Decentralized finance, or DeFi, is a growing ecosystem of financial applications based on blockchain technology, primarily on the Ethereum network. These applications aim to recreate traditional financial instruments and services, such as lending, borrowing, trading, and insurance. The DeFi brokerage chain connects a series of intermediaries that find arbitrage opportunities, group transactions into blocks, validate these blocks, and ultimately add them to the blockchain. In this article, we summarize the findings of our report describing how arbitrage opportunities arise on the Ethereum blockchain and how the need to keep these arbitrage opportunities private gives rise to the brokerage chain.
Blockchain networks are far from frictionless
In a blockchain network, a large number of pseudonymous nodes distributed around the world must reach consensus on which transactions are valid and which are not, while avoiding double-spending and ensuring the correct execution of a wide range of smart contracts. The distributed and permissionless nature of this network prevents transactions from being processed in real time. Instead, transactions must be grouped into blocks, and the blocks must be validated to ensure that all transactions are correct, smart contracts are properly executed, and there are no double-spending. Transactions are only considered executed if they are part of a block that has been added to the blockchain.
These frictions within blockchain networks give rise to the DeFi brokerage chain, which connects a series of intermediaries specialized in different aspects of block production. Across the different levels of this chain, intermediaries compete for a share of the arbitrage profits that are constantly generated in the DeFi ecosystem.
Understanding the DeFi intermediation chain is not just an intellectual curiosity. Ethereum ETFs were recently approved by the SEC. If Ethereum ETFs gain traction, traditional asset managers would become key players in the DeFi intermediation chain we examine in this article. As the lines between traditional finance and DeFi continue to blur, understanding the dynamics of intermediation in decentralized markets is becoming increasingly relevant for academics and practitioners looking to navigate this evolving landscape.
The Origin of DeFi Intermediation: The Need for Privacy
The most basic transaction type on Ethereum is a Payment transaction: a transfer of ETH (Ethereum’s native cryptocurrency) from one address to another. The transaction includes the sender’s address, the recipient’s address, the amount of ETH to be transferred, and a transaction fee (commonly called gas fees) paid to the network for processing the transaction. In addition to ETH transfers, Ethereum allows transfers of other cryptocurrencies, including stablecoins and governance tokens of DeFi platforms.
Ethereum also allows users to perform more complex operations. smart contract transactionsSmart contracts are self-executing programs that can facilitate, verify, and enforce the terms of an agreement. Transactions that interact with smart contracts can include multiple steps, such as invoking contract functions, exchanging tokens, or conditional transfers based on predefined rules. These transactions require higher gas fees and have a higher level of complexity than simple cryptocurrency transfers. Examples of smart contract transactions include transactions on decentralized exchanges, transactions on lending platforms, and complex financial agreements.
In most cases, Ethereum users want their payment transactions to be processed immediately. To achieve this, they broadcast their payment transactions to the entire network of nodes, hoping that they will be added to the blockchain by the next block proposer, and will be added as soon as possible.
On the other hand, there are several reasons why Ethereum users may want to keep their smart contract transactions more private. Because Ethereum enables many different decentralized finance applications, arbitrageurs are constantly identifying mispricings between different DeFi protocols or between centralized and decentralized exchanges. By executing trades that take advantage of these price discrepancies, arbitrageurs can profit while also helping to improve market efficiency and liquidity. Arbitrageurs who identify profitable block creation opportunities must keep their transactions private until they are added to the blockchain to avoid being outpaced by competitors using sophisticated AI-based tools.
The DeFi Intermediation Chain
This need for privacy in smart contract transactions has led to the emergence of specialized intermediaries known as block builders. When an arbitrageur discovers a profitable transaction, they do not necessarily broadcast it directly to all Ethereum nodes. Instead, they may send their transaction directly to a trusted block builder who groups multiple transactions into a block with a large number of other transactions. The block builder keeps the arbitrageur’s transaction private until the block is added to the chain, at which point the transaction is executed and publicly revealed.
To ensure that their transaction is included, the arbitrageur typically pays an additional fee or direct payment to the block builder. The total value generated by adding the block to the blockchain, called the maximum extractable value (MEV), consists of the arbitrageur’s profits, the transaction fees paid to the block builder, and any direct payments made to incentivize the block builder to include the transactions.
The distinction between arbitrageurs and builders is driven by economies of scale: a high-revenue block will have a high number of non-arbitrage transactions and a small (often zero) number of arbitrage transactions. Block builders specialize in maintaining the hardware and software that continuously aggregates these transactions to produce high-value blocks. Arbitrageurs, on the other hand, focus on finding a small number of high-value arbitrage transactions that they can pass on to block builders.
The next layer of the DeFi brokerage chain is block proposers. These proposers are randomly selected through a proof-of-stake consensus mechanism, in which the probability of being chosen is proportional to the amount of cryptocurrency they have staked. Block builders compete to create the most profitable block and submit it to the proposer along with a bid. The proposer then selects the winning block to add to the blockchain.
One of the key factors driving the separation between the proposer and the builder is maintaining the privacy of arbitrageurs. If a proposer could see the contents of a block before selecting it, they might be able to identify and replicate profitable arbitrage opportunities, thereby reducing the incentive for arbitrageurs to participate in the system. By only revealing the contents of the block after it has been selected, the separation between the proposer and the builder helps protect the privacy of arbitrageurs’ transactions and maintain the economic incentives that drive the DeFi ecosystem.
Since the proof-of-stake consensus mechanism implies that block proposers with more staked cryptocurrencies are chosen more consistently, proposers operate large staking pools in which cryptocurrency holders pool their assets, most of these pools consisting of large centralized exchanges. These pools then share the profits from block proposals with individual investors. As such, cryptocurrency holders are the last layer of the brokerage chain, and proposers act as “delegated stakers” for them.
This multi-layered brokerage chain connects arbitrageurs to ETH holders, while preserving the privacy of arbitrageurs’ transactions. Each broker is compensated for their role, with profits flowing from arbitrageurs to block builders, then to block proposers, and finally to individual ETH depositors in staking pools or exchanges.
In summary
Despite the permissionless nature of blockchain technology, the need for privacy and efficient risk sharing has led to the formation of the DeFi brokerage chain and the concentration of market power among a few intermediaries. Of the 167 known block builders, over half of all revenue from builders and blocks proposed is captured by three builders. Similarly, of over 150,000 proposers, the top five staking pools or exchanges account for over 50% of the revenue from proposers and blocks added to the chain.
Pablo Azar is a research economist in financial studies in the Research and Statistics Group of the Federal Reserve Bank of New York.
Adrian Casillas is a technical associate at the MIT Sloan School of Management.
Maryam Farboodi is the Jon D. Gruber Associate Professor of Career Development and associate professor of finance at the MIT Sloan School of Management.
How to cite this article:
Pablo D. Azar, Adrian G. Casillas, and Maryam Farboodi, “The DeFi Intermediation Chain,” Federal Reserve Bank of New York The Liberty Street EconomyAugust 5, 2024,
Disclaimer
The views expressed in this article are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
