Arbitrage opportunities are widespread in traditional finance and cryptocurrency. However, arbitrage opportunities are more significant in the cryptocurrency space due to the visibility of unconfirmed transactions and slower settlement times.
The MEV phenomenon on Bitcoin
Although the Maximum Extractable Value (MEV) phenomenon is more prominent on Ethereum, Bitcoin is also experiencing similar problems. For example, MEV is beginning to manifest on Bitcoin through behaviors such as "snatching" ordinal inscriptions, hollowing blocks, and miner cartels.
Arbitrage mechanism on Bitcoin
The possibility of MEV on Bitcoin may prompt the market to demand that the memory pool be "privatized", which would go against the original intention of decentralization of cryptocurrency. It is believed that one of the "killer applications" of cryptocurrency and blockchain is the ability to trade various assets without centralized financial intermediaries. However, even if most of these assets have no practical use, they can still bring huge returns through trading.
For example, SHIB coins made many people rich in 2020, and WIF and PEPE coins in 2023 have also repeated this miracle. These tokens were originally traded on decentralized exchanges (AMMs) rather than centralized cryptocurrency exchanges. AMMs are decentralized applications that match buyers and sellers of cryptocurrency tokens without cumbersome data sharing procedures (such as those required by regulated exchanges). Users only need to connect their crypto wallets, click to buy, and the transaction is completed.
Besides the convenience and privacy of avoiding identity verification, these AMMs have a distinct advantage: despite being touted by crypto influencers as the “next iteration” of the stock market, the stock market is still closer to real-time trading than AMMs.
Arbitrage in the stock market
Arbitrage is very common in the stock market. For example, Party A wants to buy XYZ stock for $100, while Party B sells it for $99. When Party C learns this information, he can buy it from Party B for $99 and immediately sell it to Party A for $100. In this way, Party A gets the stock, Party B gets $99, and Party C earns $1 through arbitrage. This process of eliminating inefficiencies happens in real time in the stock market.
Arbitrage in AMM
Similar arbitrage behavior also occurs in AMMs. For example, suppose someone buys a large amount of SHIB tokens on an AMM, and this transaction is visible to everyone before it is finally confirmed. This transparency allows other users to take advantage of market inefficiencies, buy SHIB before the original buyer, and then sell it to him at a higher price. Such transactions are called sandwich transactions because they revolve around the original buyer to take advantage of market inefficiencies.
This type of sandwich and other types of inefficiency discovery is called Maximum Extractable Value (MEV). On Ethereum, MEV is more common because Ethereum verifies transactions every 12 seconds or so, which gives arbitrage trades plenty of time to proceed.
MEV Development on Bitcoin
The MEV phenomenon on Bitcoin is much more fragile than on Ethereum. “It’s more of a game to play than MEV,” said Colin Harper, director of research and content at Luxor Technology, a Bitcoin mining company.
Taproot Updates and Ordinals Protocol
Three years ago, Bitcoin went through an update called Taproot that made the network more expressive. This expressiveness also made it possible to equate Bitcoin with NFTs through Casey Rodarmor’s Ordinals protocol. The act of “trading Bitcoin for Bitcoin” in this context is actually buying specially marked Bitcoins.
For example, when selling an inscription on Magic Eden or other markets, the seller partially signs the transaction, and the buyer completes the transaction with their own signature after purchasing it. If someone sees this transaction in the memory pool, they can front-run it by broadcasting a transaction with a higher fee, thus preempting the original buyer's transaction.
Other MEV-like phenomena
There are other MEV-like phenomena on Bitcoin. For example, empty block mining and miner cartelization. Empty block mining means that miners mine an empty block that only contains coinbase transactions. Although there are technical reasons for this situation, it is difficult to say that it is beneficial to Bitcoin.
In addition, the joint mining of miners through mining pools may lead to cartelization of miners and form systemic risks. Large mining pools may maximize profits through monopoly power and increase opportunities for external payments. This behavior may lead to the emergence of private memory pools and concentrate the power of the blockchain.
The Prospects of MEV on Bitcoin
The MEV phenomenon on Bitcoin is still developing and network participants need to be vigilant. As MEV expands, the Bitcoin community needs to take measures to protect the original intention of decentralization and prevent excessive concentration of power.
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