Impact of Transaction Ordering Policies on Ethereum Arbitrage Strategies

In a recent exploration of Ethereum's Layer 2 solutions, researchers have delved into how different transaction ordering policies impact arbitrage opportunities. The study, authored by academics including Akaki Mamageishvili, Ed Felten from Offchain Labs, and others, examines the potential profitability of arbitrage strategies when time advantages are auctioned for transaction inclusion on Layer 2 networks, according to Offchain Labs.

Investigative Methodology

The research outlines three distinct scenarios to assess the impact of transaction ordering policies on arbitrage:

1. First Come, First Serve (FCFS): This method involves seizing arbitrage opportunities immediately as they arise, with no premium for faster transaction inclusion. Participants invest in latency infrastructure to enhance their speed in the transaction sequence.
2. Priority Gas Auction (PGA): Here, transactions are prioritized based on a monetary tip given to block builders, incentivizing traders to pay more for earlier transaction processing within a block.
3. FCFS with Time Advantage: In this scenario, users bid for priority transaction ordering, using dynamic programming to optimize trade execution timing for maximum profit.

The researchers conducted simulations to determine potential profits under these market conditions.

Research Findings

The study indicates that the choice of transaction ordering policy significantly influences arbitrage profits. The FCFS with Time Advantage method emerged as the most profitable approach, particularly in high-volatility trading pairs such as ETH-USDT. Simulations showed that this strategy yielded 47.7% more profits than PGA and 86.77% more than traditional FCFS.

Implications for MEV Extraction

The research further highlights the implications for Maximum Extractable Value (MEV) operations. The design of transaction sequencing mechanisms affects profit distribution, with time-advantaged arbitrageurs advised to delay trades within their time window to maximize returns. Additionally, Automated Market Maker (AMM) pools could potentially recapture MEV by adjusting fees and limiting transaction frequency for arbitrageurs.

The paper also notes that while negative autocorrelation in price movements can favor immediate FCFS strategies, overall, FCFS with Time Advantage remains more lucrative compared to PGA, especially under volatile market conditions.

These findings provide critical insights for traders and developers in optimizing transaction ordering policies to enhance arbitrage profitability on Ethereum's Layer 2 networks.