No Risk, High Reward?

Crypto arbitrage trading has emerged as an incredibly successful means of using high-frequency trading to produce very low-risk returns.

What is Arbitrage?

Arbitrage has existed in TradFi markets for many years now, with some reports tracing back to cases occurring across the Roman frontier into India. Essentially, it is the embodiment of the “buy low, sell high strategy”, where an individual purchases an asset in one market and sells it for a higher price in another market. For example, if the price of a ton of salt was $80 in the US and $40 in Asia, a way to take advantage of this discrepancy would be to purchase the salt in Asia and sell it in the US.

How does Crypto Arbitrage differ?

To compare, Crypto Arbitrage is when an asset has different prices on different exchanges.

For example: If one BTC is worth 14 ETH on Exchange A and 16 ETH on Exchange B, I can purchase 1 BTC on DEX A and immediately sell it on DEX B for a profit of 2 ETH (subtracting the gas fee).

So this system becomes dependent on finding the right opportunities and acting as fast as possible to ensure maximum profit. The issue with this, of course, is the speed at which the trade can occur. Hypothetically, if the opportunity disappears after having purchased the initial asset, you can experience significant losses.

So how is this risk alleviated?

Flash Loans: A loan that occurs instantaneously with funds borrowed and returned within a single transaction. This is being made possible through smart contracts that perform an instantaneous trade for the user in exchange for a “Gas Fee”. The caveat to this is that if the trade is unprofitable or smart contract conditions are not met, then the transaction is reversed with funds being returned to the lender. Risk is reduced for both borrowers and lenders through the implementation of a smart contract.

Returning to the previous example of Crypto Arbitrage, you can see how this is desirable as it allows the user to, without any ETH or initial capital, derive a profit.

An example of the constituents of a single Flash Loan Crypto Arbitrage trade:

  • Request a flash loan and borrow 1000 ETH on Uniswap
  • Then exchange the 1000 ETH for 28 BTC on DEX A
  • Then trade the 28 BTC for 1004 ETH on DEX B
  • Repay the flash loan with 1000 ETH from the previous step
  • Ultimately giving a profit of 3 ETH after Gas Fees

By observing the price difference between the 2 platforms, you’re able to maximize the profit of a single trade through borrowing, via flash loans. Outside of the gas fees, this process becomes a very low-risk way of receiving returns.

But what are the risks?

So far, there are two classifications. The first is the actual source code behind the loan itself, with an individual paying gas fees to be able to access the flash loans.

The second (and more infamous) risk is the “flash loan attacks” that have taken place on several DeFi exchanges. The most prominent was the attack on PancakeBunny (yield farm aggregator for the Binance Smart Chain), with a loss of around $45Million and a 95% drop in the value of the token itself.

This attack occurs when an individual borrows significant amounts of tokens through a flash loan in order to exploit different vulnerabilities in the DeFi protocols. One specific vulnerability is that, through the loan, the attacker can generate slippage.

Slippage: The price difference between the real value of a trading pair and the exploitable contract.

Through triggering this slippage, the attacker can acquire the token for significantly less while selling it for a higher price. This allows them to deplete the value of the contract by forcing it to give up the tokens it contained. Then they can use other exchanges to convert the stolen tokens into their preferred cryptocurrency.

Ultimately, the key to any long-term strategy is to understand the market and how others interact with it. There’s a large gap of knowledge between knowing which direction the market will flow and a profitable trading strategy.

By staying up to date with trends and dynamics of how individuals and organisations trade, you can better develop your own method. However, by actively immersing yourself in the process of building these trading platforms and markets, you can put yourself in the optimal position to truly become financially free.

📅 This Week in Crypto 📅

Stablecoin exchange inflows are up, which could mean the crypto market is headed for an eventual recovery, say researchers for Bank of America. Analysts Alkesh Shah and Andrew Moss said that despite digital assets behaving like “risk assets,” stablecoins flowing into exchanges touched $490 million the week before the report—a 58% seven-day increase and the third consecutive week of inflows.

Researchers from Stanford University have developed a prototype for ‘reversible transactions’ on Ethereum, claiming it could be a way to mitigate the effects of crypto theft. Kaili Wang, a blockchain researcher at Stanford University, provided an overview of the Ethereum-based reversible token concept in a tweet on Sunday. She noted that the idea is still in its early stages and is intended to spark discussion and lead to even better solutions from the blockchain community.

The U.K. introduced a bill to make it easier for law enforcement agencies to seize, freeze and recover crypto assets when used for criminal activities such as money laundering, drugs and cybercrime, the government said Thursday.