Good/bad MEV: arbitrage

This is a first text in my series on "good/bad" MEV. In the series, I'll aim to map the ethical and legal issues surrounding various MEV strategies. My central thesis for the series is that no MEV strategies are "good" or "bad" in the abtract—ethical and legal analysis of MEV is highly dependent on context. We are likely to reach different conclusions depending on whether transactions involved are broadcaster publicly or depending on the precise role of the involved actors in the blockchain network.

As to how I understand "MEV," I recommend my separate text addressing that question. In short, I see MEV as arising where there is (1) scarce blockspace, (2) valuable uses for that space, (3) discretion over transaction ordering, and (4) competition among users.

Today, I'll look at arbitrage—buying low and selling high. Arbitrage in decentralized finance represents one of the most competitive and fundamental forms of MEV. This strategy tends to be viewed as benign, especially in comparison with sandwiching. However, in some contexts, even arbitrage may be problematic.

What is arbitrage?

At its core, arbitrage involves profiting from price discrepancies of the same asset across different markets.[1] In the DeFi context, this typically means buying an asset on one decentralized exchange (DEX) where it's priced lower and selling it on another where it's priced higher. The MEV aspect emerges because these opportunities are competitive—multiple sophisticated actors race to be first to realize the profit, making transaction ordering crucial.[2]

Consider a simple example: if DAI trades at 0.99 USDC on one DEX but 1.01 USDC on another, an arbitrageur can buy DAI cheap on the first exchange and sell it for a profit on the second. This trade becomes MEV when multiple arbitrageurs compete for the same opportunity, as only the trader whose transactions are included first in a block will capture the profit.

The good: market efficiency and price discovery

Arbitrage serves a vital market function by equalizing prices across venues, contributing to what economists call price discovery.[3] When arbitrageurs spot and act on price discrepancies, they effectively push prices toward equilibrium, ensuring that the same asset doesn't trade at wildly different prices across markets. This benefits all market participants by creating more reliable and consistent pricing.

In my analysis of MEV on Ethereum, I noted that arbitrage "helps to promote market efficiency and is typically considered benign."[4] This view aligns with traditional finance theory, where arbitrage is seen as a mechanism that keeps markets honest and efficient. Without arbitrageurs, price discrepancies could persist, creating confusion and inefficiency in markets.

The complex: when context matters

However, the story becomes more nuanced when we examine specific contexts. Not all arbitrage realization is created equal, and several factors can shift it from beneficial to potentially problematic:

Competition and negative externalities

The competitive nature of MEV arbitrage can create negative externalities. In the early days of Ethereum MEV, arbitrageurs would engage in "priority gas auctions," essentially bidding wars that clogged the network with spam transactions and raised costs for all users.[5] While technical solutions like private relays have mitigated this specific problem, the underlying tension remains: fierce competition for arbitrage opportunities can impose costs on the broader ecosystem.

Multi-block MEV and manipulation

A more concerning scenario emerges when arbitrage is combined with multi-block MEV—situations where an actor controls multiple consecutive blocks.[6] This control could enable strategies that blur the line between legitimate arbitrage and market manipulation. For instance, an actor might artificially create price discrepancies in one block only to "arbitrage" them in the next.

The question of access

There's also a deeper question about who gets to realize arbitrage opportunities. When arbitrage profits flow primarily to validators or those with privileged access to block production infrastructure, it may raise concerns about fairness and market structure.[7] Is it problematic if the same actors who control transaction ordering also capture most arbitrage profits? This touches on fundamental questions about conflicts of interest in blockchain systems.

From a legal perspective, pure arbitrage—buying low and selling high across markets—rarely raises regulatory concerns. Courts and regulators generally view it as legitimate trading activity that serves a beneficial market function.[8] The profit motive driving arbitrageurs is considered a "legitimate economic rationale" that distinguishes it from manipulative trading.[9]

However, context can change this analysis. If arbitrage is realized through:

  • breach of a duty of trust (e.g., front-running private order flow)[10]
  • market manipulation (e.g., artificially creating the price discrepancy)[11]
  • exploiting non-public information[12]

Then what appears to be simple arbitrage might actually constitute prohibited conduct. The key is examining not just the trade itself but the broader context and methods used to realize it.

Toward a nuanced view

Rather than labeling arbitrage as universally good or bad, we should evaluate specific instances based on their effects and the methods used to realize them. Consider these factors:

Potentially beneficial arbitrage:

  • corrects genuine market inefficiencies,
  • uses only public information,
  • doesn't breach any duties of trust,
  • contributes to price discovery without creating artificial discrepancies.

Potentially problematic arbitrage:

  • exploits artificially created price differences,
  • relies on non-public information or breach of trust,
  • imposes significant negative externalities on other users,
  • concentrates profits among actors with infrastructural advantages in ways that undermine market integrity.

Looking forward

The challenge for regulators, developers, and market participants is to preserve the beneficial aspects of arbitrage—price discovery and market efficiency—while addressing contexts where it might harm market integrity or individual traders. This requires moving beyond simple good/bad classifications to examine the specific circumstances, methods, and effects of each arbitrage strategy.

Ultimately, arbitrage exemplifies why nuanced analysis matters in understanding MEV. What appears to be a straightforward market mechanism reveals layers of complexity when examined closely. By focusing on specific contexts rather than broad categories, we can better distinguish between arbitrage that serves markets well and instances where it might cross ethical or legal lines.

  1. Mikołaj Barczentewicz, 'MEV on Ethereum: A Policy Analysis' (2023) ICLE White Paper 2023-01-23. ↩︎

  2. In technical terms, this competition transforms what would otherwise be ordinary trading into MEV because "only those who can process their arbitrage transactions earliest will be able to exploit the price discrepancy before others erase it through similar trades." Mikołaj Barczentewicz, Alex Sarch and Natasha Vasan, 'Blockchain Transaction Ordering as Market Manipulation' (2024) 20 Ohio State Technology Law Journal 1, 17. ↩︎

  3. For a technical exploration of how arbitrage contributes to price discovery in decentralized exchanges, see Jiahua Xu and others, 'SoK: Decentralized Exchanges (DEX) with Automated Market Maker (AMM) Protocols' (2023) 55 ACM Computing Surveys 1. ↩︎

  4. Barczentewicz (n 1) 11-12. ↩︎

  5. Philip Daian and others, 'Flash Boys 2.0: Frontrunning, Transaction Reordering, and Consensus Instability in Decentralized Exchanges' (2019) arXiv:1904.05234, discussing how "priority gas auctions" led to network congestion. ↩︎

  6. Barczentewicz (n 1) 13-14, noting that controlling two consecutive blocks "may give rise to a different class of multi-block MEV opportunities." ↩︎

  7. This connects to broader concerns about "conflicts of interest" when "a proposer does not act only as neutral infrastructure... but also as a self-interested trader or a profit-sharing enabler of other traders." Barczentewicz, Sarch and Vasan (n 2) 57. ↩︎

  8. As discussed in Barczentewicz, Sarch and Vasan (n 2) 60: "trading with the purpose of receiving the best possible price for oneself is a 'legitimate economic rationale,' even where it detrimentally impacts another trader." ↩︎

  9. In re Amaranth Natural Gas Commodities Litigation, 587 F Supp 2d 513, 535 (SDNY 2008). ↩︎

  10. For detailed analysis of when arbitrage might involve breach of trust, see Barczentewicz, Sarch and Vasan (n 2) 65-74, discussing private order flow and fiduciary duties. ↩︎

  11. Barczentewicz (n 1) 12-13, discussing "oracle manipulation" where actors might manipulate benchmark prices to create artificial arbitrage opportunities. ↩︎

  12. The distinction between public and private information is crucial. A transaction is considered public "when an actor who did not receive the transaction directly from a user who submitted the transaction, can access it in an unencrypted state without too much delay and without special arrangements with the node that originally received the transaction." Barczentewicz, Sarch and Vasan (n 2) 20-21. ↩︎