Crypto manipulation: A feature or a bug?

Blockchain-based cryptocurrencies and decentralized finance (DeFi) protocols that rely on “miners” to verify transactions are inherently vulnerable to front running and other forms of market manipulation, according to new research.

In a bulletin from the Bank for International Settlements (BIS), researchers suggest that regulators may need to address practices in the crypto world that would be illegal in traditional securities markets.

Specifically, they point to an inherent feature of pseudo-anonymous blockchains, which involve miners validating transactions and updating the shared ledger.

“[E]ach of the validators or ‘miners’ updating the blockchain can determine which transactions are executed and when, thus affecting market prices and opening the door to front running and other forms of market manipulation,” the report noted.

The profit generated by taking advantage of transaction sequencing is known as “miner extractable value” (MEV), it said, noting that, since 2020, total MEV has amounted to an estimated US$550 million to US$650 million on the Ethereum network alone.

“These estimates are based on just the largest protocols and are hence likely to be understated,” it said.

In fact, “MEV is so pervasive that, at times, one out of 30 transactions is added by miners for this purpose,” the paper said.

And in early June of this year, “This share was even higher,” the paper noted, “due to a number of particularly large MEV transactions during the recent market stress.”

Given that this type of trading would typically be considered offside in traditional financial markets, which impose best execution obligations and other conduct requirements on market players, the paper said regulators should scrutinize this sort of activity in crypto markets too.

“Regulatory bodies around the world need to establish whether value extraction by miners constitutes illegal activity,” the paper said. “In most jurisdictions, activities such as front running are considered illegal.”

However, the application of traditional trading regulation to crypto markets is ambiguous, it noted.

“While developers and miners may claim decentralization to shield themselves from legal liability, it has been argued that regulators should not uncritically accept these claims,” the paper said.

That said, it also conceded that the anonymity of blockchain participants could make it difficult to enforce regulatory action.

Moreover, MEV may pose an existential threat to the crypto industry itself, the paper suggested.

“Looking forward, MEV could intensify,” it said. “[M]iners may be forced to engage in MEV to survive. Miners who engage in MEV will on average make higher profits and buy more computing power, and they could thus eventually crowd out miners who do not.”

As a result, “a form of rat race develops from the combination of the competitive and decentralized nature of updating and the fact that every miner can assemble their block any way they want,” the paper said, adding that this amounts to “a fundamental shortcoming of blockchain-based activities.”