The blockchain industry is rapidly evolving into a multi-chain ecosystem, with numerous projects striving to connect all chains together. Such connectivity and interoperability will enable users to work seamlessly across networks, platforms, and applications. However, the crypto world remains pretty fragmented for now, as is apparent when making a multi-part exchange across several chains, which is often complicated and exhausting. Yet, the abundance of platforms and liquidity pools creates many arbitrage opportunities for users.
With time, the popularity of trading has led to intense competition among traders and their software, making it increasingly difficult to profit. As a result, many traders have been looking for new opportunities, including exploring MEV (Maximal Extractable Value). By enhancing bots and creating more complex trading strategies, arbitrageurs have been able to open a new area for trading — cross-domain.
What is cross-domain arbitrage? How is it linked to MEV? What risks can it bring? Let's take a closer look.
MEV once stood for "Miner Extractable Value" and referred to the amount of profit that miners could earn by reordering, censoring, or including specific transactions in a block. With Ethereum switching to the Proof-of-Stake model instead of Proof-of-Work, the term was slightly altered to reflect changes. Now, it means "Maximum Extractable Value" and refers to the maximum profit amount validators of transactions or traders can gain by manipulating the order of transactions.
MEV, in its new form, is a relatively new concept in the world of cryptocurrency. It has gained significant attention due to its potential impact on the security and fairness of blockchain networks, which are the backbone of the entire crypto ecosystem. As a result, MEV has become a key consideration for developers and crypto enthusiasts alike as they strive to create and support blockchain networks that are secure, transparent, and equitable.
Cross-domain arbitrage is a trading that involves taking advantage of price differences for the same asset across different domains. Cross-domain arbitrageurs seek to profit from these price differences by buying the asset at a lower price in one domain and selling it at a higher price in another domain. In the crypto context, domains include blockchains, layer-2 networks, side-chains, centralized exchanges, and other entities with individual, separate liquidity. Consequently, this type of trading overlaps with cross-exchange and cross-chain arbitrages that exploit price differences between different exchanges and chains, respectively, allowing far more flexibility than straightforward trading.
As mentioned above, cross-domain arbitrage is often linked to MEV, enabling traders to maximize their profits by creating more complex trading schemes.
Essentially, MEV is possible due to the use of a mempool (short for "memory" and "pool"), a place where transactions wait to be validated and finalized in the next block. An order of validation for transactions waiting in the mempool is not precise, leaving room for reorganization. Since such mempools are visible to anyone, traders can examine existing transactions and use strategically placed orders to profit.
For instance, an arbitrageur can find a transaction that can cause the price of a particular asset to move. This movement will enable the arbitrageur to place a transaction to take advantage of the potential price difference across multiple DEXes and other platforms. There are several ways traders can place transactions: before, after, and on both sides of a target, price-changing transaction.
Some MEV tactics are relatively harmless for crypto users. For example, suppose a trader places their transaction immediately after the target transaction (engaging in so-called back-running). In that case, they can profit by buying an asset low on some platform and then selling it at a higher price on another platform after the target transaction leads to a price change as predicted. This type of MEV is generally considered not harmful because it does not negatively affect the target transaction and the user who placed it.
However, other types of MEV, such as front-running, sandwiching, and suppression, can damage users, affecting the execution of their orders and the cost-effectiveness of their transactions.
In addition to the back-running strategy described above, there are two other popular MEV strategies or attacks: front-running and sandwich attacks.
A front-running attack is when a trader observes a transaction broadcasted by another user and placed in a mempool. The trader then sends their transaction with higher gas fees to the pool, causing their transaction to be executed before the original user's transaction. This tactic is called "front-running" and can affect the asset price, creating more profit opportunities for the attacker.
The sandwich attack can be perceived as a continuation of the front-running strategy. When a trader sees a large trade of asset A (whether selling or buying), they quickly place the same buying order, followed by the sell order. This way, they increase the price of asset A, causing the user to buy at a higher slippage and then sell at a profit.
Traders often use various tools, including bots, to aid in the process of MEV extraction. Bots help to automate the process, maximizing possible margins. Another tool that is often used is flash loans, which enable traders to borrow, use, and repay funds within the same transaction. Such loans allow them to go for profitable trades without requiring upfront capital.
Cross-domain arbitrage can be highly profitable but comes with many challenges and risks. One of the biggest hurdles is the lack of cross-chain atomicity, which significantly limits the potential for cross-domain arbitrage. Cross-chain atomicity refers to the ability to execute a transaction involving multiple blockchain networks in a way that guarantees the transaction's completion or cancellation in its entirety. This feature is essential for performing cross-domain arbitrage efficiently. Although researchers and developers are working on solutions to this problem, such as decentralized multi-chain block production, achieving cross-chain atomicity is still a big dream for current traders. However, there is hope that it will become more achievable in the near future.
The next challenge, which follows from the lack of atomicity, is the time and expense of transferring assets between different domains. Traders should be considerate of all fees and commissions they may have to pay during this process and how they can affect their margins significantly. Even smart trading bots cannot compensate for a lack of atomicity, leading to insufficient profits.
The third challenge is the use of arbitrage bots itself. Arbitrage bots are essential in the field of arbitrage trading as humans cannot search, analyze, and execute transactions as fast as them. However, it is important to note that using bots requires a good understanding of how they work and how the crypto market operates. Over-reliance on bots can lead to significant losses, so it is crucial for arbitrageurs to carefully evaluate the potential risks and rewards of cross-domain arbitrage before engaging in this strategy.
Mike Shishko, Kinetex co-founder and solution architect, expressed his opinion regarding cross-domain arbitrage's current state and future. He stressed that atomicity, currently non-existent in cross-domain space, is one of the main components that can make cross-domain truly efficient and enable traders to benefit from the great revenue opportunities presented by this practice. The DeFi industry is rapidly developing, and solutions to this issue are anticipated to emerge soon. Meanwhile, the Kinetex team is also working to bring atomicity closer to reality, opening up new opportunities for the users.