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Exploring DeFi trading strategies: Arbitrage in DeFi

January 28, 2021

 DeFi markets are fragmented and inefficient which can be fertile for arbitrageurs to develop strategies. We discuss two categories of arbitrage strategies in DeFi such as yield arbitrage (interest rate and staking) and cross-DEX arbitrage. DeFi infrastructure has atomic batch-based processing of transactions as a new feature which enables new trading strategies in traditional financial markets. Both yield and cross-DEX arbitrage seem to be opportunities for arbitrageurs.

 

Intro about Defi

 

Decentralized Finance (DeFi) is a term created to describe the movement of projects to build a transparent, permissionless and programmable financial infrastructure. Then later on, the movement has grown in size, followers and diversity have been considered a promising short-term catalyst for the next wave of blockchain-based technology adoption. Even if DeFi has grown, its market remains inefficient and fragmented compared to their centralized counterparts. Market fragmentation and inefficiencies remain as the music to the ears of traders seeking alpha.

 

Arbitrage

 

The fragmentation and inefficiencies of Defi markets portrays that prices for same financial instruments vary for different Defi venues(fragmentation) and adjust differently to the same market movements(inefficiencies). We have splitted DeFi arbitrage strategies in two categories such as yield arbitrage and cross-exchange arbitrage.   

 

Yield arbitrage

 

Yield arbitrage strategies are executed with different lending products (i.e. interest rate arbitrage) or between staked assets. These strategies are profitable as rates are significantly fragmented across the space and relatively non-competitive. Capacity, although hard to estimate, is a function of traded volume and outstanding available tokens.

 

Cross-exchange arbitrage

 

We focus on finite, scarce and winner-take-all arbitrage opportunities in decentralized finance. Cross-exchange arbitrage between decentralized exchanges and the resulting gas bidding wars trading bots are the main piece of interest engaged in. The goal is to end up with more money than they started with. This is possible in cross-DEX arbitrage, as traders will continuously scan decentralized exchanges to execute a series of trades sequentially between different trading venues.

 

Atomic batch-based processing of transactions

 

Ethereum is a smart contract system that is Turing-complete which allows encoding of arbitrary smart contract functionality and smart contracts atomically executes programs written in Turing complete scripting languages. One can encode within a single transaction sent to a smart contract and that is atomically executed by miners. These orders are of arbitrary complexity and can have conditional preferences on trade execution. 

 

 

 


 

 

 

Generalized taking strategies in Defi

 

Both yield arbitrage and cross-DEXs arbitrage strategies are short-lived opportunities for traders. One example of it is the automated market maker Uniswap where constant arbitrage between Uniswap pair pools and other decentralized exchanges is required to keep the rate offered with the market rate for the pair’s assets. 

 

While arbitrageurs are recognized as useful to the system, they stay as limited in their profit capabilities. Another example is the asset-backed stablecoin DAI. DAI depends on arbitrageurs (Keepers) to liquidate CDPs when they fall. These liquidation opportunities are latency sensitive and prioritized with gas auctions with each other to fill them. DAI is set to switch in to Multi-collateral DAI (MCD) from its single collateral system (i.e. ETH). When MCD takes place, liquidations for each collateral will switch to English auctions by default. This intimates that the competition between takers will be their internal systems optimization rather than external latency games. 

 

Other protocols in Defi have chosen to use auctions such as TokenSets which rebalance the Dutch auction and Gnosis’ decentralized exchange DutchX. Auctions contribute a healthier DeFi ecosystem by shifting the competition to price (and a traders’ internal systems) rather than network latency. This is fairer and also allows for better price discovery. This changes the definition of an arbitrageur as the individual with the best optimized internal systems which wouldn’t be profitable to others. 

 

Are you wondering here again how limited profit capabilities will be in such a system?

 

Conclusion

 

DeFi markets are having a small percentage of overall trading volume related to blockchain-based products. Also they have a long way to go to grow that volume to meaningful numbers, we’ve seen some encouraging growth in this sector and are excited about the trading strategies its new features enable. 

 

Strategies like cross-DEX arbitrage and liquidation premiums that are used as bootstrapping mechanisms will become a pure drag when those networks reach a steady state. 

 

These strategies warrant a trader’s interest and an investor’s work

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