Arbitrage trading, the invisible driving force behind the prosperity of the cryptocurrency market

Authors: Chi Anh, Ryan Yoon & Yoon Lee

Compiled by: Shen Chao TechFlow

Key Takeaways:

• Arbitrage Trading in Finance and Cryptocurrency: Arbitrage trading refers to borrowing low-interest currency to invest in high-yield assets. This strategy is widely used in both traditional and crypto markets, where traders leverage it to drive liquidity and influence currency valuations. In the cryptocurrency space, this often manifests as borrowing stablecoins to invest in decentralized finance (DeFi), which, while offering high returns, also carries significant risks due to volatility.

• Market Dynamics and Risks: Arbitrage trading can enhance market liquidity, but during crises, it may lead to severe volatility and exacerbate market instability. In the crypto market, this can trigger speculative bubbles. Therefore, risk management is crucial for investors and businesses employing this strategy.

• Future Trends and Challenges: Innovations such as yield tokenization and decentralized liquidity are shaping the future of arbitrage trading in cryptocurrencies. However, the potential rise of anti-arbitrage mechanisms presents challenges, necessitating the development of more resilient financial products to cope with them.

1. The Impact of Arbitrage Trading on Markets

Arbitrage trading is a fundamental strategy in global finance, where investors borrow low-interest currency to invest in high-yield assets. Its core objective is to profit from interest rate differentials, which can be significant depending on the currencies and assets involved.

An example of arbitrage trading in traditional markets Source: Jefferies & Co, Tiger Research

For instance, an investor might borrow Japanese yen at an interest rate of about 0.1% and then invest in Mexican bonds yielding approximately 6.5%, achieving about 5% profit without using their own capital. Arbitrage traders provide liquidity by borrowing and investing across different markets, aiding price discovery and stabilizing financial markets.

However, this provision of liquidity comes with risks, especially when market conditions change unexpectedly, such as during a financial crisis or sudden shifts in monetary policy. During times of significant market stress, like the 2008 global financial crisis, arbitrage trading can collapse rapidly, leading to sharp reversals in currency values and substantial losses for investors.

In stable foreign exchange rate conditions, arbitrage trading can be highly profitable. However, in unstable markets, these trades may be quickly unwound. In such cases, investors often rush to sell high-risk assets and buy back borrowed currency, leading to severe market adjustments. This chain reaction can amplify market volatility. Large-scale sell-offs increase market volatility and trigger a vicious cycle of asset price declines and forced liquidations.

2. How Arbitrage Trading is Applied in the Cryptocurrency Market

Table: Tiger Research, created using Datawrapper

The numbers shown in the table are averages derived from multiple platforms. Actual figures may vary depending on market conditions, specific platform operations, and the timing of data collection. Readers are advised to verify current data and conduct independent research before making decisions based on this information.

The concept of arbitrage trading also has significant implications in the cryptocurrency market.

A typical strategy involves borrowing USDT at an annual percentage yield (APY) of 5.7% and then investing in a DeFi protocol that offers 16% returns. With stable asset values, this can yield about a 10% profit margin. Compared to the approximately 6% yield from Mexican bonds, the profit margins in cryptocurrency are often higher due to volatility.

According to data from AAVE, current lending rates indicate that stablecoins have become central to cryptocurrency arbitrage trading, as they provide stable and low-cost borrowing options. For example, DeFi protocols in 2021 offered annual yields exceeding 20%, making stablecoins an ideal low-cost borrowing tool for arbitrage traders.

In 2022, the Anchor Protocol offered a fixed annual yield of 20% for UST. However, the market was not without risks. The collapse of the Terra/Luna ecosystem in 2022 serves as a warning. Many arbitrage traders borrowed stablecoins to invest in Terra's Anchor Protocol, which promised returns of up to 20%. However, when the value of $LUNA plummeted rapidly, these arbitrage trades were forced to unwind quickly, leading to massive liquidations and significant losses in the market.

This example highlights the inherent risks of arbitrage trading in the cryptocurrency space. In this domain, borrowing stablecoins to invest in high-yield assets has become a common strategy. The volatility of crypto assets can amplify the effects of these trades to levels rarely seen in traditional finance.

At the same time, this challenge also presents significant opportunities. The market has the potential to develop innovative financial products and services tailored to the needs of cryptocurrency arbitrage trading, such as advanced risk management tools and yield optimization platforms. However, businesses must adopt flexible strategies to respond quickly to market fluctuations, given the high volatility of crypto assets.

3. How Do Traditional Arbitrage Strategies Differ from Cryptocurrency Arbitrage Strategies?

Source: Tiger Research, created using Datawrapper

While both traditional and cryptocurrency arbitrage trading are based on interest rate differentials, they differ significantly in terms of investor types, target assets, and risk levels. Traditional arbitrage trading is typically the domain of institutional investors, such as funds and financial institutions, whereas cryptocurrency arbitrage trading offers opportunities for retail investors.

In terms of assets, traditional arbitrage trading primarily focuses on currency pairs in regulated markets, which usually offer stable returns and moderate risk. In contrast, cryptocurrency arbitrage strategies utilize a more diverse range of platforms, providing greater flexibility and higher potential returns, but with significantly increased risks. The use of leverage, yield farming, and staking rewards adds complexity to cryptocurrency arbitrage trading, making it a potentially lucrative but higher-risk investment strategy.

In the rapidly changing cryptocurrency market, decision-makers must carefully weigh these factors when considering arbitrage trading.

4. What Impact Does Arbitrage Trading Have on the Cryptocurrency Market?

4.1. Self-Reinforcing Mechanisms and Market Upward Momentum

Arbitrage trading creates a self-reinforcing mechanism that drives market upward momentum. As mentioned earlier, arbitrage trading involves borrowers leveraging low-interest assets to invest in high-yield opportunities. When market prospects are optimistic, this can trigger a cycle: rising prices attract more traders, further enhancing the profitability of trades, specifically manifested as:

1. More investors borrow stablecoins to invest in the market for profits.

2. Increased borrowing of stablecoins drives up market prices.

3. As prices rise, more investors join, creating a self-reinforcing cycle.

However, this cycle brings significant risks in the highly volatile cryptocurrency market. Sudden changes in the market—such as declines in the value of investment assets or spikes in borrowing costs—can lead to rapid unwinding of these trades. Such large-scale withdrawals may trigger liquidity issues and significant price drops, further exacerbating market instability. While arbitrage trading can enhance liquidity and yield, it can also provoke sudden and severe market turmoil.

4.2. Enhancing Liquidity in the Cryptocurrency Market

Source: DeFiLlama

During the DeFi summer of 2021, the total value locked (TVL) in DeFi experienced significant growth.

Cryptocurrency arbitrage trading, especially trades involving stablecoins, has significantly enhanced market liquidity. Stablecoins like USDT, USDC, and DAI are commonly used in arbitrage trading, providing essential liquidity to DeFi platforms, including lending protocols. This influx of funds facilitates smooth trading and improves price discovery efficiency, benefiting the entire cryptocurrency market.

In 2023, the daily trading volume of stablecoins exceeded $80 billion, demonstrating their crucial role in maintaining liquidity in the crypto market. Furthermore, the increase in liquidity attracts institutional investors, who typically prefer markets with higher liquidity. This, in turn, brings more capital inflows, promoting market stability.

5. New Trends in Arbitrage Trading

5.1. The Rise of Yield Tokens

Annual percentage yield (APY) of stablecoins on the Pendle protocol, source: Pendle

As the crypto market continues to evolve, new trends are emerging in arbitrage trading. One such trend is the rise of yield tokens, where investors can trade future yields separately from the principal on platforms like Pendle. This innovation enables more complex arbitrage strategies, allowing investors to hedge or speculate on future yields.

5.2. The Potential for Anti-Arbitrage Mechanisms in the Crypto Market

Anti-arbitrage mechanisms refer to situations where the market anticipates that future volatility will exceed current levels. This presents specific challenges for the crypto market, particularly for arbitrage trading. When price volatility increases, the efficiency of arbitrage trading declines, as it typically involves borrowing low-interest assets to invest in high-yield assets. As liquidity costs rise and leverage-related risks increase, this strategy not only sees reduced profits but can also become dangerous.

However, due to the deflationary characteristics of crypto assets like Bitcoin (i.e., limited supply), they may perform well in anti-arbitrage environments. Fiat currencies are susceptible to inflation, while Bitcoin and similar crypto assets can serve as stores of value and hedge against the depreciation of traditional investments. In this context, they may become strong alternatives to traditional arbitrage trading strategies.

6. Conclusion

Arbitrage trading has long been a key driver of global finance, and its application in the crypto market marks a significant evolution of this strategy. In the future, arbitrage trading will develop amidst innovation, regulatory changes, and the ongoing interaction between traditional and crypto markets. As more crypto ETFs enter the market, the lines between traditional finance and digital finance are increasingly blurred, providing institutional investors with opportunities to enter the crypto market for high returns. This shift may attract capital inflows from the traditional finance sector, further enhancing the legitimacy of the crypto market and expanding its influence.

However, businesses and investors in the crypto space need to carefully balance the risks and rewards of arbitrage strategies while closely monitoring emerging trends that may reshape the market landscape. The potential for anti-arbitrage mechanisms due to regulatory changes or shifts in market dynamics adds complexity to the market. This complexity will challenge traditional approaches while also providing new opportunities for participants who can respond flexibly. By identifying these changing trends and maintaining flexibility, market participants can better seize the unique opportunities presented by the convergence of traditional finance and crypto finance.