Ethereum Block Building

Blocknative Merge Ethereum

Planning for the Post-Merge Future

The Merge is coming and it will be, by far, the most significant and substantial upgrade Ethereum has experienced to date. The network will make the transition to proof-of-stake (PoS), rewarding years of research and persistence by the community.

While there are many intricacies surrounding how The Merge will change Ethereum now, and in the future – today we’re focused on Block Building.

What is block building? Public blockchain networks batch transactions into blocks. The term “block building” is used to describe the process of precisely ordering the transactions that end up being included in these blocks. Each individual block contains transactions that occurred over a certain period of time in the network’s history.

Since these blocks cannot be edited after they are confirmed by the network, their ordering is critical. “Block building” is how the history of a network is written at the most granular level, transaction-by-transaction. A “block builder” is a network participant that can influence the way that these transactions are ordered.

In this post, we’ll cover the current state of block building on Ethereum, how it will change after The Merge, what those changes mean for Ethereum’s users, and how Blocknative can help you prepare for these new economic realities.

Block Building in Proof-of-Work

To better understand the importance of the shift that will happen once proof-of-stake Ethereum is launched, it’s essential to review how block building currently works under Ethereum’s proof-of-work (PoW) system.

Under the current regime, Ethereum miners do the job of both validating the network’s blocks and building the blocks. These miners have the final say in the exact order of all the transactions that they confirm.

This is a powerful position to be in; controlling the flow of transactions allows you to profit from on-chain activities. The value that is extracted by miners is referred to as Maximal Extractable Value (MEV).

Originally MEV stood for “Miner Extractable Value", but this name could not have held up after The Merge when miners will no longer be needed. Validators will instead act as the main actor securing the chain.

With increasingly sophisticated on-chain financial activity occurring on Ethereum, MEV “searchers” have emerged that specialize in capitalizing on the related arbitrage opportunities. These searchers monitor the mempool looking for opportunities to profit by strategically ordering the contents of a specific block.

arbitrage-transaction-ordering

An example of MEV arbitrage transaction ordering

Because the knowledge involved in being a good searcher is specialized, it’s rare for top-tier MEV searcher to also happen to be mining pool operators. With this in mind, searchers in the current PoW environment still need to collaborate with miners to ensure that their MEV-rich transaction bundles are included in blocks.

This is done through communication channels that have largely been developed by the research collective/company Flashbots. Their open marketplace for MEV allows searchers to submit transaction bundles to miners for inclusion in blocks. To gain the attention of a miner, they also include payments for the miner that amount to a share of the MEV they expect to earn from the transaction bundle.

This becomes a third source of revenue for miners under PoW. They receive the issuance for winning a block, the priority fee of transactions, and payments for including MEV on behalf of searchers that request specific transaction ordering.

To be clear, it’s not required at the protocol level that miners do this. However, thanks to the economic incentives at play, the overwhelming majority of them collaborate with MEV searchers. Flashbots has estimated in the past that “>90% of miners are outsourcing some of their block construction to Flashbots”.

In summary, the block building lifecycle looks like this under PoW:

  • Human users and dapps generate economic activity on the Ethereum network that triggers arbitrage opportunities.
  • Sophisticated actors called “searchers” compete to see who can create MEV-focused transaction bundles in a way that makes the most of these opportunities. They then offer these bundles to miners and incentivize inclusion by giving miners a cut of the MEV that will be generated.
  • Ethereum miners monitor the transaction bundles being offered by searchers and pick the most lucrative options to include in the blocks that they produce.

The Migration to Proof-of-Stake

Now that we understand the current state of block building on the Ethereum network, let’s explore the changing environment that will emerge with the migration to PoS.

The Merge will usher in the era of “validators” on the network. While PoW was dependent on users expending physical energy in the form of mining to prove trustworthiness, PoS will require users to follow a different set of rules that are dependent on staking ETH. Here’s how Ethereum.org outlines the process:

“To participate as a validator, a user must deposit 32 ETH into the deposit contract and run three separate pieces of software: an execution client, a consensus client, and a validator. On depositing their ether, the user joins an activation queue that limits the rate of new validators joining the network. Once activated, validators receive new blocks from peers on the Ethereum network. The transactions delivered in the block are re-executed, and the block signature is checked to ensure the block is valid. The validator then sends a vote (called an attestation) in favor of that block across the network.

Whereas under proof-of-work, the timing of blocks is determined by the mining difficulty, in proof-of-stake, the tempo is fixed. Time in proof-of-stake Ethereum is divided into slots (12 seconds) and epochs (32 slots). One validator is randomly selected to be a block proposer in every slot. This validator is responsible for creating a new block and sending it out to other nodes on the network.”

While the requirements for becoming a validator under PoS are not small, they are substantially less than what is currently needed to compete as a miner in today’s PoW environment. This will likely lead to an influx of new validators, which is key to further decentralization of Ethereum’s network.

Many of these newer validators will lack the skill to build optimized, profitable blocks the same way that miners were able to. This is where Block Builders come into play. Instead of all block building happening via the network's previous validator equivalent (miners), under PoS anyone will be allowed to participate in the process of building blocks and proposing them to validators.

The Importance of Block Builders

Block Building is being prioritized in the switch to PoS as a mechanism to help preserve the decentralization of the network. The underlying concept is called proposer/builder separation (PBS). Vitalik covers the logic behind this prioritization in this manner:

In the current transaction market, the block proposer (today: a miner, post-merge: a validator) directly chooses which transactions to include in the next block by looking at which transactions in the mempool pay the highest priority fee. This puts the block proposer in a position to use sophisticated strategies to choose which transactions to include, or even include their own, to take advantage of opportunities such as DEX arbitrage and liquidations (hereinafter just called “MEV” for simplicity) to maximize their profits. The complexity of these strategies creates a high fixed cost in running an effective miner or validator, and advantages centralized pools that take on this task on behalf of their participants.

Proposer/builder separation (PBS) fixes this by splitting the block construction role from the block proposal role. A separate class of actors called builders build exec block bodies (essentially an ordered list of transactions that becomes the main “payload” of the block), and submit bids.

A key piece of information to understand regarding validators and the post-merge Ethereum block building landscape is this: While proposer/builder separation is on track to be baked into the network’s consensus rules at the protocol level after The Merge, it will not be a requirement of the network immediately after PoS Ethereum goes live.

So if proposer/builder separation isn’t required after The Merge, how does block building happen? It will be due to decentralized community efforts that have rallied around ways to streamline how MEV is discovered and utilized on the network. These efforts have coalesced into a project known as mev-boost which is described as such:

“mev-boost can connect to relays that aggregate multiple builders. The builders prepare full blocks, optimizing for MEV extraction and fair distribution of the rewards. The Consensus Layer client of the validator proposes the most profitable block received from mev-boost.”

mev-boost-flashbots-diagram

Image sourced from Flashbots GitHub

Ethereum will have support for mev-boost when PoS goes live, meaning that there will be a built-in option for actors to begin building blocks from scratch and proposing them to validators via relays for confirmation. 

One thing that will not change in the migration from PoW to PoS is validator incentivization. In the same manner that competing MEV searchers today incentivize miner inclusion by offering a percentage cut of their profits, block builders will likely incentivize validators to utilize their blocks by offering a percentage of the MEV they’ve captured. The difference is that this value will now be flowing in a more decentralized fashion that creates new economic possibilities for actors on the network.

It’s important to understand the way that this change reflects an overall goal of The Merge to move Ethereum’s network towards a more modular future. Specifically, the transition to PoS is an aggressive move towards decentralization through modularity.

When you break apart the different pieces of block construction, you can decentralize them individually. This allows different actors with different specialties to focus on their particular strengths. The net result is a more capable network with fewer external dependencies and a lower threshold for participation.

The New Economic Realities of Block Building

We now understand that the migration to PoS will introduce a fundamentally new economic actor (block builders) that plays an important role in supporting the underlying mission of increasing modularity.

While this is interesting on its own, the fascinating part of the transition is that, beyond knowing there will be a new class of economic actors, we do not know how these actors will act in practice. We’re about to see an unprecedented shift: New actors, new behaviors, and the possibility of radically new outcomes.

Who will these actors be? We do know that block building will be resource-intensive and will require significant network bandwidth. With this in mind, block building will likely emerge via groups that already have these types of capabilities on the Ethereum network. Existing infrastructure providers like Infura and established community groups like Flashbots are certainly likely candidates. And while we do not know exactly who will step in to perform these duties, it’s best for the ecosystem if this process is highly decentralized.

Part of the reason that decentralization of block builders is important is that it will encourage diversity in the types of blocks that are prioritized. Everyone will be competing to build the “best” blocks. But what makes a block the “best”?

There will be blocks that are focused completely on maximizing MEV. But what are the other options? Here at Blocknative we believe there will be incentives for a wide variety of PBS blocks including (but not limited to):

  • Maximum MEV
  • Fair Ordered
  • Benevolent-Only MEV
  • Gas Price Ordered
  • Time Ordered
  • Futures Auctioned
  • Censorship Enabled

It will be up to the choices of validators to determine what types of blocks will gain traction. You may think that the obvious answer is that validators will choose the blocks that maximize their profit in the same way that miners do today (Maximum MEV), but the reality is likely to be more complicated.

Remember, there will be a much wider collection of individuals acting as validators under PoS than there are miners in PoW Ethereum. Currently, the miners that prioritize profitable MEV are largely nameless, faceless entities. This will no longer be the case with PoS Ethereum. Some validators will be anonymous, but there will also be validators run by well-known members of the community.

There are questions to be asked regarding the social pressures that will evolve around block selection. Will someone with an outstanding reputation in the web3 community select a block with blatant front-running and censorship when it is their validator’s turn to propose a block?

Legal considerations are also in play. Regulators are starting to pay attention to MEV since activities such as front-running are outlawed in legacy financial markets. Since exchanges such as Coinbase and Binance will be operating validators on behalf of staking customers, their legal teams will need to weigh the risks of toxic MEV being proposed by a heavily regulated cryptocurrency exchange.

Decentralized block building also opens up the potential for a previously overlooked economic actor in the Ethereum ecosystem to gain access to the fruits of MEV: Users.

This is hugely exciting as Blocknative CEO Matt Cutler outlined in his recent Bankless interview:

“There's a user, there's a wallet, there’s a dapp, there's a protocol, all of which you could sort of look at and say ‘these are the sources of transactions of which MEV results’...Wouldn't it be a more level playing field if they were to participate in this as well?...So now you can have block builders that provide rebates. I always like to say imagine instead of you having a wallet that you add money to pay for your gas fees, your wallet pays your user…One might imagine different wallets with different techniques (for) how much they capture versus how much to share. And then users now have all sorts of new possibilities to select which wallet provides the greatest rate of rebate.

(S)o if you're a dapp developer, you can participate in this. If you are a wallet developer, you can participate in this. If you're a protocol, you can potentially participate in this as well. And so now as a block builder, you have the opportunity to take that (into consideration for) blocks. And instead of just giving (MEV) all to the validator, you can say ‘I want to share some of it with the user’.”

Reward credit card style rebates for utilizing crypto apps? It’s a real possibility. Since individual network participants are the originators of all MEV opportunities on the network, there is a logical argument that can be made around returning some of this value to them. If the idea becomes widespread, validators could face significant community pressure to select more equitable blocks.

Blocknative Is Here to Help

All of the outcomes presented above are dependent on decentralized community action. It will be up to the validators, MEV searchers, developers, users, and infrastructure providers to coordinate and align on healthy block building practices.

With this in mind, we want to make one thing clear: Blocknative is committed to promoting and enabling progressive block building strategies before, during, and well into the post-merge future.

If you want to join this mission, contact us today. With our robust toolkit of web3 developer tools focused on the pre-chain layer, no team is better situated to prepare you for the new world of block building under PoS. 

Monitor transactions with Mempool Explorer, keep tabs on ETH gas fees in real-time, or simulate transactions to see the on-chain future before it happens. And if you’re looking to make sure that as many users as possible can interact with your project, utilize Web3 Onboard, the most powerful wallet connect button in the industry.

The Merge has many unknowns, but we are confident that the shift it enables towards decentralized block building will be one of the most important factors in allowing Ethereum to reach its full potential. Don’t get left behind by failing to prepare.

Want to learn even more about what to expect with block building after The Merge? Check out the full recording of Blocknative CEO Matt Cutler on Bankless.

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