July 14, 2023

MEV slows DeFi adoption

MEV’s effect has been characterized in different ways:

  • As an uneven tax on less-informed participants;
  • As a centralizing force that threatens consensus security;
  • As securing the economic guarantees of protocols and on-chain markets (“Good” MEV).

Let’s shed light on another effect of MEV: MEV threatens the adoption of DeFi.

MEV makes DeFi hostile

DeFi promises to cut out inefficiencies, increase transparency, and thereby security and trust. Why is that so attractive? Because besides security, you also expect less friction and fairer treatment.

But MEV damages this promise. Instead, it turns DeFi into a hostile environment – worse than its centralized alternatives.

Ever been sandwiched, frontrun on an NFT mint, pushed out of liquidity mining or LP rewards, or effectively locked out of a token sale by gas wars? These experiences are badly disillusioning, costing users thousands or, in some cases millions, of dollars.

Most wouldn’t return to a service that treated you like that. It’s no wonder bots are one of the top complaints.

DeFi use today is unrealistic: You are expected to be a math and econ major with trading experience; keep an eye on ethresear.ch and twitter; know how to hide your transactions from bots; and possess the wisdom for when to use curve vs uniswap (or rather, why to use neither and instead use CowSwap).

The system will extract from anyone arriving less prepared. It’s no surprise nobody invites their parents to DeFi in a hurry.

→  MEV drives users away.

But, direct loss for users is only one way MEV hinders DeFi adoption.

MEV forces dapps to charge higher fees

Passive dapps face a disadvantage. They lack the real-time streams of market data that MEV bots possess. Likewise, the ability to act in <100ms. To compensate for this latency, dapps charge high fees on their trades.

This creates larger spreads. And, in many cases, it makes execution in DeFi more expensive than centralized alternatives.

Similarly, derivative protocols must raise their trading fees higher than they want, to make Oracle latency arbitrage unprofitable, which protects their LPs from losing money.

As a result, DeFi applications are much more expensive than they want to be. Although their cost basis is smaller than centralized alternatives, they often don’t offer better fees.

→ MEV makes dapps more expensive and less competitive.

MEV not only hurts users and makes dapps less competitive. It also threatens the economic incentives of many protocols.

MEV reduces liquidity in DeFi

Many AMMs – if not most – are under scrutiny for being unprofitable. AMM pools and their liquidity providers are constantly catching up with market prices. As a result, they’re on the losing side of trades against the toxic order flow and arbitrageurs.

The same is true for other protocols offering any form of swap – e.g., bridges, stablecoins, synthetic and derivative protocols. They all pay a constant MEV tax. This reduces yields for their stakers.

These losses can entirely drain the yield for stakers or LPs, making it irrational to provide liquidity or stake. If DeFi can't offer yields that adequately compensate for risk, many DeFi building blocks can break down.

→ MEV reduces yields, therefore threatening the economic design of DeFi protocols.

MEV protection speeds up DeFi adoption 

Without the heavy tax of MEV, DeFi would be safer, cheaper, and more liquid.

Luckily, protocols have the power to protect their users and themselves from MEV extraction. Read more here about how to protect your protocol from MEV.

If you think your protocol is at risk of MEV, reach out below. We can analyze your exposure and recommend solutions:

  • Telegram:yellow_propeller
  • Twitter:@0xPropeller
  • Email: markus@propellerheads.xyz

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