Understanding Arbitrage in DeFi: Opportunities, Strategies, and Risks
Published August 1, 2022.
Arbitration is the simultaneous purchase and sale of an asset in different markets to take advantage of price discrepancies. In traditional finance, this usually refers to buying and selling assets in different countries or exchanges to profit from differences in prices.
In the world of decentralized finance (DeFi), arbitration refers to the practice of taking advantage of price differences between different protocols or exchanges. This can be done by buying an asset on one platform and selling it on another platform for a higher price or by lending an asset on one platform and borrowing it at a lower rate on another platform.
By arbitraging between these different platforms, users can earn a risk-free return on their investment. But going through the hassle of centralized platforms would make DeFi arbitrage much more difficult than it has to be. Thankfully, this is where decentralized exchanges come in, as decentralization is one of the key features of DeFi.
How Does Arbitrage Work in DeFi?
So far, we've covered what arbitrage is, but how does DeFi arbitrage work? Arbitration in DeFi works by taking advantage of the fact that different protocols have different prices for the same asset.
For example, suppose you have cash ready to buy 1 ETH.
Let's say that the price of ETH on Binance is $1,000, while the price of ETH on Nexo is $1,050. If you buy ETH on Binance and then immediately sell it on Nexo, you will earn a profit of $50. This arbitrage opportunity exists because the two protocols have different prices for the same asset. Of course, to take advantage of this opportunity, you need to be able to move your ETH from one protocol to another quickly and with minimal fees.
Transferring Crypto Between Exchanges
Decentralized exchanges are protocols that allow you to trade assets without having to trust a centralized third party. Instead, trades are executed by smart contracts on the blockchain. This means that you can move your ETH from one protocol to another quickly and without fees, making them perfect for arbitrage trading.
There are many different decentralized exchanges available, each with its own advantages and disadvantages. Some of the most popular decentralized exchanges include 0x Protocol, Kyber Network, Bancor Network, and AirSwap. With many different of DEXs to choose from, they rarely have the exact same prices for the same assets, so arbitraging between them is a great way to earn a risk-free return on your investment.
Types of Arbitrage Strategies in DeFi
There are many different arbitrage strategies that can be used in DeFi. Let's take a look at the most popular ones.
In triangular arbitrage, a user takes advantage of the fact that the prices of assets are not always directly correlated. For example, suppose the price of ETH on Kyber Network is $1,000, and the price of ETH on Bancor Network is $1,100.
At the same time, the price of BNT on Kyber Network is $100, and the price of BNT on Bancor Network is $110.
If you trade 1 ETH for 10 BNT on Kyber Network and then trade 10 BNT for 1.1 ETH on Bancor Network, you will end up with 1.1 ETH and $10 in BNT—giving you a clear profit. This arbitrage opportunity exists because the prices of ETH and BNT are not directly correlated. To take advantage of this opportunity, you need to be able to move your ETH and BNT between the two exchanges quickly and with minimal fees.
In cross-exchange arbitrage, a user takes advantage of the fact that the prices of assets can differ on different exchanges. It's the most frequent type of arbitrage as it's the easiest one to do, and it can be quite profitable if you have trading strategies in place.
For example, suppose the price of BTC on Kyber Network is $19,000, and the price of BTC on Bancor Network is $20,000.
If you buy BTC on Kyber Network and then sell it on Bancor Network, you will earn a profit of $1,000 for each BTC sold. Similar to triangular arbitrage, this opportunity exists because the two exchanges have different prices for BTC.
Market making is a type of arbitrage that involves providing liquidity to a market. In return for providing liquidity, market makers are rewarded with a small portion of each trade that is executed on the market.
For example, suppose there is a market for the token ADA with a bid price of $1, and an ask price of $1.5. If you buy ADA at the bid price of $1 and then sell it at the ask price of $1.5, you will earn a profit of $0.5 for each token traded. This opportunity exists because there is a spread between the bid and ask prices.
By providing liquidity to the market, you are effectively narrowing the spread and increasing the efficiency of the market. However, it's worth mentioning that, in order to be successful at market-making, you need to have a deep understanding of the market you are trading in and be able to execute trades quickly.
Risks Associated With Arbitrage in DeFi
While arbitrage can be a great way to earn a risk-free return on your investment, there are a few risks associated with it.
- Counterparty risk When you are trading on a decentralized exchange, you are trusting that the other party will fulfill their side of the trade. If they do not, you could lose your profit.
- Liquidity risk When you are trading on a decentralized exchange, you are also trusting that there will be enough liquidity in the market to fill your order. If there is not, you could end up being stuck with an asset that you cannot sell.
- Volatility risk Crypto assets are quite volatile, usually having price swings of 3-5% in 24 hours. This could make you have a smaller profit than what you originally anticipated.
How to Find DeFi Arbitrage Opportunities
There are many different ways to find arbitrage opportunities in DeFi.
One way is to manually check the prices of assets on different protocols and exchanges. This can be time-consuming and is not always accurate, as prices can change quickly. Usually, a better way is to use a tool like the DeFi Pulse index or Codefi Data to track prices in real-time. These tools allow you to quickly and easily see which assets are under or overpriced on different exchanges.
Once you have found a DeFi arbitrage opportunity, you can trade directly on a DeFi based on the Ethereum network, or use a tool like 1inch Exchange or Paraswap to automatically execute the trade for you.