The exchange of cryptocurrencies has grown exponentially since 2017 and is aimed at retailers, institutional customers and an ever-increasing number of sophisticated traders who have developed high-frequency algorithmic strategies.
Especially in recent years, spot exchanges have taken the markets by storm and expanded their trading products with leveraged derivatives. Derivative products have offered traders a range of markets, from futures and options to better hedging and better access to market discrepancies for profits across multiple exchanges. However, the liquidity to split global stock market growth is associated with fixed costs for parking capital in numerous locations in order to take advantage of arbitrage opportunities. This is mainly due to blockchain transmission times that will remain slow for the foreseeable future. For this detailed function, which was technically prepared for Crypto AM, Copper interweaves the potential effects and missed opportunities that result from slow blockchain transmission speeds.
Blockchain transmission speeds, especially for Bitcoin, were inherently a slow process compared to traditional technological infrastructure. This design feature of the Bitcoin blockchain has led to massive waiting times and potentially exorbitant fees to protect the network from attacks as the blocks fill to the brim in times of extreme price movements that occur frequently.
1: Bitcoin median transaction times (minutes)
With average transaction confirmation times between 4 and over 19 minutes in 2020, an important question remains for market participants. How efficient can arbitrage traders be in times of increased activity and volatility?
It is important that the blockchain confirmation times do not take into account the number of trade center confirmations that are required for traders to have access to their assets and capital. Due to the speed and security of the blockchain, such required policies suppress the potential for fast trades and affect market liquidity at the point when it is most needed by both the buyer and the seller.
With such waiting times until Bitcoin reaches an intended exchange where algorithms may have identified market inefficiencies, the arbitrage opportunities decrease unless the capital is parked at multiple trading venues to take advantage.
Holding assets on an exchange is an optional tactic that high-frequency traders can use as a volatile asset whose violent price fluctuations have become the expected norm. The alternative would be to miss the time window that could be closed due to slow transfer speeds or other traders who can put their assets on a stock exchange in a matter of seconds.
Park assets and capital also increasingly look like the norm. Blockchain analytics company Chainalysis estimates that 60% of bitcoins (which are not believed to be lost) are held by a virtual asset service provider (VASP) (see Figure 4). This trend is growing.
4: Bitcoins Holdings (by custodian) – millions
The chain analysis also found that only 3.5 million bitcoins are used for active trading. That is less than 20% of all mined bitcoins. While retailers account for a whopping 96% of all transfers sent to exchanges, these transactions make up only 15% of the total US dollar value sent in the chain (see diagrams 2 and 3).
2: Weekly Avg Number of exchange transfers received by transfer size (000)
3: Weekly Avg USD AC flows by transfer size (USD million)
This data provides insight into professional traders who maintain liquidity effectively and still have to get in and out of different exchanges to make potential profits. However, you have to deal with slow blockchain times and confirmations. This means fewer arbitrage opportunities as competition against traders with assets already parked increases.
Where are the options?
Studies by the University of Vienna conclude that "settlement latency implies limits to arbitrage since arbitrageurs are exposed to a price risk". The University's Institute for Statistics and Operations Research assessed that "trustworthy markets are expensive and potentially have far-reaching implications" and that "arbitrage limits implied by the latency of settlement can affect price efficiency as arbitrageurs are less active the flow of information across markets decreases. "
Lead lag analysis data shows that most arbitrage opportunities exist on spot exchanges, while derivative markets lead the way in pricing. This further shows why Chainalysis on-chain statistics show that the majority of Bitcoin flows go to and from spot exchanges (see Figure 5). This volume on the spot markets is overshadowed in spite of the trading volume on derivatives exchanges, which can be observed on predominantly retail and semi-professional exchanges.
5: Bitcoin flows between exchange types
While arbitrage opportunities arise, chain transfers may not be the best tactic. A study conducted by the Bitwise wealth management firm shows that markets can close arbitrage opportunities relatively efficiently. The data shows that the chances of making arbitrage profits across different spot exchanges are an extremely small window and in most cases disappear within seconds (see Figure 6). These price movements can occur several times in volatile periods. However, if assets have to go public via on-chain routes, the opportunities disappear relatively quickly.
6: Duration / number of occurrences with 1% deviation from the consolidated BTC price