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A few days ago @AlexanderGerko linked to a really fascinating paper on the strategies & evolution of HFT arbitrage among decentralized crypto exchanges. The paper gives the best summary I've seen to date of DEX arb bots & their strategies.
Here's a summary of the paper:pic.twitter.com/b4eS3c8oOT
Across all forms of market structure, fragmentation breeds arbitrage. In legacy markets, HFT firms exploit this fragmentation across exchanges by being first to a trade & righting mispricings across markets, collecting riskless profits in the process.pic.twitter.com/eoGkpgkfQX
The same dynamic is playing out in DeFi with exchanges like 0x and Uniswap. When tokens are swapped on an AMM protocol a mispricing is created between different exchanges that arbitrage bots correct for profit:pic.twitter.com/xFvsXBbn1l
Smart contracts make this kind of exchange arbitrage very easy to execute. Using a smart contract, an arb bot can transact across multiple tokens & exchanges with one on-chain block. This is another DeFi innovation I find very interesting.pic.twitter.com/2Sgif7Dp2k
There exists a key difference between legacy HFT and DeFi HFT however, in the form of a gatekeeper to the whole operation: miners. Miners hold immense power over DeFi arb bots as they control what transactions are finalized & in what order.pic.twitter.com/yrGgQ0iEym
Sometimes, miners take the arb bot's trade in full and execute it on chain for themselves, collecting their full "miner extractable value" or MEV. The arb bots have no choice but to move on to the next mispricing or find other ways to get miners to play their game.
These other games breed what's called a PGA, or a "priority gas auction". The arb bot that pays the highest transaction fee to the miner gets to go first and take the riskless profit. Arb bots can bid against each other to win PGAs every time they trade:pic.twitter.com/oRlKUPbYpu
Key takeaways from the paper: - DEXs have some key innovations over legacy finance, but they're not perfect. - Miners have INSANE power in crypto market structure. - As DeFi grows, this kind of HFT arbitrage can begin to hurt the overall blockchain/network at large.
this is terrific, thank you!
Im looking forward to reading this. I’ve only done introductory reading on Defi but the idea that people think AMMs are fantastic while getting arbed constantly makes me chuckle. It’s cool to spin up a market in some shitcoin simply through code, but what else is good about it?
Right. While yields are juicy the tourists getting arb’d so much likely don’t care. When yields compress / bull market loses heat this should come under more pressure. Although saying that, I’m not sure we are going to see TCA on shitcoins anytime soon...
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