In this episode I speak with Grug, an anonymous MEV searcher on the Ethereum blockchain.  If that sentence made no sense to you, I promise this will be a fun episode.
To begin the conversation, Grug explains the basic architecture of the Ethereum blockchain and how its structure allows for the emergence of MEV strategies like sandwich attacks, arbitrage, and liquidations.  
He discusses some of the criteria he looks for when identifying a profitable MEV strategy and provides examples of some of the long-tail approaches he has deployed in the past as well as some of the risks associated with them.  We discuss the pro-cyclical nature of some of these strategies, the role of retail flow, and the edge in being able to deploy rapidly.
Grug also provides his thoughts on the impact of alt-L1’s and L2’s on MEV, airdrop strategies, and the end game of MEV if Ethereum infrastructure becomes too centralized.
Please enjoy my conversation with Grug.

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In this episode, I speak with Grug, an anonymous MEV searcher on the Ethereum blockchain.

If that sentence made no sense to you, I promise this will be a fun episode.

To begin the conversation, Grug explains the basic architecture of the Ethereum blockchain and how its structure allows for the emergence of MEV strategies like sandwich attacks, arbitrage, and liquidations.

He discusses some of the criteria he looks for when identifying a profitable MEV strategy and provides examples of some of the long-tail approaches he's deployed in the past, as well as the risks associated with them.

We discussed the pro-cyclical nature of some of these strategies, the role of retail flow, and the edge in being able to deploy rapidly.

Grug also provides his thoughts on the impact of alt L1s and L2s on MEV, airdrop strategies and the endgame of MEV if Ethereum infrastructure becomes too centralized.

Grug, welcome to the show, excited to have you here.

We are just gonna do something a little different than we've done in the past.

We're gonna dive into the world of MEV, which is, I think for anyone coming from a traditional finance background, hopefully going to be a pretty exciting and unique look at strategies in crypto that maybe they've never heard of.

So I appreciate you joining and being willing to do this.

I know there's a meme out there in crypto Twitter about you know Grug teach me Mev so I'm glad you're actually coming on and maybe you can teach me Mev here.

Thanks so much for having me yeah yeah hopefully I can be of some assistance in that regard.

So I know we want to be careful about providing too much information, your anonymity is important to you, so I do want to maybe start with a little bit of background what you're willing to share about how you got into crypto and MEV specifically.

Yeah absolutely, So my journey into crypto kind of started in 2017 but back then I was more just dabbling and behaving like a very unsophisticated market participant.

I was speculating on all sorts of shitcoins on Binance and things like sciacoin and other crap like that.

And after the market crash, I didn't really look at crypto again.

For several years, I worked in what I guess people in crypto today would call Web2, specifically in the machine learning space, but I ended up pretty burnt out on the tech industry and was just doing some boring web dev contracting stuff in the interim for a while before I ended up going full bore into crypto and MEV after the fact.

So yeah, after the big crash in 2017 and abandoning crypto, I determined I was a pretty bad speculator.

And to be completely honest, I really still am, although maybe a little bit better than before.

I did have a decently sized ETH bag I bought near the top back then, but was too stubborn to sell that I ended up holding all the way down and back up again.

So I guess I managed to squeeze a little bit of upside out of that.

But when I really got into crypto though, it was near the tail end of DeFi summer.

Somewhere by happenstance, I was just browsing Twitter and I stumbled across a tweet by some guy who had made a killing farming this Wi-Fi token.

And that kind of sparked my initial interest.

So I decided I would give it another try, but this time I'd throw myself at it in an uncompromising manner.

So I made this my Grug Twitter account because That's kind of where I intuited that everyone who actually knew anything about crypto hung out and operated on.

And I started aggressively using DeFi products like Uniswap and shitposting on Twitter and finding my way discord servers with like-minded folks.

So I was determined to lock myself away in my attic and make life-changing money along the way like so many of the people that I had observed on Twitter had during DeFi Summer previously.

My center of attention was primarily on communities with a focus on development and where most of the members were engineers.

I figured since I had an engineering background surrounding myself with others who did too, or were at least decently technical, so to speak, would be the best route to quickly hone my skills.

And far and above the most impactful community I found my way into was FBC, which is, of course, where we initially met.

And FBC was chock full of a bunch of super smart and terminally online individuals.

And it seemed like just the place that I was looking for.

And for a very long time, my daily routine basically consisted of waking up, hanging out in FBC all day and drinking from the fire hose of information there.

So yeah, a lot of the FBC alums actually also went on to start protocols or businesses in the crypto space that ended up being super successful.

I would say probably the best example there would be Gem, which was an NFT aggregator that I invested in and that a very close friend of mine founded that sold to OpenSea in 2022.

So that was a bit of how I stumbled into crypto.

And relatively early on during my time in FEC, I ended up reading an article, I think it was on Cointelegraph, that someone posted about MEV and it caught my interest.

Prior to this, I'd just been toying around learning about structured products and the Ribbon Finance server and options trading, and I was pretty unfocused.

I distinctly remember the moment that really sparked my MEV journey being watching 1 of Robert Miller, who is a steward over at Flashbots, 1 of his early Twitch streams, which was kind of just a walkthrough of a GitHub repository on a simple arbitrage bot.

After that, Robert and I began chatting about all sorts of things MEV, and he took me under his wing.

This is pretty much where I started to more exclusively focus on MEV.

I would say the zero-sum aspect and it being a explicitly player versus player game was what was very attractive to me.

You know, I used to play a lot of chess and I've always been hyper competitive.

So I guess It sort of makes sense that that's where I ended up within the crypto sphere

1 of the things that I make an assumption with with this podcast is that listeners have a general Finance background we don't go into standard definitions I assume they sort of have that sort of CFA level, masters in finance type knowledge.

But my guess is there's a lot of people who are listening right now that come from a traditional finance background, whose head might be swimming a bit, right?

You're throwing out things like DeFi, Summer, Wi-Fi, token, Uniswap, Flashbots, all of which they may have never heard of and have no context for.

So let me start by saying to those listeners, hold on, we're going to get there.

By the end of this conversation, you're going to know what all that means.

But with that in mind, Grug, I'm going to ask you to do a little bit of table setting if you can for me, because I think for the rest of this conversation to make sense, we have to sort of start from basics.

And so I want to start with the most basic question, which is at a high level, can you explain how the Ethereum blockchain works?

It's probably a pretty in-depth topic, but I'll try to give a good overview and 1 that appropriately sets the stage for diving into more MEV-specific discussions.

So Ethereum's essentially a blockchain with a computer inside of it.

The computer is called the Ethereum Virtual Machine or the EVM.

And everyone who is a participant in this network collectively agrees on the state of the EVM at any given time.

So anyone can make a request to perform some sort of arbitrary computation on the network, like making a transaction or deploying a smart contract, which is the foundation that all these DeFi apps are built on top of.

And whenever someone does, they pay some amount of ETH or rather gas, which is just a denomination of the youth to the network.

And 1 of the most important actors involved in a theory and then in any block chain are block producers.

This would be validators now and previously miners before.

Ethereum's semi recent transition to proof of stake So validators propose and validate new blocks of transactions.

This ensures consensus among participants in the network and also secures it.

And probably 1 of the most important factors with regards to MEV is that validators have free reign to order transactions however they want within a block.

So when someone submits a transaction to the network, it's also not instantly included in a block.

The transaction gets held in this waiting area or buffer zone that is called the mempool, and the mempool is publicly viewable.

So while transactions sit in the mempool, anyone can see it, including searchers, who are sort of an actor in this MEV ecosystem.

And validators look in the mempool for transactions that pay the highest gas fee and they then include them in the block.

So it's not really like a first in first out system like in tradfi.

There's sort of a gas auction that's occurring here and new blocks are created every 12 seconds as well.

So the basic breakdown here is that block producers create and confirm blocks.

Blocks are composed of a sequence of transactions based on fees and block producers possess the ability to order these transactions however they want within said block.

So in the context of that description, can you explain what MEV actually is?

Yeah, so this is still a rather hotly debated topic.

I mean, there have been a lot of efforts to come up with a more formalized definition of what MEV is.

The acronym has shifted from standing for minor extractable value to maximal extractable value.

As activities that might not have been classified as MEV at some point.

In the past now are or at least considered sort of MEV adjacent.

So we don't muddy the waters here too much I'll stick with a more rigid definition which is also.

The 1 that I believe flashbots uses are similar to it and that would be that any the refers to additional profit.

Aside from blocker words and transaction fees that a minor or now validator.

Can make by auctioning off transaction ordering rights in the blocks that they mine.

More specifically, prioritizing or entirely excluding certain types of transactions.

And this will make more sense when we jump into what Flashbots is, but I think that's a decent broad definition in my opinion.

You've mentioned Flashbots a couple of times.

What is Flashbots and why is it so important, at least historically, to MEV?

So before I get into what Flashbots is and what they do, I think it's important to establish the types of participants in the MEV ecosystem that make this whole sort of grand digital dance work.

And these would be users, searchers, and validators.

So users generate the flow that creates the value to be extracted.

Searchers hunt for profitable MEV opportunities and build the bots to submit profitable transactions to the network, and validators confirm the users' and the searchers' transactions.

And I think walking through the evolution of Flashbots and MEV over the past several years would probably be helpful here too.

So prior to Flashbots and the advent of private mempools, most MEV opportunities involved searchers competing by sending multiple transactions in real time, often triggered by other searchers chasing the same opportunity.

There was really no way to effectively communicate with block producers how to granularly express transaction ordering preferences and Flashbots changed this.

And the reason Flashbots exists is because during the second half of 2020 and the start of 2021, big spikes in Ethereum usage brought with them a bunch of negative externalities that were sort of incurred onto users and were caused by MEV extraction.

I think PGA bots are a good example here.

They caused just mountains of spam and transaction reverts that led to network and chain congestion, which made gas fees become artificially inflated and block space artificially scarce.

So Flashbots saw that there was an inefficient communication channel between bots and miners for order preference, which was leading to all of these negative externalities incurred on to users and they set out to fix this problem.

But ultimately at its core, Flashbots is a research organization that's focused on mitigating the negative externalities MEV incurs on users.

Really though, Flashbots builds MEV infrastructure.

I would personally say they mostly build software for validators, but we'll be charitable here and say that they build MEV infrastructure for searchers on the ecosystem in general.

Their primary product and the ones that see the most use are Flashbots Auction and MEV Boost.

So Flashbots Auction basically establishes a private communication channel between searchers and validators for communicating transaction ordering preferences within a block.

FlashBots Auctions is a sealed bid auction, so you can't see other searchers' bids.

The basic flow of how a searcher interacts with FlashBots is that They build a bot to identify or capture an MEV opportunity.

The bot finds that opportunity and submits a bundle along with a bribe.

If their bribe wins the FlashBots auction, their transactions are included on chain and they capture the opportunity.

Because MEV opportunities are zero-sum, The more competitors there are trying to go after a given opportunity, the greater percentage of a searcher's profit ends up given away to the validator via the auction.

And FlashBots auction is built into MEV Boost, which is the software that validators run and is FlashBots implementation a proposer-builder separation on Ethereum, which we can get into at a later date.

But I think the last thing that would be instructive here is exploring an example of how a searcher might use flashbots.

So say a user makes a trade on a decentralized exchange like Uniswap and he's trading some very illiquid shitcoin.

Because the liquidity for the pair is not very deep, the user has to set his slippage high on Uniswap in order to make sure that his order gets filled.

This leaves him vulnerable to something called a sandwich attack.

So a searcher who's built a bot, sees this user's transaction sitting in the mempool, and he submits a bundle to flashbots to sandwich the user.

A bundle is just 1 or more transactions that are grouped together and get executed in the order they're provided and they can include both the searchers and the users transactions.

In this case the searcher wants to sandwich the user, so he places a large buy before the user's transaction, which increases both the slippage and the price of the token that the user is trading.

He puts the user's transaction in the middle, which drives the price of the token up even further and gives the user a worse quote.

And then he places his transaction, his cell transaction immediately after it, and then pockets the profit as a result.

It's generally considered a very malicious form of MEB.

And unlike traditional finance, just on that last point there, because it's all done via smart contracts, the searchers can actually calculate precisely how much they can move price with the transaction and optimize the trade, right?

So 1 of the things you mentioned there was this idea of proposer builder separation.

So prior to Ethereum's transition to proof of stake, Block proposers built the blocks and proposed the blocks.

And at the protocol level, they still technically do.

But now a majority of validators run FlashBot's MEV Boost client, which essentially separates proposing and building into 2 different actors.

So validators running MEV boost sell their block space to the specialized third parties called block builders.

Who then collect and sequence transactions to produce a block and pass it on to them.

And block builders want to produce a block that maximizes fees collected in the form of priority fees and MEV and this sort of just leads to the most efficient the most efficient way to produce a block and it also prevents MEV from centralizing the validator set and mitigates against censorship, which is generally a concern as most people regard MEV as a centralizing force.

So if the block building competition is very fierce, builders are required to bid up as their bid approaches total revenue, And this reduces their net income while increasing the net income of the validators in general which makes it harder for builders to centralize their potential.

To buy more validators to have a greater chance of extracting any V.

And then use the revenue to hire better searchers cetera et cetera which is sort of like a centralizing risk and on the other side.

Separating builders and proposers from 1 another makes it much harder for builders to censor transactions because all sorts of different complex inclusion criteria can be added that ensure censorship isn't taking place before the block ends up getting proposed.

You mentioned sandwich attacks as 1 example of an MEV strategy.

Can we maybe take a step back and move to a higher level?

I'd love for you to talk through maybe the topology of MEV strategies, the general way you would consider categorizing them and maybe provide an example of each?

So I think the best example of a long tail distribution is generally the most accurate.

So on the left side of the distribution, we have the MEV that occurs the most.

So this would be like sandwiching, arbitrage and liquidations.

And these categories encompass the most MEV that occurs on chain.

Some people would probably lump stat ARB in here too, which has become a larger and larger percentage of total MEV so far, but to keep things simple, we'll stick with these sort of big 3 categories.

And then on the right side of the distribution, we have a ton of different long tail strategies, which encompass just a wide range of activity, where there's much less competition.

There's a lot fewer searchers going after these opportunities.

So sandwiching, as I touched on before, is probably the most malicious and detested form of MEV.

And it occurs when a searcher buys an asset immediately before a targeted user's transaction and then sells that same asset immediately after.

And 1 thing that, as you talked about, that's interesting when it comes to sandwich attacks is that you can use the pricing formulas detailed in the Uniswap docs to calculate the exact price impact that any order will have on any given trading pair.

And this is a pretty important advantage that sandwich attacks have over front running in tradfy.

Where calculating slippage is totally probabilistic so because individual trades on decentralized exchanges are all deterministic searchers can derive and calculate the optimal trade size to front run a purchase with which allows them to extract the maximal amount of profit from any given sandwich attack.

Most people view sandwich attacks, as I said, as totally exploitative.

The broad opinion is that they're parasitic and they prey on uninformed retail users who have little to no concept of the blockchain's underlying mechanisms.

But there is another take on the opposite side of them being a net positive or at least neutral to the ecosystem.

The first point being that sandwich attacks incentivize protocols towards better mechanism design, like MEV shielding via private transaction channels, which I generally agree with.

And the more niche take here is that when a user submits a swap via an automated market maker like Uniswap, they're declaring their maximum willingness to pay and so if they get filled at the better price.

That they're declared willingness to pay there exists this consumer surplus and thus the absence of an ash equilibrium so the sandwichers actually moving the system towards the Nash equilibrium so that the market meets the consumer's maximum willingness to pay while also extracting some value for themselves.

And in doing so the sandwiches generating more utility.

And reaching the national equilibrium where no other action would produce additional utility given the current state of the system.

On the declared economic preferences of the- participants not sure I really agree with this take though.

Because I don't necessarily believe that users are actually declaring their maximum willingness to pay and they're likely just ignorant or sort of being led astray by UI and UX design on some of these are the front ends for these decentralized exchanges.

My stance on sandwich attacks is a bit more of a moral argument.

I think that they are fine, or at least tolerable, because crypto is just the biggest and greatest casino ever created and in the end almost all of the activities that people are engaging in on chain are 0 sum anyway.

The second type of MEV would be arbitrage and the concept here is pretty straightforward and 1 that your listeners or anybody with a TradFi background will probably be the most familiar with.

So we're essentially moving money from 1 market to another and we're pocketing the spread as the profit.

Arbitrage on Ethereum functions the same way it does in TradFi with 1 crucial difference.

Transactions on Ethereum are all atomic, which means that either all the conditions are met or the transaction reverts.

So in TradFi, when you're executing a multi-hop arb, you run the risk of the market moving against your position while you're halfway through your arb, which would force you to sell at a loss.

With the existence of atomic execution on Ethereum, not only does every leg of your hop execute and be guaranteed to execute 1 after another, but you can record in your code your initial starting balance and at the end of execution you can assert that you want your ending balance to be greater than your starting balance.

So then if the assertion fails, the smart contract will revert and it basically undoes all the trades made and leaves you with your starting balance.

So this means that atomic ARBs are effectively riskless.

And another 1 of the ways that searchers make money via ARBs is called back running.

In this case you want your transaction to land right behind someone else.

So let's say Bob buys X token on decentralized exchange A.

When he does so he moves the bonding curve of the AMM that he's trading on.

And this means that the purchased token is more valuable now, while the token that Bob just sold is less valuable.

So a searcher, Alice, who's back running his transaction, can then utilize this imbalance that Bob has just created to perform arbitrage with another decentralized exchange.

So Alice buys the sold token from Bob for very little and sells it on another decentralized exchange for a premium and that premium minus the transaction fees that Alice incurs ends up being her profit.

The third type of MEV in the big 3 would be liquidations.

So just like in TradFi, in DeFi there are lending markets except because we don't have the state to chase people down if they run away with the money, all the loans in DeFi are over collateralized.

And at their most basic level, DeFi lending protocols consist of users borrowing assets against some amount of collateral that they deposited to the protocol.

But the value of a user's deposited collateral can drop sharply, and lending protocols need to ensure that all the outstanding loans are always fully backed or else they end up risking insolvency.

So, in the event that the value of the collateral drops below a certain threshold, the protocol actually lets anyone liquidate the user's position.

So to incentivize liquidations, these protocols pay a flat fee or they allow liquidators to keep a cut of the collateral being liquidated.

And the liquidator needs to repay some or all of the loan amount to the protocol, at which point the protocol transfers the borrower's deposited collateral to the liquidator.

So the value of the deposited collateral ends up always being greater than the value of the loan because otherwise there would be no economic incentive for a searcher to liquidate the loan.

While you can liquidate a loan by just repaying the debt from your wallet, it ends up being quite capital intensive.

You'd need a million dollars to liquidate a million dollar loan of course.

And so you can expose yourself to losses if the value of the collateral you receive continues to drop.

So lots of searchers instead leverage something called flash loans to front the necessary capital to liquidate the position and sell all the received collateral and then repay the flash loan while keeping the extra profit for themselves.

And a flash loan essentially is just a tool that allows someone to borrow any given amount of assets available as long as they repay them in the same block for a small fee.

And then the fourth type of MEV, which sits sort of on the narrow side of the long tail, would be, and these are opportunities that fall outside of the scope of the majority of MEV activity on chain.

And these would include like sniping a fat fingered listing for a valuable NFT, like a CryptoPunk, as well as like a litany of other strategies.

Given the breadth of potential MEV strategies, can you share your criteria for identifying what a profitable MEV strategy might be?

So when I'm looking to identify a profitable MEV strategy, I generally ask myself 3 main questions.

And these would be, where is the dumb flow, also known as the retail flow.

Where is the concentration of competitors the smallest?

So since our shop generally focuses on long tail strategies, This is a bit of a different approach to those that perform a lot of atomic or statistical arbitrage probably, but these are the things I look for.

Can you provide an example of some of the long tail strategies you've pursued in the past?

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Grug Capital – Grug (Finally) Teaches Us MEV (S6E12)