This is a joint research article written by Chorus One and Superscrypt

Blockchain transactions are public and viewable even before they get written to the block. This has led to maximal extractable value (‘MEV’), i.e. where actors frontrun and backrun visible transactions to extract profit for themselves.

The MEV space is constantly evolving as competition intensifies and new avenues to extract value are always emerging. In this article we explore one such avenue - Oracle Extractable Value, where MEV can be extracted even before transactions hit the mempool.

This is particularly relevant for borrowing & lending protocols which rely on data feeds from oracles to make decisions on whether to liquidate positions or not. Read on to find out more.

Value is in a constant state of being created, destroyed, won or lost in any financialized system, and blockchains are no exception. User transactions are not isolated to their surroundings, but instead embedded within complex interactions that determine their final payoff.

Not all transaction costs are as explicit as gas fees. Fundamentally, the total value that can be captured from a transaction includes the payoff of downstream trades preceding or succeeding it. These can be benign in nature, for example, an arbitrage transaction to bring prices back in line with the market, or impose hidden taxes in the case of front running. Overall, maximal extractable value (or “MEV”) is the value that can be captured from strategically including and ordering transactions such that the aggregate block value is maximized.

If not extracted or monetized, value is simply lost. Presently, the actualization of MEV on Ethereum reflects a complex supply chain (“PBS”) where several actors such as wallets, searchers, block builders and validators fill specialized roles. There are returns on sophistication for all participants in this value chain, most explicitly for builders which are tasked with creating optimal blocks. Validators can play sophisticated timing games which result in additional MEV capture; for example, Chorus One has run an advanced timing games setup since early 2023, and published extensively on it. In the PBS context, the best proxy for the total MEV extracted is the final bid a builder gets to submit during the block auction.

Such returns on sophistication extend to the concept of Oracle Extractable Value (OEV), which is a type of MEV that has historically gone uncaptured by protocols. This article will explain OEV, and how it can be best captured.

Oracles are one of crypto's critical infrastructure components: they are the choreographers that orchestrate and synchronize the off-chain world with the blockchain’s immutable ledger. Their influence is immense: they inform all the prices you see and interact with on-chain. Markets are constantly changing, and protocols and applications rely on secure oracle feed updates to provide DeFi services to millions of crypto users worldwide.

The current status-quo is that third-party oracle networks serve as intermediaries that feed external data to smart contracts. They operate separately from the blockchains they serve, which maintains the core goal of chain consensus but introduces some limitations, including concepts such as fair sequencing, required payments from protocols and apps, and multiple sources of data in a decentralized world.

In practical terms, the data from oracles represents a great resource for value extraction. The market shift an oracle price update causes can be anticipated and traded profitably, by back-running any resulting arbitrage opportunities or (more prominently) by capturing resulting liquidations. This is Oracle Extractable Value. But how is it captured, and more importantly, who profits from it?

In MEV, searchers (which are essentially trading bots that run on-chain) profit from oracle updates by backrunning them in a free-for-all priority gas auction. Value is distributed between the searchers, who find opportunities particularly in the lending markets for liquidations, and the block proposers that include their prices in the ledger. Oracles themselves have not historically been a part of this equation.

OEV changes this flow by atomically coupling the backrun trade with the oracle update. This allows the oracle to capture value, by either acting as the searcher itself or auctioning off the extraction rights.

OEV primarily impacts lending markets, where liquidations directly result from oracle updates. By bundling an oracle update with a liquidation transaction, the value capture becomes exclusive, preventing front-running since both actions are combined into a single atomic event. However, arbitrage can still occur before the oracle update through statistical methods, as traders act on the true price seen in other markets

UMA and Oval:

• UMA has developed a middleware product called Oval (in collaboration with Flashbots), which aims to redistribute value more fairly within the DeFi space.

• Oval works by wrapping data and conducting an order flow auction where participants bid for the right to use the data, with proceeds shared among protocols like Aave, UMA, and Chainlink.

• This means that Oval inserts an auction mechanism and lets the market decide what a particular price update is worth.

• This system helps DeFi protocols like Aave capture value that would otherwise go to liquidators or validators, potentially increasing their revenue.

• Recently, Oval announced they had successfully completed the “world’s first OEV capture”, through a series of liquidations on the platform Morpho Labs. They even claim a 20% APY boost on some pairs on Morpho.

API3 and OEV Network:

• API3 launched the OEV Network as a L2 solution, which uses ZK-rollups to capture and redistribute OEV within the DeFi ecosystem.

• The network functions as an order flow auction platform where the rights to execute specific data feed updates are sold to the highest bidder.

• This is a different extraction mechanism, as it turns the fixed liquidation bonus into a dynamic market-driven variable through competition.

• This approach aims to enhance the revenue streams of DeFi protocols and promote a more balanced ecosystem for data providers and users.

• API3’s solution also incentivizes API providers by distributing a portion of the captured OEV, thus encouraging direct participation and somewhat disrupting the dominance of third-party oracles​.

Warlock

• Warlock is an upcoming OEV solution that will combine an oracle update sourced from multiple nodes with centralized backrun transactions.

• The oracle update will feature increasing ZK trust guarantees over time, starting with computation consistency across oracle nodes.

• Centralizing the backrun allows for lower latency updates, precludes searcher congestion, and protects against information leakage as the searcher entity retains exclusivity, i.e. does not need to obscure alpha. Warlock will service liquidations with internal inventory.

• The upshot is that lending markets can offer more margin due to less volatility exposure via lower latency. The relative upside will scale with the sophistication of the searcher entity and the impact of congestion on auction-type OEV.

• Overall, the warlock team estimates that a 10-20% upside will accrue to lending markets initially, with a future upside as value capture improves.

The upshot of this MEV capture is that oracles have a new dimension to compete on. OEV revenue can be shared with dApps by providing oracle updates free of charge, or by outright subsidizing integrations. Ultimately, protocols with OEV integration will thus be able to bid more competitively for users.

OEV solutions share the same basic idea - shifting the value extraction from oracle updates to the oracle layer, by coupling the price feed update with backrun searcher transactions.

There are several ways of approaching this - an OEV solution may integrate with an existing oracle via an official integration, or through third party infrastructure. These solutions may also be purpose built and provide their own price update.

Heuristically, the key components of an OEV solution are the oracle update and the MEV transaction - these can be either centralized or decentralized.

We would expect purpose-built or “official” extensions to existing oracles to perform better due to less latency versus what would be required to run third party logic in addition to the upstream oracle. Additionally, these would be much more attractive from a risk perspective, as in the case of third party infrastructure, updates could break undesired integrations spontaneously.

The practical case is that a centralized auction can make most sense in latency-sensitive use cases. For example, it may allow a protocol to offer more leverage, as the risk of stranding with bad debt due stale price updates is minimized. By contract, a decentralized auction likely yields the highest aggregate value in use cases where latency is not as sensitive, i.e. where margin requirements are higher.

1. Atomic Liquidations

   • In a network supply chain, several blockchain actors can benefit from the information arbitrage that they possess.

   • Entities with privileged access to oracle data can leverage this information for liquidation or arbitrage

   • This can create unfair advantages and centralize power among those with early data access.

2. A new dimension to compete on

   • OEV can lead to substantial profit opportunities, with estimated profits in the millions of dollars. This is especially true in highly volatile markets.

   • OEV enables oracles to distribute atomic backrun rights to searchers, capturing significant value

   • Ecosystems that distribute value in proportion to the contributions (of users, developers, and validators) are likely to thrive.

3. Potential Risks and Concerns

   • If not managed properly, OEV can undermine the fairness and integrity of decentralized systems. Although the size of the oracle remains the same, it opens the door to competition on the value they can extract and pass onto dApps.

   • Some oracles like Chainlink have moved to reduce OEV and mitigate its impact, by refusing to endorse any third-party OEV solution. However, canonical OEV integrations are important as third party integrations bring idiosyncratic risk.

   • In traditional finance, market makers currently make all of the money from order flow. In crypto, there is a chance that value can be shared with users.

4. Mitigation Strategies

   • Decentralization of Oracles: Using multiple independent oracles to aggregate data can reduce the risk of any single point of control.

   • Cryptographic Techniques: Techniques like zero-knowledge proofs can help ensure data integrity and fair dissemination without revealing the actual data prematurely.

• Revenue Enhancement: By capturing OEV, projects can significantly enhance the revenue streams for DeFi protocols. For example, UMA’s Oval estimates that Aave missed out on about $62 million in revenue over three years due to not capturing OEV. By enabling these protocols to capture such value, they can reduce unnecessary payouts to liquidators and validators, redirecting this value to improve their own financial health.

• Decentralization and Security: API3’s use of ZK-rollups and the integration with Polygon CDK provides a robust, secure, and scalable solution for capturing OEV. This approach not only ensures transparency and accountability but also aligns with the principles of decentralization by preventing a single point of failure and enabling more participants to benefit from the system. An aspect of this is also addressed by oracle-agnostic solutions and order flow auctions.

• Incentives for API Providers: Both API3 and UMA’s solutions include mechanisms to incentivize API providers. API3, in particular, allows API providers to claim ownership of their data in Web3, providing a viable business model that promotes direct participation and reduces reliance on third-party oracles.

• Impact on Users and Developers: For users and developers of DeFi applications, these innovations should be largely invisible yet beneficial. They help ensure that DeFi protocols operate more efficiently and profitably, potentially leading to lower costs and better services for end-users.

• Adoption by Oracles and Protocols: Ultimately, the oracles have a part to play in the expansion and acceleration of OEV extraction, through themselves or more realistically, by partnering with third-party solutions. In the last weeks, UMA has launched OEV capture for Redstone oracle feeds, whilst Pyth Network announced their pilot for a new OEV capture solution. Protocols might also want to strike a balance between a new revenue stream ( for the protocol, liquidity pools, liquidity providers…) and the negative externalities of their user base.

OEV is still in its early stages, with much development ahead. We're excited to see how this space evolves and will continue to monitor its progress closely as new opportunities and innovations emerge.

This is a joint research article written by Chorus One and Superscrypt

Blockchain transactions are public and viewable even before they get written to the block. This has led to maximal extractable value (‘MEV’), i.e. where actors frontrun and backrun visible transactions to extract profit for themselves.

The MEV space is constantly evolving as competition intensifies and new avenues to extract value are always emerging. In this article we explore one such avenue - Oracle Extractable Value, where MEV can be extracted even before transactions hit the mempool.

This is particularly relevant for borrowing & lending protocols which rely on data feeds from oracles to make decisions on whether to liquidate positions or not. Read on to find out more.

Value is in a constant state of being created, destroyed, won or lost in any financialized system, and blockchains are no exception. User transactions are not isolated to their surroundings, but instead embedded within complex interactions that determine their final payoff.

Not all transaction costs are as explicit as gas fees. Fundamentally, the total value that can be captured from a transaction includes the payoff of downstream trades preceding or succeeding it. These can be benign in nature, for example, an arbitrage transaction to bring prices back in line with the market, or impose hidden taxes in the case of front running. Overall, maximal extractable value (or “MEV”) is the value that can be captured from strategically including and ordering transactions such that the aggregate block value is maximized.

If not extracted or monetized, value is simply lost. Presently, the actualization of MEV on Ethereum reflects a complex supply chain (“PBS”) where several actors such as wallets, searchers, block builders and validators fill specialized roles. There are returns on sophistication for all participants in this value chain, most explicitly for builders which are tasked with creating optimal blocks. Validators can play sophisticated timing games which result in additional MEV capture; for example, Chorus One has run an advanced timing games setup since early 2023, and published extensively on it. In the PBS context, the best proxy for the total MEV extracted is the final bid a builder gets to submit during the block auction.

Such returns on sophistication extend to the concept of Oracle Extractable Value (OEV), which is a type of MEV that has historically gone uncaptured by protocols. This article will explain OEV, and how it can be best captured.

Oracles are one of crypto's critical infrastructure components: they are the choreographers that orchestrate and synchronize the off-chain world with the blockchain’s immutable ledger. Their influence is immense: they inform all the prices you see and interact with on-chain. Markets are constantly changing, and protocols and applications rely on secure oracle feed updates to provide DeFi services to millions of crypto users worldwide.

The current status-quo is that third-party oracle networks serve as intermediaries that feed external data to smart contracts. They operate separately from the blockchains they serve, which maintains the core goal of chain consensus but introduces some limitations, including concepts such as fair sequencing, required payments from protocols and apps, and multiple sources of data in a decentralized world.

In practical terms, the data from oracles represents a great resource for value extraction. The market shift an oracle price update causes can be anticipated and traded profitably, by back-running any resulting arbitrage opportunities or (more prominently) by capturing resulting liquidations. This is Oracle Extractable Value. But how is it captured, and more importantly, who profits from it?

In MEV, searchers (which are essentially trading bots that run on-chain) profit from oracle updates by backrunning them in a free-for-all priority gas auction. Value is distributed between the searchers, who find opportunities particularly in the lending markets for liquidations, and the block proposers that include their prices in the ledger. Oracles themselves have not historically been a part of this equation.

OEV changes this flow by atomically coupling the backrun trade with the oracle update. This allows the oracle to capture value, by either acting as the searcher itself or auctioning off the extraction rights.

OEV primarily impacts lending markets, where liquidations directly result from oracle updates. By bundling an oracle update with a liquidation transaction, the value capture becomes exclusive, preventing front-running since both actions are combined into a single atomic event. However, arbitrage can still occur before the oracle update through statistical methods, as traders act on the true price seen in other markets

UMA and Oval:

• UMA has developed a middleware product called Oval (in collaboration with Flashbots), which aims to redistribute value more fairly within the DeFi space.

• Oval works by wrapping data and conducting an order flow auction where participants bid for the right to use the data, with proceeds shared among protocols like Aave, UMA, and Chainlink.

• This means that Oval inserts an auction mechanism and lets the market decide what a particular price update is worth.

• This system helps DeFi protocols like Aave capture value that would otherwise go to liquidators or validators, potentially increasing their revenue.

• Recently, Oval announced they had successfully completed the “world’s first OEV capture”, through a series of liquidations on the platform Morpho Labs. They even claim a 20% APY boost on some pairs on Morpho.

API3 and OEV Network:

• API3 launched the OEV Network as a L2 solution, which uses ZK-rollups to capture and redistribute OEV within the DeFi ecosystem.

• The network functions as an order flow auction platform where the rights to execute specific data feed updates are sold to the highest bidder.

• This is a different extraction mechanism, as it turns the fixed liquidation bonus into a dynamic market-driven variable through competition.

• This approach aims to enhance the revenue streams of DeFi protocols and promote a more balanced ecosystem for data providers and users.

• API3’s solution also incentivizes API providers by distributing a portion of the captured OEV, thus encouraging direct participation and somewhat disrupting the dominance of third-party oracles​.

Warlock

• Warlock is an upcoming OEV solution that will combine an oracle update sourced from multiple nodes with centralized backrun transactions.

• The oracle update will feature increasing ZK trust guarantees over time, starting with computation consistency across oracle nodes.

• Centralizing the backrun allows for lower latency updates, precludes searcher congestion, and protects against information leakage as the searcher entity retains exclusivity, i.e. does not need to obscure alpha. Warlock will service liquidations with internal inventory.

• The upshot is that lending markets can offer more margin due to less volatility exposure via lower latency. The relative upside will scale with the sophistication of the searcher entity and the impact of congestion on auction-type OEV.

• Overall, the warlock team estimates that a 10-20% upside will accrue to lending markets initially, with a future upside as value capture improves.

The upshot of this MEV capture is that oracles have a new dimension to compete on. OEV revenue can be shared with dApps by providing oracle updates free of charge, or by outright subsidizing integrations. Ultimately, protocols with OEV integration will thus be able to bid more competitively for users.

OEV solutions share the same basic idea - shifting the value extraction from oracle updates to the oracle layer, by coupling the price feed update with backrun searcher transactions.

There are several ways of approaching this - an OEV solution may integrate with an existing oracle via an official integration, or through third party infrastructure. These solutions may also be purpose built and provide their own price update.

Heuristically, the key components of an OEV solution are the oracle update and the MEV transaction - these can be either centralized or decentralized.

We would expect purpose-built or “official” extensions to existing oracles to perform better due to less latency versus what would be required to run third party logic in addition to the upstream oracle. Additionally, these would be much more attractive from a risk perspective, as in the case of third party infrastructure, updates could break undesired integrations spontaneously.

The practical case is that a centralized auction can make most sense in latency-sensitive use cases. For example, it may allow a protocol to offer more leverage, as the risk of stranding with bad debt due stale price updates is minimized. By contract, a decentralized auction likely yields the highest aggregate value in use cases where latency is not as sensitive, i.e. where margin requirements are higher.

1. Atomic Liquidations

   • In a network supply chain, several blockchain actors can benefit from the information arbitrage that they possess.

   • Entities with privileged access to oracle data can leverage this information for liquidation or arbitrage

   • This can create unfair advantages and centralize power among those with early data access.

2. A new dimension to compete on

   • OEV can lead to substantial profit opportunities, with estimated profits in the millions of dollars. This is especially true in highly volatile markets.

   • OEV enables oracles to distribute atomic backrun rights to searchers, capturing significant value

   • Ecosystems that distribute value in proportion to the contributions (of users, developers, and validators) are likely to thrive.

3. Potential Risks and Concerns

   • If not managed properly, OEV can undermine the fairness and integrity of decentralized systems. Although the size of the oracle remains the same, it opens the door to competition on the value they can extract and pass onto dApps.

   • Some oracles like Chainlink have moved to reduce OEV and mitigate its impact, by refusing to endorse any third-party OEV solution. However, canonical OEV integrations are important as third party integrations bring idiosyncratic risk.

   • In traditional finance, market makers currently make all of the money from order flow. In crypto, there is a chance that value can be shared with users.

4. Mitigation Strategies

   • Decentralization of Oracles: Using multiple independent oracles to aggregate data can reduce the risk of any single point of control.

   • Cryptographic Techniques: Techniques like zero-knowledge proofs can help ensure data integrity and fair dissemination without revealing the actual data prematurely.

• Revenue Enhancement: By capturing OEV, projects can significantly enhance the revenue streams for DeFi protocols. For example, UMA’s Oval estimates that Aave missed out on about $62 million in revenue over three years due to not capturing OEV. By enabling these protocols to capture such value, they can reduce unnecessary payouts to liquidators and validators, redirecting this value to improve their own financial health.

• Decentralization and Security: API3’s use of ZK-rollups and the integration with Polygon CDK provides a robust, secure, and scalable solution for capturing OEV. This approach not only ensures transparency and accountability but also aligns with the principles of decentralization by preventing a single point of failure and enabling more participants to benefit from the system. An aspect of this is also addressed by oracle-agnostic solutions and order flow auctions.

• Incentives for API Providers: Both API3 and UMA’s solutions include mechanisms to incentivize API providers. API3, in particular, allows API providers to claim ownership of their data in Web3, providing a viable business model that promotes direct participation and reduces reliance on third-party oracles.

• Impact on Users and Developers: For users and developers of DeFi applications, these innovations should be largely invisible yet beneficial. They help ensure that DeFi protocols operate more efficiently and profitably, potentially leading to lower costs and better services for end-users.

• Adoption by Oracles and Protocols: Ultimately, the oracles have a part to play in the expansion and acceleration of OEV extraction, through themselves or more realistically, by partnering with third-party solutions. In the last weeks, UMA has launched OEV capture for Redstone oracle feeds, whilst Pyth Network announced their pilot for a new OEV capture solution. Protocols might also want to strike a balance between a new revenue stream ( for the protocol, liquidity pools, liquidity providers…) and the negative externalities of their user base.

OEV is still in its early stages, with much development ahead. We're excited to see how this space evolves and will continue to monitor its progress closely as new opportunities and innovations emerge.