HashKey: Inventory of cryptocurrency arbitrage opportunities and DeFi arbitrage trends
Editor's Note: This article comes fromChain News ChainNews (ID: chainnewscom), published with permission.
Chain News ChainNews (ID: chainnewscom)
Reviewer: Zou Chuanwei, Chief Economist of Wanxiang Blockchain and PlatON
Chain News ChainNews (ID: chainnewscom)
, published with permission.
Written by: Lin Bullen at HashKey Capital Research
Reviewer: Zou Chuanwei, Chief Economist of Wanxiang Blockchain and PlatON
Arbitrage refers to the behavior of investors in the market to take advantage of the imperfection of the price system of the market economy to obtain additional profits through buying and selling. Arbitrage activities can help financial markets operate effectively and improve asset pricing efficiency, increasing market liquidity.
This article mainly studies and sorts out the arbitrage mechanism in the cryptocurrency market. We found that the cryptocurrency industry as a whole is in a relatively early stage of development, and the entire trading market lacks a complete trading system and regulatory measures, so there is a large room for arbitrage. At present, there are a variety of arbitrage mechanisms in the market. In theory, almost all of them can achieve arbitrage, but in actual arbitrage operations, there may be many risks involved, as well as the wear and tear of various handling fees in the arbitrage process. In the future, the arbitrage mechanism will always exist and become more abundant, helping the market to develop more effectively.
The reason for arbitrage
Generally speaking, arbitrage space generally appears in some immature markets with a small number of participants, and investors use information gaps to carry out arbitrage behaviors to obtain additional income. In the traditional financial market, due to the development of the market scale and the improvement of the trading system, the arbitrage space is constantly being compressed.
The implementation of arbitrage in the financial market is faster and more convenient than other markets, which makes the arbitrage opportunities in the financial market always exist short-lived. Once the arbitrage space is discovered, investors will quickly implement arbitrage and return the market to no arbitrage in a state of balance. Therefore, how many arbitrage opportunities exist in the market and how long the arbitrage opportunities exist can judge the effectiveness of the market mechanism and the degree of marketization.
Cryptocurrency Arbitrage Mechanism
The cryptocurrency industry as a whole is in a relatively early stage of development, and the entire trading market still lacks a complete trading system and regulatory measures, so there is a large room for arbitrage.
From multiple dimensions, cryptocurrency arbitrage mechanisms are mainly divided into the following categories:
Cross currency arbitrage
Cross-currency arbitrage Also known as triangular arbitrage, it refers to the arbitrage behavior that occurs between two trading pairs formed for three currencies within an exchange. For example, in an exchange, cryptocurrency A has two trading pairs of A/BTC and A/ETH. Assume that at a certain moment when the price of A is greater than A/ETH in the A/BTC trading market, the price of A/BTC is 11 yuan , the price of A/ETH is 10 yuan. The specific arbitrage steps are as follows:
The initial investment capital is ETH worth 100 yuan, use ETH to buy cryptocurrency A in the A/ETH trading market at a price of 10 yuan, and obtain A with a total value of 100 yuan;
Sell A in the A/BTC trading market for 11 yuan, and get BTC with a total value of 110 yuan;
Exchange 110 yuan of BTC for ETH, get a total value of 110 yuan of ETH, and a total profit of 10 yuan.
Under ideal circumstances, cross-currency arbitrage can be realized without risk, but the actual situation may reduce the arbitrage profit due to various factors.
First of all, cross-currency arbitrage involves three major transactions, and exchange fees need to be considered. If the total amount of arbitrage funds is high, the transaction fee involved may greatly reduce the arbitrage profit.
Cross-currency arbitrage requires exchanges to have high liquidity. If the arbitrage funds are large and the liquidity is insufficient, not enough orders will cause the transaction to fail to be matched in time and miss the best arbitrage opportunity. If the market price order is adopted, the price of the underlying asset for arbitrage may fluctuate greatly, reducing the overall return.
The assets that can be used for cross-currency arbitrage are limited. According to the market value and recognition of cryptocurrencies, the exchange will choose the number of online trading pairs. Assets with multiple trading pairs that can be used for triangular arbitrage are generally mainstream cryptocurrencies, and triangular arbitrage cannot be applied to most altcoins.
futures arbitrage
Futures arbitrage refers to arbitrage based on the price difference between the futures contract and the spot on the cryptocurrency exchange.
Generally speaking, the futures price represents the future trend of the spot price, and the futures contract price will converge with the spot price on the expiration date of the futures. However, before the delivery time, there may be a basis difference between the futures price and the spot price (the difference between the spot price and the futures price). Once the basis difference is large, there will be an opportunity for arbitrage.
Futures spot arbitrage mainly includes forward basis arbitrage and reverse basis arbitrage.
Positive basis arbitrage means that when the spot price is lower than the futures contract price, the arbitrageur can sell the futures contract and buy the same amount of spot at the same time to establish an arbitrage position. When the gap between the spot and futures prices tends to be the same (not necessarily the expiration date of the futures contract), the futures contract is closed and the corresponding spot is sold to obtain a profit. Reverse basis arbitrage is the opposite operation. When the spot price is higher than the futures contract price, the arbitrageur can buy the futures contract and sell the same amount of spot at the same time to establish an arbitrage position. When the spot and futures prices tend to be the same, the positions are closed at the same time to make a profit.
Although from a theoretical point of view, the realization of cash-futures arbitrage is relatively simple, but there are many risks and uncertainties in actual operation.
First, the basis difference between the futures price and the spot price is changing all the time. Due to market price fluctuations, the basis may become larger at certain moments. In this way, the futures and spot goods in the hands of users will lose money, so the timing of opening a position and the follow-up judgment of the market are particularly critical in futures-spot arbitrage.
The futures contracts involved in spot futures arbitrage have the risk of liquidation. Although the leverage of futures contracts in futures and spot arbitrage is low, the "pin insertion" of individual exchanges will still cause the user's contract to liquidate.
Therefore, generally speaking, the technical threshold for futures and cash arbitrage is high, and it requires a high level of judgment on market trends, which is not suitable for novice users to participate.
Exchange arbitrage
Exchange arbitrage refers to the arbitrage behavior of buying cryptocurrency at a low price on an exchange and selling it at a high price on another exchange to obtain the difference.
There are a large number of exchanges in the cryptocurrency market, and the price of the same currency in each exchange will have a slight difference at the same time. When the market fluctuates violently, the rise or fall of cryptocurrency prices is often started by a certain exchange. Then the price difference between various exchanges will attract arbitrageurs to move bricks, and finally smooth out the price difference in each exchange.
Exchange arbitrage will be limited by the cryptocurrency blockchain transfer time and exchange audit time. When there is a price difference between exchanges, arbitrageurs need to buy at a low price in a short period of time and transfer the money to a high-price exchange for selling to make a profit. However, if the blockchain network is congested (such as the frequent congestion of Bitcoin and Ethereum) or the exchange review takes a long time, it will result in the inability to timely arbitrage and damage the interests.
Therefore, most institutional quantitative investors will reserve a large amount of cryptocurrencies in various exchanges in advance to explore arbitrage opportunities, which will directly skip the disadvantages caused by the transfer delay step, but the disadvantage is that large amounts of funds need to be deposited in the exchange China and Israel are always ready for arbitrage at the expense of the liquidity cost of funds.
DeFi arbitrage
DeFi arbitrage usually refers to borrowing at low interest rates in one DeFi market and depositing assets in another DeFi market for high interest rates. Arbitrage opportunities arise when there is a difference in borrowing and deposit rates between platforms and the deposit rate is higher than the borrowing rate.
Different from the arbitrage method described above, DeFi arbitrage uses the "interest rate difference" of cryptocurrency products to make profits instead of directly using the price difference of asset targets.
Decentralized DeFi protocols are still in their early stages. Factors such as high volatility of cryptocurrencies, over-collateralization, and smart contract risks will become risk compensation for DeFi protocols to provide users with high interest rates. Similarly, funds deposited in the traditional financial lending market will bear lower risks, so the DeFi market needs to use high interest rates to compensate for the risk exposure brought about by the decentralized mechanism.
The following will illustrate the arbitrage process with an example:
Another advanced DeFi arbitrage method is to borrow ETH (the currency with the lowest borrowing rate in the market) in the Compound market, and exchange it for USDC (the currency with the highest deposit rate in another market) through the exchange and deposit it in Nuo Network, thus achieving a higher annualized rate of return of 9.19%.
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Figure 1: Compound market interest rate information (partial)
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Figure 2: Nuo Network market interest rate information (partial)
In the same way, using the above logic, DeFi arbitrage can be applied to any two lending markets, including lending services provided by some centralized exchanges. As long as there is a difference between the borrowing rate and the deposit rate, there is room for arbitrage.
There may also be arbitrage space between the DeFi market and the staking of some projects, borrowing through the low-interest rate market, and converting it into staking currency on the exchange for high-interest staking to earn arbitrage on the interest rate difference.
In addition, there is a more complex and high-threshold arbitrage method in the DeFi market: using smart contract loopholes and the characteristics of flash loans for arbitrage.
Flash Loans is designed for developers to take out loans instantly without providing any collateral. All operations are done in one transaction (one block confirmation time). Developers can borrow money from the reserve pool of DeFi projects that support flash loans, on the condition that the funds are returned to the pool before the transaction is closed. If such funds are not returned to the reserve in time, the transaction will be reversed thereby securing the reserve pool.
On February 16, 2020, the DeFi project bZx suffered an "arbitrage attack" triggered by flash loans. Hackers used a bug in the bZx smart contract to transfer the bZx funds that should have been locked to Uniswap and further transfer the funds to Compound for lending , by continuously calling bZx margin trading function instructions to increase the exchange rate between WBTC and ETH and finally make a profit. Of course, this type of arbitrage is not common and flash loans are limited to developers with the ability to write code. At the same time, arbitrageurs need to seize the contract loopholes and carry out arbitrage behaviors. For most ordinary users, it is almost impossible to use flash loans to arbitrage, so the practicability is not wide.
To sum up, arbitrage using the difference between high and low interest rates in the two lending markets is a common operation in DeFi arbitrage. It should be noted that users may encounter the following problems in the process of DeFi arbitrage:
First of all, the interest rate in the DeFi market will be adjusted at any time according to supply and demand. After the user deposits funds, the interest rate will decrease, which will cause the income to decrease and cause the interest rate to be inconsistent with the expected interest rate.
The essence of the lending process in DeFi arbitrage is an operation of "magnifying capital leverage". Although the leverage ratio is not high, there is still a risk of being liquidated. In the case of violent market fluctuations, asset losses may result.
Smart contract issues for DeFi programs. At present, there have been many hacking problems caused by smart contract vulnerabilities in the cryptocurrency market, which have threatened user funds. Therefore, borrowing and lending large amounts of funds through smart contracts requires DeFi to have extremely high security.
The price difference between different DeFi platforms can be eliminated to a certain extent through DeFi arbitrage. First of all, arbitrage will trigger changes in DeFi interest rates and reduce arbitrage space. With the emergence of arbitrage opportunities, most arbitrageurs will lend out low-interest-rate currencies, which will lead to increased demand in the market and insufficient supply, resulting in an increase in lending rates.
On the other hand, if the deposits of high interest rate currencies continue to increase, the supply will increase and demand will decrease, resulting in a reduction in deposit interest rates. The design mechanism of the interest rate in the DeFi protocol reflects the supply and demand factors in the DeFi market, and the emergence of arbitrageurs can narrow the interest rate gap in the DeFi market. The arbitrage mechanism will play the role of an interest rate regulator in the DeFi market to feed back the real lending interest rate.
With the rise of the DeFi market, more and more lending projects have emerged, and the high interest rate differential in the market will exist for a long time, which also reflects to a certain extent that the development of the DeFi market is still in its early stages.
The high interest rate difference is mainly reflected between some "newly issued" DeFi projects and "more mature" DeFi projects. New DeFi projects generally have higher interest rates to attract users. However, with the maturity of the DeFi market and the continuous influx of arbitrageurs, the space for arbitrage will gradually decrease. In addition to using high interest rates to attract users, new DeFi projects in the future also need a more complete and comprehensive incentive mechanism to ensure project liquidity.
Cross-border arbitrage
Cross-border arbitrage refers to the arbitrage method in which arbitrageurs buy cryptocurrency at a low price with legal currency in one country and sell it at a high price with legal currency in another country to earn the difference.
Due to the differences in the supply and demand of cryptocurrencies in different countries and the policies of different countries, the prices of cryptocurrencies are often inconsistent, so there are opportunities for arbitrage. For example, in South Korea in 2018, users frenziedly hyped cryptocurrencies, causing the price of local cryptocurrencies denominated in fiat currency to be much higher than those in other countries, which is called "Kimchi Premium" (Kimichi Premium).
The arbitrage mechanism and operation in cross-border arbitrage are not complicated. The main process is: buy cryptocurrency at a relatively low price in the country, then transfer it to the legal currency exchange in a country with a high premium through the blockchain for sale, and finally pass the legal currency foreign exchange Transfer back to your home bank. Although the operation and logic of cross-border arbitrage are relatively simple, the whole process will be subject to many restrictions.
Users need to open a legal currency exchange account in a foreign country. Fiat currency exchanges often need to carry out KYC for users and apply for local bank savings cards. Most exchanges are limited to domestic users due to legal compliance, so it is difficult and costly to open an account.
Foreign exchange funds are restricted. Due to foreign exchange control, the amount of legal currency transferred through the bank is generally limited, which also means that the profit earned by arbitrage is also very limited.
Arbitrage opportunities and less profit. The last time there was a high premium for cryptocurrencies was in South Korea in early 2018. The reason for the premium came from the big bull market in the cryptocurrency market at the end of 2017, which is relatively rare. Although there may still be occasional premiums in various countries, cross-border arbitrage needs to consider that foreign exchange, exchange and other handling fees will reduce profits.
The role of cryptocurrency arbitrage
Arbitrage is often considered a necessary condition for the effective operation of a financial market, and arbitrage can reasonably price assets in the market. In the digital currency market, the price of cryptocurrencies often changes significantly due to relevant information such as regional policies and cooperation benefits, and arbitrageurs use the arbitrage mechanism to accurately position the prices of cryptocurrencies in various exchanges in the market (interest rates in DeFi arbitrage) , to achieve the current state of supply and demand balance.
At the same time, it plays a role in supervising the transparency of network information in the entire industry. Only in an efficient trading system can investors fully enjoy the timeliness of transactions and reduce transaction costs. On the other hand, the arbitrage mechanism can make the overall cryptocurrency market more standardized, so that each exchange can feed back the real asset price trend. Arbitrage can also promote the consensus of global users on encrypted assets and accelerate the future development of the entire industry.
The development of cryptocurrency arbitrage
From the perspective of arbitrage sites, arbitrage opportunities in the cryptocurrency market initially appear in the price difference between multiple exchanges, so in the early days, arbitrageurs generally used the price difference between cryptocurrency exchanges for exchange arbitrage and cross-border arbitrage, etc. . With the emergence of derivatives, futures and spot arbitrage has also become a new type of arbitrage method. Until the recent rise of the DeFi market, arbitrageurs focused on the DeFi market, hoping to use the unique mechanism of DeFi to discover more arbitrage opportunities.
Summarize
Since the DeFi market is a new type of market that is earlier than centralized exchanges, there is a lot of arbitrage space worth exploring. Therefore, the overall trend of arbitrage venues is changing from centralized cryptocurrency exchanges to decentralized DeFi markets, and more arbitrage mechanisms may be derived.
From the perspective of arbitrage operation methods, the arbitrage space in the early cryptocurrency market is large and the feedback time for the market to return to a reasonable price is relatively long, so arbitrageurs can carry out manual operations to realize asset sales. Arbitrageurs need to monitor the price of the exchange in real time, and immediately perform operations such as manual pending orders and transfers after discovering arbitrage opportunities.
