popularity in the first half of 2021, resulting in high gas prices the first few months of the year.  According to Flashbots’ data, which only measures the lower bound of total extracted MEV and tracks only eight DeFi protocols, more than $689 million has been extracted from unsuspecting users of the Ethereum network since Jan. 1, 2021.

Because of limited bandwidth, MEV has the potential to undermine the usability, neutrality, transparency, decentralization, and security of the Ethereum and other blockchain networks.  But DeFi, like most markets, can adapt and become more efficient particularly as new competitors and protocols emerge.  So stay tune for the next wave of problem solvers and MEV 2.0!