Arbitrage is as simple as buying low and immediately selling high. The less time there is between those transactions, and the more similar those assets are, the more “pure” that arbitrage is said to be.
College economics textbooks provide fanciful examples of buying gold in London and selling it in New York. If this price difference is big enough to pay for your plane fare, then you’ve found a ticket more valuable than Charlie’s golden one.
Transaction costs are a major friction to arbitrage. In securities markets there are complicated fee schedules and transaction rates that vary based on a myriad of factors and may be different for every participant. An arbitrage opportunity may exist for one trader but not another, because of their volume discounts or overall business economics.
Pricing differentials and “too good to be true” opportunities crop up across every market. That one bedroom apartment with a washer dryer and a park view for 20% less than comparables? Look a little closer, and odds are there’s a broker fee that brings things back in line.
Markets are fundamentally about allocating resources, and the competitive behavior of participants is what drives pricing harmony. Everyone wants to buy Apple stock a dollar cheaper, or get an extra perk for their home.
This means that pure arbitrage rarely exists, or is only accessible to the fastest and most connected players in the market. But in the never ending quest for better returns and uncovered opportunities, the limits of arbitrage get pushed.
Fifteen years ago one of the largest hedge funds blew up based on the outsized bets of one player trying to corner the natural gas market. Brian Hunter was a wunderkind trader who repeatedly made billions until he lost it all, taking Amaranth Advisors down with him.
While it was an outsized bet on the relative price of gas between the summer and winter that ultimately took him down, a key component of their strategy was playing on the price differentials between the ICE and NYMEX. Access to the unregulated ICE market lets large players offer more competitive pricing on NYMEX, but also evade position limits and push the needle further.
Where scale and access formed the backbone of arbitrage opportunities historically, that edge is increasingly getting eaten by technology focused opportunities. It still takes a lot of money to buy the high performance software and savvy to execute, but with market structures and venues proliferating rapidly, that barrier is being lowered every day.
A watershed moment for equities markets was the creation of “Reg-NMS” which formalized the interactions between various exchanges and trading facilities that had developed. No longer was the NYSE the only place to swap shares, but all electronic venues offered better pricing and execution for large and frequent traders.
This legislation was intended to ensure that customers always got the best price of any venue, but also opened up a major structural opportunity for the “Flash Boys” to capture near risk free arbitrage like money. By reading the ticker tape faster and managing pennies across microseconds, these high frequency trading firms reaped millions.
The window for that opportunity was short, and both regulatory and competitive interests closed it. Certain firms were getting access to privileged information, but more importantly there’s only room for one king of the hill, and if you weren’t the fastest, it was no longer worth it and time for a different game.
Crypto trading has accelerated this process even further. For 15 years I went to options conferences and listened to everyone from brokers to market makers complain about the number of different venues. There are 16 equity options exchanges. There have been at least that many new crypto venues this month.
The slight nuances across different exchanges and pools means that the complexity of possible arbitrage opportunities is endless. While you might see the price of Bitcoin quoted in several different places, and see price differentials that are meaningful, there are a number of hurdles before that free money hits the bank.
First off all access is a question. The US regulatory regime is strict, and has either explicitly barred access or called into question the legality of numerous centralized and decentralized venues. But top level price differentials are only the beginning. One must look deeper into how exactly trading works, and what exactly you’re trading for. Some exchanges quote Bitcoin versus US dollars, others versus Tether, and yet others treat stable coins and dollars the same.
Tether in particular has been under heavy scrutiny for how well collateralized their coins are. While the market has treated them very favorably with the price barely deviating from the US dollar peg, there is some degree of risk that your Tether is worth less than a dollar. All of the sudden that free money has strings attached.
The cost to move around to different opportunities is meaningful. We talked the other week about Congestion Price Discovery, and how expensive transacting on Ethereum has gotten. The time it takes for blocks to complete, and the charges paid to the blockchain accountants has a major impact on how long price dislocations will last.
The cycle will continue to repeat. New products get developed, and hungry participants seek out profit opportunities. The act of doing this not only reduces these opportunities for others, but it more importantly keeps pricing in line for everyone.
For customers and users to gain confidence in a new protocol or product, they must see that its pricing and dynamics obey the rules of market forces. And to get there, it usually means someone has made a lot of money keeping prices in line. Liquidity won’t grow if there is constantly a differential vis a vis the broader market, making arbitrage - strings or not - a vital growth component for the market.