Title: Introducing a New Concept: MEV Taxes
Researchers Dan Robinson and Dave White from Paradigm have introduced a groundbreaking concept known as “MEV taxes.” This mechanism allows applications to reclaim a portion of MEV from transactions in order to redistribute the value of MEV and prevent it from being solely captured by the transaction sequencers. This mechanism can be effectively implemented on OP Mainnet, Base, Blast, and other OP Stack L2 networks.
Introduction to MEV Taxes
MEV taxes are a mechanism that enables smart contracts to automatically extract fees by analyzing the priority fees in transactions. Under this framework, smart contracts charge a certain percentage of MEV tax based on the priority fees of transactions. Priority fees are the fees paid by users to expedite the confirmation of their transactions on the network. Following EIP-1559, Ethereum’s transaction fees are divided into base fees and priority fees. The base fee is automatically set by the network and dynamically adjusted based on network congestion, while the priority fee is an additional fee paid by users to incentivize sequencers to prioritize their transactions.
Smart contracts charge an additional fee proportionate to the priority fee by examining the priority fees of transactions, known as MEV taxes. For example, under MEV taxes, a user pays a priority fee of 1u to the sequencer to incentivize them to prioritize the transaction. In order for the sequencer to capture all the MEV from this transaction (e.g. making a profit of 100u), they must pay 99u to the smart contract based on the 1:99 fee ratio set by the smart contract, with the 99u being returned to the application (used for rewarding users, etc.). Without MEV taxes, if a user pays a priority fee of 1u, the sequencer would still receive 1u for processing the transaction, but all the MEV generated by the transaction (100u) would go to the sequencer.
Effectiveness Based on Competitive Priority Ordering Rules
The effectiveness of MEV taxes is based on the rules of “competitive priority ordering”:
Priority fee sorting: Sequencers should prioritize transactions based on the highness of the priority fees, with transactions having higher priority fees being processed first.
No censorship: Sequencers cannot censor or exclude any transactions, even those with lower priority fees.
No front-running and delays: Sequencers cannot front-run transactions or unnecessarily delay the processing of certain transactions.
Based on these rules, MEV taxes are only effective on OP Stack L2 networks. This is because the sequencers on these networks (sorters) adhere to the rules of competitive priority ordering. If sorters violate these principles, they can also evade MEV taxes by manipulating the order of transactions to capture the value for themselves.
As for Ethereum L1, block construction is carried out through competitive block-building auction systems like MEV-Boost, where multiple block builders compete to maximize their income by including high-fee transactions. Since MEV taxes would reduce the income of builders, in highly competitive block-building environments, builders would prefer to prioritize transactions without MEV taxes, making this mechanism ineffective on Ethereum.
Issues Addressed by MEV Taxes
MEV taxes can be adopted by any smart contract without the need for specific external infrastructure, allowing smart contract developers to customize their fee models according to their application needs. This flexibility ensures that different blockchain protocols and applications can optimize according to their strategies while remaining compatible with other systems. For example:
Optimizing DEX transactions: Introducing MEV taxes in DEX means that the execution price of transactions not only depends on market supply and demand but also includes the component of MEV taxes. To expedite the completion of transactions and obtain better prices, sequencers need to pay higher MEV taxes. This portion of fees can be used to increase the priority of the transaction in the block or as a reward mechanism, feedback to users or liquidity providers, potentially changing the execution price of the transaction and indirectly reducing transaction price slippage.
Reducing losses for liquidity providers in AMMs and addressing rebalancing issues: AMMs can prioritize processing transactions that pay higher MEV taxes, allowing them to directly recoup profits from arbitrageurs and return them to the AMM or liquidity providers, ensuring more stable income for liquidity providers.
Capturing “backrun” MEV generated by transactions: By integrating MEV taxes into smart contract wallets, a mechanism can be designed for wallets to automatically collect MEV taxes during transactions. This way, when other market participants try to exploit the MEV generated by a user’s transaction, they must pay MEV taxes, with this revenue being returned to the original user. This mechanism effectively allows users to capture the MEV generated by their transactions, protecting their interests.
Limitations of MEV Taxes
In addition to the high dependence of MEV taxes on sorters strictly adhering to the competitive priority ordering rules, there are other limitations. For example, when blocks are fully filled, sequencers may have to prioritize higher priority transactions rather than simply including lower-priority transactions later in the block. Furthermore, the success of MEV taxes requires competition in the market, meaning that the opportunities for transactions need to be widely known, which may require disclosing user intentions for some intent-based applications, potentially leading to value leakage in competition.
While the mechanism of MEV taxes faces challenges and limitations, this innovative approach is a way to redistribute MEV more fairly, returning MEV profits that would otherwise go solely to sequencers back to applications. MEV taxes and MEV Share share a similar goal in finding ways to redistribute MEV, promoting fair distribution within the MEV ecosystem.
