TL;DR As Ethereum’s DeFi ecosystem has become more complex, sophisticated actors have extracted more and more value known as MEV and the problem is getting worse. These entities leverage a variety of strategies to profit from retail users. Due to the impact of MEV extraction, LPs are facing extinction. Arrakis proposes a fix with its upcoming AMM HOT.

Key Takeaways:

• Sophisticated actors extract value known as MEV from Ethereum’s DeFi ecosystem every day. These actors profit from MEV extraction at retail’s expense.

• Searchers extract MEV through strategies like sandwich attacks and arbitrage while builders and proposers also profit. Due to MEV, LPs are getting marginalized on AMMs.

• Arrakis is focused on solving the MEV problem for LPs by building onchain solutions that vertically integrate into the MEV supply chain to help LPs protect their capital and become more profitable.

• Starting with the MEV-aware AMM HOT, Arrakis is innovating at the forefront of MEV recapture to push Ethereum DeFi forward.

Ethereum DeFi is growing fast and new innovations are advancing the ecosystem. But there is a big problem to address: the MEV problem is getting worse and it’s driving retail LPs towards extinction.

MEV stands for “maximal extractable value” and it’s often used alongside other terms like LVR (“loss vs. rebalancing”) and toxic flow to refer to value that sophisticated actors extract from DeFi users.

MEV’s biggest winners use complex strategies to extract value during Ethereum’s block production process. These actors profit from users alongside builders and proposers. They all form part of what’s known as “the MEV supply chain.”

MEV is not a trivial issue for DeFi—Flashbots estimates that over 500,000 ETH (worth over $1 billion) has been extracted as MEV since The Merge and the amount leaked is steadily increasing over time.

The amount of MEV extracted through CEX/DEX arbitrage, atomic arbitrage, and JIT attacks has jumped over the last two years. Sandwich attacks impact swappers while arbitrage and JIT-related MEV hurts LPs. Atomic arbitrage has been rising at a particularly fast rate as onchain activity has increased, marginalizing LPs.

To address the MEV problem, Arrakis is focusing on developing cutting-edge solutions that vertically integrate into the MEV supply chain to protect DeFi users, starting with HOT, the MEV-aware DEX focused on protecting LPs. To understand how, it’s worth considering why MEV exists and the role each actor plays in the MEV supply chain today.

How Searchers Extract MEV

When DeFi emerged, retail swappers and LPs became the first DEX users. Lenders and borrowers, meanwhile, bootstrapped lending protocols.

DEXs then attracted arbitrageurs who were incentivized to balance prices between pools and lending platforms attracted liquidators who were incentivized to close underwater positions. This created MEV and the extractors became known as searchers.

As MEV incentivized proposers to reorder blocks for their own gain, the MEV research team Flashbots implemented Proposer Builder Separation (PBS) for Ethereum through MEV-Boost. With this infrastructure, builders offer blocks and proposers add them to the chain. About 90% of Ethereum blocks are proposed through MEV-Boost today.

When searchers extract MEV, they bribe builders to get their transaction added to blocks and builders bribe proposers to get their blocks added to the chain. Each of these actors profits from users when MEV gets leaked.

Searchers extract MEV in between Ethereum blocks. Most MEV gets leaked on L1, where new blocks are produced much slower than L2.

On AMMs, MEV is typically extracted through sandwich attacks and arbitrage (lending protocols also leak a type of MEV known as OEV during liquidation events).

Sandwich attackers search for large swap orders and frontrun them ahead of the user. As a result, the user’s slippage increases and they get a worse price. The attacker then backruns the order and pockets the difference—their transactions “sandwich” the order to extract a profit and the user gets burned.

Just-in-Time liquidity attackers (also known as sandwich LP attackers) search for large swap orders and add liquidity to the pool then remove it immediately after the swap. The user benefits from a lower price impact and the attacker earns pool fees, while LPs lose out on revenue. In this case, the attackers “sandwich” liquidity provision rather than the swap and LPs get burned.

Arbitrageurs search for price discrepancies between a CEX and DEX or two pools. When a user makes an order, the arbitrageur buys or sells the asset at a better price offered elsewhere then swaps into the price offered by LPs in the pool. This means they profit from the price difference and LPs get burned.

Why LPs Lose out to MEV

MEV losses are frequently associated with swappers because most retail DeFi users interact with DEXs to execute swaps. But passive LPs collectively account for the biggest losses in today’s MEV landscape because they offer stale prices and lose out on fees to searchers, builders, and proposers (and they need these fees to maintain profitability).

In the 2022 paper Automated Market Making and Loss-Versus-Rebalancing, Columbia University professor and a16z researcher Tim Roughgarden found that arbitrage costs ETH-USDC LPs about 11% of their principal per year.

Loss-Versus-Rebalancing is a term used to describe MEV lost through arbitrage as a result of LPs offering stale prices. As AMM prices update slower than CEXs, LPs become exposed to losses when arbitrageurs correct the discrepancy. LVR accounts for most MEV extraction on Ethereum.

The AMM space has evolved since MEV extraction started to encroach on DeFi. Uniswap V3 pioneered liquidity concentration to help LPs earn more fees but this feature requires active monitoring. As MEV is brokered offchain through MEV-Boost, and most LPs passively provide liquidity onchain, LPs keep getting burned.

How HOT AMM Is Pioneering MEV Awareness

Our answer to today’s worsening MEV landscape is the HOT AMM, an MEV-aware DEX that focuses on protecting LPs from toxic flow.

HOT adopts an intent-centric design with DeFi’s first hybrid request for quote (RFQ) AMM system for LPs, offering them more non-toxic flow and better returns.

In the DeFi ecosystem today, arbitrageurs are driving LPs towards extinction because they take advantage of stale prices offered on AMMs. HOT’s mechanism solves this problem by bringing LPs more volume and fees without exposing them to toxic flow.

We like to say that HOT is pioneering MEV awareness because it provides awareness of the offchain brokering that occurs during block production and solves the problem for LPs.

HOT recaptures MEV to benefit LPs and its goal is to make LPing more sustainable and profitable. It’s the key to Arrakis’ mission to vertically integrate into the MEV supply chain to empower DeFi users.

To learn more about how Arrakis is fixing DeFi’s MEV problem to make onchain markets fairer, look out for our explanation on how Centralized Vertically-Integrated Market Makers are taking over DeFi and full details on how we aim to fix the problem dropping in the coming weeks.