Traders in the DeFi space are currently presented with numerous arbitrage opportunities thanks to the increasing popularity of DeFi products and services. While some traders prefer to engage in arbitrage trading on CEXes, others opt for DEXes and other decentralized platforms.
Trading in DeFi provides users with multiple advantages, such as increased privacy and security, lower fees, the ability to use flash loans, and, most importantly, complete control of private keys throughout the trading process. The last feature is crucial for many crypto enthusiasts who value decentralization.
Crypto arbitrage strategies can take various forms, some of which are exclusive to DeFi, while others are not. In this article, let's look at some of these strategies, flash loans, and possible risks.
One of the main strategies used in arbitrage trading is cross-exchange arbitrage, which involves a trader purchasing cryptocurrency on one exchange and selling it on another in an attempt to earn a profit. This type of trading can be further divided into subtypes.
One subtype is spatial or cross-border trading, where traders take advantage of differences in demand and supply of particular crypto assets in different regions or counties.
Another subtype is arbitrage between DEXes and CEXes, which use different models of calculating the rates of assets and inadvertently create profit opportunities for traders.
Triangular arbitrage is a trading strategy that exploits pricing inefficiencies between three crypto assets, whether using multiple exchanges or a single one. It is important to note that triangular arbitrage between assets A, B, and C is only possible when the amount received after swapping each pair in succession is greater than that obtained after swapping asset A to asset C. So, traders must correctly calculate their potential profits before making any decisions. Since identifying such profit opportunities can be challenging, many traders use the help of trading bots or similar tools.
This method involves using a combination of econometric, statistical, and computational techniques to carry out arbitrage trades on a large scale. Traders employing this method depend on mathematical models and trading bots to execute high-frequency arbitrage trades and maximize profits. You can learn more about trading bots in this post.
Cross-domain arbitrage is currently one of the most popular types of arbitrage. This type is closely connected to the concept of MEV (Maximal Extractable Value; learn more about it in this post) and involves the manipulation of the order of transaction validation by traders who work as validators to maximize their profits when trading across different domains. These domains could include blockchains, Layer-2 networks, side-chains, centralized exchanges, and more.
Any trader can purchase a token from one exchange and sell it on another, thus making a profit. However, as price differences are often tiny, the profit largely depends on the trading volume. Not every trader has thousands of dollars readily available; this is where flash loans can come in handy. They enable traders to take advantage of a good profit opportunity even without having significant funds.
Flash loans let a user borrow assets with no upfront collateral as long as the borrowed assets are paid back within the same blockchain transaction. Such loans offer many possibilities to traders engaged in arbitrage, yet they have one major downside: technical complexity. Flash loans can be quite challenging to execute since they require advanced technical knowledge that is often beyond the scope of regular traders. Furthermore, automated arbitrage bots have dominated the flash loan market, making it even more difficult for not-advanced traders to find profitable opportunities.
Arbitrage trading is not risk-free since certain factors could diminish a trader's chances of generating profit or lead to significant losses.
Firstly, it is important to remember that when engaging in arbitrage trading across two exchanges, the trader may incur withdrawal, deposit, and trading fees. These fees can accumulate and reduce profits.
To reduce the risk of losses due to high fees, traders can limit their activities to exchanges with reasonable fees. They can also deposit funds on multiple exchanges to increase their chances of taking profit opportunities without paying extra fees. In such cases, traders only need to consider trading fees, which are relatively low for those executing high volumes of trades.
The next factor traders should remember is time. Crypto arbitrage trading is time-sensitive. The price disparity tends to disappear as more traders capitalize on a particular arbitrage opportunity. Besides, your trading can be held by problems with blockchain transaction speed and AML (Anti-Money Laundering) checks by centralized exchanges.
Thirdly, it is essential for traders who use arbitrage bots to avoid becoming too dependent on the software. Learning about arbitrage bots and the technologies involved beforehand is recommended to ensure you understand all the risks and can control the process. Moreover, all traders should utilize appropriate risk management strategies to minimize their exposure to potential losses.
Despite its potential risks, arbitrage trading is considered one of the safest trading practices. First of all, it does not typically require predictive analysis, which is one of the main risk factors in trading. Additionally, the trades executed by arbitrage traders generally only last for a few minutes, significantly reducing the exposure to trading risk.
In DeFi arbitrage, it is crucial to thoroughly understand the market, including the existing risks and opportunities, to succeed. It requires a meticulous approach to analyzing the market state, identifying potential opportunities, executing them at the right time, and gaining enough knowledge to operate bots. Additionally, staying up to date with the latest developments in the DeFi space can provide insights into emerging opportunities for arbitrage.
Tigran Bolshoi, co-founder of Kinetex, shared his thoughts on the state of arbitrage trading in DeFi today: "Currently, the majority of arbitrage is focused around MEV, turning trading into the gas war within the Ethereum ecosystem. The market needs tools for cross-domain arbitrage, which can help navigate this new, highly competitive field, enabling traders to take advantage of many opportunities waiting there."
Overall, DeFi arbitrage can be a highly profitable venture for those willing to learn, strategize, and take responsibility for potential risks.