Module: 3.3 Arbitrage in DeFi
This module explores arbitrage in DeFi, illustrating it as a means to profit from price differences and interest rates between platforms due to the decentralized structure of finance. Strategies discussed include triangular arbitrage, cross-exchange arbitrage, yield arbitrage, market making, and arbitrage using flash loans. Risks are emphasized, including smart contract errors, transaction costs, price volatility, front-running attacks, and temporary value loss.
DeFi, or decentralized finance, represents an innovative financial infrastructure built on blockchain technology, offering users lending, cryptocurrency trading, and staking services without intermediaries. Due to its decentralized nature, operating across various blockchains and smart contracts, asset prices and interest rates can vary between DeFi and CeFi platforms, creating arbitrage opportunities. DeFi arbitrage allows profiting from these discrepancies using automated trading mechanisms such as smart contracts and flash loans, capitalizing on market imperfections and volatility. Manual execution is also feasible but more challenging due to potential timing issues.
Strategies for DeFi Arbitrage:
1. Triangular Arbitrage
- Description: Utilized on a single platform to profit from price differences among three assets.
- Example: On the Uniswap exchange with three tokens: ETH, DAI, and USDC, the following exchange rates are discovered:
- 1 ETH = 3000 USDC
- 1 ETH = 1000 DAI
- 1 DAI = 3.1 USDC Starting with 3000 USDC, exchanging them for 1 ETH, then 1 ETH for 1000 DAI, and finally 1000 DAI for 3100 USDC, results in a profit of 100 USDC, indicating earnings from price disparities without altering the initial asset.
2. Cross-Exchange Arbitrage
- Description: Employed to earn from the price difference of the same asset across different platforms.
- Example: ETH is priced at $3000 on Binance and $3100 on Coinbase. Buying 1 ETH on Binance for $3000 and immediately transfering it to Coinbase and selling it on Coinbase for $3100 yields a profit of $100 minus transaction fees.
3. Yield Arbitrage
- Description: Earning from the difference in interest rates for loans or deposits across various platforms.
- Example: On the Aave platform, the interest rate for borrowing DAI is 5%, while on Compound, the deposit rate for DAI is 8%. Borrowing 1000 DAI on Aave at 5%, then depositing these DAI on Compound to earn 8%, results in a net profit of 3% minus fees.
4. Market-Making
- Scenario: A market maker operates on a cryptocurrency exchange, setting buy and sell orders for Ethereum (ETH) with a minimal spread: buy at $1999 for ETH and sell at $2001 for ETH. As traders execute these orders, the market maker profits from the price difference (spread). If market prices fluctuate, the market maker adjusts orders to minimize risks and continue earning from the spread.
5. Arbitrage Using Flash Loans
- Flash loans represent a unique instrument in DeFi, allowing for borrowing funds without collateral, provided the loan is repaid within one blockchain transaction. Flash loans are not yet implemented anywhere on the TON blockchain.
- Example: Assuming a price discrepancy for DAI exists on two different DeFi platforms. On platform A, DAI can be purchased for 1.00 USDC, and on platform B, sold for 1.01 USDC. Taking a flash loan of 10,000 USDC, buying 10,000 DAI on platform A, selling them on B for 10,100 USDC, returning the loan, and retaining the 100 USDC difference as profit minus loan and transaction fees. No initial capital is required for this operation.
Risks of Arbitrage in DeFi :
- Smart contract errors: The foundation of many decentralized platforms, their immutability, and transparency can backfire if there’s a flaw in the code. For instance, a bug in Zunami Protocol’s smart contract led to a $2.1 million loss due to a critical vulnerability that allowed an attacker to manipulate token price.
- Transaction costs: Each transaction on the Ethereum blockchain, where DeFi operations are most common, requires gas payment. These expenses can significantly reduce arbitrage operation profits, especially when gas prices are high.
- Price volatility: The cryptocurrency market’s volatility can lead to swift price changes, making arbitrage risky. Asset prices can worsen quickly, resulting in losses instead of the expected profit.
- Front-running attacks: Attackers can use upcoming transaction information in the mempool to execute their transactions first, benefiting by increasing the asset price before an arbitrage operation is completed.
- Impermanent loss: Related to mechanisms like Impermanent loss in liquidity pools. If the price of one asset in a pair sharply changes, investors might find their pool share value has decreased compared to the investment moment.
Conclusion
Arbitrage in DeFi demands a deep understanding of decentralized finances and the market, along with the ability to react swiftly to changes. These strategies involve risks, such as market volatility and transaction fees, which must be considered for successful trading.
All Educational modules list:
Module: 1.1 Differences between TradFi, DeFi and CeFi
Module 1.2: The History of DeFi
Module 1.3: Understanding Key DeFi Metrics
Module 2.1: Decentralized “Deposits” (Staking)
Module 2.2: Understanding Stablecoins
Module 2.3: Diving into Decentralized Borrowing and Lending
Module 2.4: Dive into Decentralized Exchanges (DEXes) and Swaps
Module 2.5: Decentralized Derivatives
Module 3.1: Providing Liquidity in DeFi
Module 3.2: Yield Farming in DeFi
This course was prepared by Julia Palamarchuk (co-founder of Aqua Protocol — the first CDP stablecoin on the TON blockchain, over-collateralized by liquid staking tokens).
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