Professor Coin: Is There a ‘Free Lunch’ in Cryptocurrency Markets?

This is the second part of the Professor Coin column in which I provide important insights from published academic cryptocurrency literature on Decryption readership. This time we will delve into arbitrage in the cryptocurrency markets.

A “free lunch” in finance describes an opportunity where profit is earned without any risks and is often referred to as arbitrage.

Arbitrage is a simple process of simultaneously buying and selling the same or very similar asset in different markets to profit from small differences in the asset’s quoted price. The aim is to exploit price variations of identical or very similar assets in different markets.

For example, if a stock is sold for $1 on the New York Stock Exchange (NYSE) and the same stock is sold on the London Stock Exchange (LSE) for the GBP equivalent of $1.10, the arbitrageur will buy the stock in the US, and sell the same stock in the UK and earn 10% returns.

In traditional markets, arbitrage is quite rare and short-term, as traders notice mispricing in two markets and trade to bring stock prices back into line.

Given that cryptocurrencies are new, innovative assets that are traded on exchanges (both centralized and decentralized), in 2020 Igor Makarov of the London School of Economics and Antoinette Schoar of MIT investigated arbitrage in cryptocurrency markets in the book Trading and Arbitrage in Cryptocurrency Markets.

At the minute level, they show extended periods of arbitrage available in the Bitcoin markets in a wide range of countries and exchanges. That is, investors can benefit from buying Bitcoin on one exchange in one country and selling Bitcoin on another exchange in another country for a profit.

Interestingly, they were one of the first to show premium kimchi where Bitcoin price in Korea it can go up to 20% above US prices. However, the price difference is much smaller for exchanges within the same country. Nevertheless, arbitrage was possible and was famously used by disgraced FTX founder Sam Bankman-Fried through his firm Alameda Research.

Arbitrage opportunities are diminishing

In a follow-up paper from 2023, Tommy Crépellière, Matthias Pelster and Stefan Zeisbergeral updated the Makarov and Schoar (2020) study and confirmed the previous findings but, importantly, showed that the size of arbitrage profits has decreased significantly since April 2018. and is unusable by investors.

Most importantly, they show that the reduction in arbitrage opportunities is due to increased price volatility, an increased number of informed traders. Therefore, they conclude that arbitrage is no longer possible within cryptocurrency markets – and this is unlikely to change due to the increased professionalization and coverage of these markets, as well as the financialization of cryptocurrencies.

So while there is no longer a “free lunch” for investors in the cryptocurrency markets, this can be interpreted as a good sign – as the markets become more professional, more visible and act more like a well-functioning market and therefore attract more institutional investment .

For more information see:

Makarov, I. Shoar, A. (2020). Trading and arbitrage in cryptocurrency markets. Journal of Financial Economics, 135, 293-319.

Crépellière, T., Pelster, M., Zeisberger, S. (2023). Arbitrage in the cryptocurrency market. Journal of Financial Markets, 64, 100817.