Yes . . . but what kind of blood is it?

I ask this question in all seriousness since as an academic philosopher of work and economics, I take aspects of the market system with a grain of salt. As we’ll see, arbitrage definitely fulfils a key function in helping to provide liquidity and correcting market inefficiencies, but when looking at something like the crypto space, it all becomes a bit fragile.

Before we get to the modern meaning of arbitrage, it’s worth considering its historical basis to see . . . well, just how far it has moved from its original practical purpose.

A Very, Very Brief History of Arbitrage

Going back to ancient times — specifically Sumeria in 1760 BCE — considering the amount of time and distance it would take to complete trades was a significant factor. Supplies and storage were precarious, travel was dangerous and unpredictable (e.g. a lack of roads); in short, absent was a uniform system of commerce as we know it today.

So arbitrage-like practices were invented to help mitigate the problem of reconciling the value of goods at one point in the trading/traveling process, as they were taken over land or sea to other destinations. Factors that caused a discrepancy in value as goods were transported included:

• Different local currencies and goods;
• Consignment roles where merchants bought goods and had to offset the purchase cost;
• Negotiating tribal and familial relations in local regions.

So, for example, let’s say:

• At the point of origin of your travels, you decided to swap your silver for gold at a rate of 3.25 to 1.
• Halfway along your journey, you stop at a city where, for whatever reasons, the exchange ratio is weighted more heavily in favor of gold — say 3.50 to 1. So, you decide to swap back to silver and make a nice little profit (assuming a lower rate can be found elsewhere or at the point of origin).

This type of discrepancy between prices and values depends on variances spread across a physical geography. What is true in one region, may be different in another. Hence the practice of judging when and where to sell can be understood as an act of arbitration. Moreover, the act of such judgment in matters of finance can be termed “arbitration of exchange”.

In modern parlance, we simply refer to arbitrage. Both “arbitration” and “arbitrage” share the same Latin root circa the 14th century AD. The Latin root is “arbiter”, which has to do with a person witnessing something specifically related to the law. Later, the term involves the act of mediating and judging. It’s not until 1875 that its financial usage arises in relation to arbitrage, which can be defined as:

“the business founded on a calculation of the temporary differences in the price of securities in different markets.”

Arbitrage Every Day of the Week

Today, profiting from the discrepancy between the prices of the same assets in different markets (or what are called market inefficiencies) can be determined by geographical distance (where one coin is valued differently at an exchange in one country versus another), but it has a lot more to do with the temporal distance between the time at which the price is noticed at one exchange and at another.

Figure in a personal computer or a smartphone and the internet, then you have the basis for quick arbitrage trading. Figure in bots and algorithms, and you have the basis for instant arbitrage trading on a massive scale.

Let’s look at another example:

• Sloane is browsing Coinbase and sees that it is offering an exchange rate for the crypto coin ACME where 1 US dollar = 2 ACME.
• She finds that on another exchange called DexLex, the rate is much lower in favor of ACME — say 1 US dollar = 1.5 ACME.
• She spends $5000 dollars at Coinbase and receives 10,000 ACME (5000 x 2).
• She then transfers her 10,000 ACME to DexLex where the rate is still 1.5.
• She then sells ACME for US dollars.
• She receives $6666.67 US dollars, a net profit of $1666.67 when compared to her initial investment of $5000 at Coinbase.

This is a simplified (and exaggerated) example to illustrate how a trader might profit from discrepancies between prices at various exchanges. Price differences tend to be slight and measured in cents, as opposed to dollars. You’d also have to figure in any transaction costs and gas fees when moving assets around. And with blockchain protocols, you have to make sure you are sending coins on the same network.

Generally, if discrepancies between the values of the same coin are large, then it is probably due to an error at one of the exchanges. More commonly, arbitrage trading is used to:

Trade on small differences when stablecoins fluctuate since several stablecoins rely on arbitrage traders to help correct the coins value. So if DAI drops from $1 to $0.98, you can expect traders to buy DAI when it is down and then sell it when it repegs at $1. So it takes a lot of trades like these with enormous amounts to make a profit.

In arbitrage trading, there is typically no money borrowed as part of the profit equation. In other words, it is a straight trade of assets. In the DeFi space, there is a lot of borrowing in order to take advantage of market inefficiencies. When the borrowing rate provides a benefit for the borrower, it is really closer to a carry trade.

Carry On with Carry Trades

You’ve probably heard the saying, “Money begets more money.” This is especially true when the money to which one has access is a significant amount for which there is little transactional cost for borrowing it. Transactional costs are typically interest rates for borrowing the lump sum, but they can also include fee penalties for using the money in one way and not another.

Absent such costs, then money can be invested and turn a profit when finding an investment opportunity that yields more in profit than you would pay in transactional costs, such as the interest rate levied for taking out a loan.

A carry trade is just this type of strategy. An investor borrows at a low interest rate and invests in an asset or assets with a higher rate of return. Carry trades are most often used in the currency market, and can become risky when the investor borrows so much that they become over-leveraged.

So imagine the following 5-Act Shakespearian tragedy called Crypto:

Act I
Romeo borrows twice the amount of his account ($5000) for a loan of $10,000. He buys Bitcoin expecting it to increase in price 3x in the next few months.

Act II
Bitcoin looks promising at first. So Romeo starts spending the principal he has saved in his account.

Act III
But then, Bitcoin drops by 5x. Even if Romeo were to cash out and trade his Bitcoin back to US dollars, he would have lost quite a bit.

Act IV
So he decides to stick it out (like Macbeth). In the meanwhile, Romeo’s principal has dwindled to a few hundred dollars. Bitcoin continues to slide while interest payments are due on the loan.

"I am in blood / Stepped in so far, that, should I wade no more, / Returning were as tedious as go o’er."
(Macbeth, III. 4.136–8)

Act V
Unfortunately at this point, Romeo is over-leveraged. He does not have enough existing cash to pay off the initial loan. Romeo defaults.

Exeunt

Enter Crypto Thugs to collect on the loan.

Because carry trading relies on finding a loan at a low interest rate, the right kinds of investment can yield a profit even if the market is neutral or even bearish. Why? Carry trading with currency relies only on the comparison between the interest rate of loan (or whatever transactional cost it has) compared to the higher yield of any other asset. It’s easier to find an asset with a higher yield in a neutral market then to find a stock that is going to do well consistently.

Arbitrage & Cryptos

Elsewhere, I’ve discussed in more detail the importance of arbitrage trading in maintaining the peg of stablecoins and the rare breed of non-pegged stablecoins.

In short and to recall a few points from above:

Arbitrage helps to smooth out market ineffeciences where a token or coin is undervalued or overvalued. When the a coin is overvalued, arbitrage traders will sell the coin for a profit. The selling helps to eventually (or sometimes quickly if it’s a run) lower the price. Conversely, when a coin is undervalued, traders will buy the coin at a discount, which in turn raises the price.

The problem with this for crypto markets is that, at least at the time of writing, the market is quite small (~2.5% of the stock market). This means that when there is a liquidity crunch or when regular traders hibernate due to a sideways market, effects ripple across all pasts of the crypto market. There could be an event where traders end up dumping a great deal of one coin in order to revert to a cash position. That leaves the arbitrage system hanging in the balance; and instead of a corrective reaction of regulating the price of the coin in question, there is a death spiral in value.

Versions of this worry have manifested throughout 2022 — notably Terra (though for other reasons, as well) — and those FUD moments when you hear a rumor that a platform or exchange might be in trouble. If said platform relies on a stablecoin whose price relies mostly on arbitrage, then the bad effects will be noticeable.

The moral of the story: coin value needs to rely on more than just arbitrage. A firm grounding in real utility might just be enough of an anchor to outrun any speculative plays.

But this is where I say, “Hey, what do I know? I’m just a philosopher.”

How This Can Be Applied

Anyone can be an arbitrage trader. Before thinking about it, do your due diligence, of course!

Most gains are small, so trading has to be done with massive amounts of coin or via an automated system. At the very least, if you find yourself yield farming in some near future, always be mindful (i.e. check that pool constantly) to see how the values of the paired coins are fluctuating due to arbitrage trading. It’s better to get out before drastic fluctuation happens, since that tends to lead to the bane of yield farmers — i.e. Impermanent Loss.

--Todd S. Mei, PhD

This article originally appeared in Medium and is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.

Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.

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