Block Building

Essence

The process of block building represents the foundational layer of market microstructure in decentralized finance. It is where the sequence of transactions is determined before they achieve finality on the blockchain. For derivatives markets, this process transforms into a critical mechanism for value extraction, often termed Maximal Extractable Value (MEV).

The specific ordering of transactions within a block dictates which market participants execute first, who gets liquidated, and who captures arbitrage opportunities.

The core issue for options and derivatives protocols is the deterministic nature of block construction. Unlike traditional markets where execution order is managed by a centralized exchange with specific rules, in DeFi, the order is determined by the block builder, who has significant discretion over the inclusion and ordering of transactions within a block. This creates an environment where liquidation risk and arbitrage risk are directly related to the block builder’s incentives.

A block builder can front-run a large options trade or liquidate a position to capture the profit, rather than letting the market naturally settle. This introduces a new layer of systemic risk for derivatives protocols.

Block building defines the true cost of execution and risk management in decentralized derivatives markets by creating opportunities for value extraction through transaction ordering.

Origin

The concept of block building as a source of value extraction traces its lineage back to traditional finance, specifically high-frequency trading (HFT) strategies like front-running and latency arbitrage. In CEX environments, HFT firms invest heavily in co-location and low-latency connections to gain milliseconds of advantage in order book execution. The advent of decentralized exchanges (DEXs) on public blockchains introduced a new, more transparent version of this problem.

The origin story of MEV as a specific phenomenon in crypto begins with the “dark forest” metaphor. This concept describes the mempool ⎊ the waiting area for transactions ⎊ as a place where bots constantly monitor incoming transactions for profitable opportunities. If a bot sees a large trade or a pending liquidation, it can submit its own transaction with a higher gas fee to ensure it executes first, effectively extracting value from the original transaction.

The block builder, in turn, selects the transactions that offer the highest fees, creating a positive feedback loop for value extraction.

Early derivatives protocols on Ethereum were particularly susceptible to this dynamic. A liquidation event ⎊ where a collateralized position falls below a certain threshold ⎊ is highly predictable. The block builder could observe the pending liquidation, insert their own transaction to execute the liquidation themselves, and collect the associated fee.

This created a new risk for users and protocols, where the integrity of the liquidation mechanism was compromised by the very architecture of the block building process itself.

Theory

From a quantitative finance perspective, block building dynamics fundamentally alter the assumptions of standard options pricing models. The classical Black-Scholes model assumes continuous trading and efficient markets, where arbitrage opportunities are fleeting and quickly eliminated by non-collusive actors. Block building introduces a systemic, deterministic source of arbitrage and information asymmetry.

Consider the impact on volatility skew. In traditional markets, volatility skew reflects the market’s expectation of future price movements, often showing higher implied volatility for out-of-the-money puts. In a DeFi environment with block building, this skew can be artificially distorted by the predictable nature of liquidations.

If block builders know they can extract value from liquidations at certain price points, the market’s perceived risk at those points changes. The block builder’s profit motive acts as a non-market force influencing price discovery.

The core theoretical problem is that block building introduces a time-of-execution risk that is difficult to model. The value of an option or a derivatives position is now dependent on its position within the block. This necessitates new approaches to risk calculation.

We must account for the probability of being front-run or liquidated by a block builder. The traditional “Greeks” (delta, gamma, theta, vega) need adjustment to incorporate this new, structural risk factor.

This dynamic creates a feedback loop where block builders’ strategies influence market behavior, which in turn influences the block builders’ profitability. This interaction makes the system more complex than a standard supply and demand model. The market for block space itself becomes a critical component of options pricing.

The price paid for transaction inclusion is a direct cost that must be factored into any derivative pricing model.

Approach

To mitigate the risks inherent in block building, derivatives protocols and market participants have adopted several approaches. These solutions aim to reduce the information asymmetry between block builders and regular users.

The primary mitigation strategy involves MEV protection services. These services allow users to send transactions directly to a block builder, bypassing the public mempool. This process prevents other bots from seeing the transaction before it is included in a block.

For derivatives, this is particularly important for liquidations and large trades that could be front-run. By submitting transactions directly to a private channel, users can ensure a more predictable execution price and avoid value extraction.

Another approach involves batch auctions and pre-confirmation services. Batch auctions aggregate multiple orders and execute them simultaneously at a single price, eliminating the possibility of ordering-based arbitrage within that batch. Pre-confirmation services provide users with a guarantee that their transaction will be included in a future block at a specific price, reducing uncertainty about execution order and cost.

These solutions attempt to create a more level playing field for market participants by reducing the block builder’s discretionary power.

A further strategy involves designing protocols that make MEV extraction less profitable. This can include:

• Decentralized Liquidation Mechanisms: Protocols that use a decentralized network of liquidators, rather than a single actor, to ensure that liquidations occur at fair market prices.
• Auction Mechanisms: Implementing on-chain auctions for liquidations, where multiple participants bid for the right to liquidate, driving up the price and reducing the profit margin for a single block builder.
• Transaction Bundling: Combining multiple transactions into a single “bundle” that is submitted to the block builder. This ensures that a series of transactions (e.g. a large trade followed by a collateral adjustment) executes atomically, preventing front-running between the individual steps.

Evolution

The evolution of block building has led to the emergence of specialized roles and new market structures. The most significant development is Proposer-Builder Separation (PBS) , a design change introduced with Ethereum’s transition to proof-of-stake. PBS separates the role of the block proposer (the entity that proposes the final block to the network) from the block builder (the entity that constructs the contents of the block).

In the PBS model, block builders compete to create the most profitable block, which they then submit to a relayer. The relayer acts as a trusted intermediary, passing the block to the proposer without revealing the contents of the block to the proposer before final selection. This separation aims to reduce the proposer’s ability to extract MEV directly.

Instead, the proposer receives a bid from the block builder, creating a more competitive market for block space.

The impact of PBS on derivatives markets is significant. It changes the nature of the relationship between liquidity providers and block builders. Block builders are now incentivized to provide better execution for users to win the block space auction.

This leads to a new form of competition, where block builders must optimize their strategies to capture MEV efficiently while providing value to users. The Flashbots project pioneered this model, leading to a complex ecosystem of builders, searchers, and relayers.

Horizon

Looking ahead, the future of block building for derivatives markets centers on two key areas: sequencer decentralization and encrypted mempools. The current PBS model still relies on a small number of centralized relayers and builders, which creates a potential point of failure and censorship risk. Sequencer decentralization, particularly in Layer 2 solutions, aims to distribute the power of block building across multiple entities.

This would reduce the risk of a single entity censoring transactions or extracting excessive value from derivatives liquidations.

The next iteration involves encrypted mempools and threshold encryption. This technology allows users to submit transactions that are encrypted until a certain time or until a block is finalized. This completely eliminates the ability for block builders to see pending transactions and front-run them.

For derivatives, this would provide true pre-trade price certainty and remove the time-of-execution risk that currently plagues many protocols. It creates a level playing field where all market participants have equal access to information.

The evolution of block building from a hidden cost to a transparent market mechanism is essential for the maturity of decentralized derivatives.

However, these solutions introduce new trade-offs. Encrypted mempools could hinder legitimate arbitrage that helps keep prices consistent across exchanges. The challenge lies in designing a system that prevents malicious MEV extraction while allowing beneficial arbitrage to maintain market efficiency.

The final architecture of block building will determine whether decentralized derivatives can truly compete with traditional finance in terms of capital efficiency and risk management.