(and how Starscape deals with them)
This is the second of a series of articles discussing the crypto arbitrage opportunity space as well as Starscape Capital’s trading approach. Part one is available here.
Previously, we walked through why the crypto market is just full of what seems to be free money for the taking in the form of arbitrage opportunities. It obviously can’t be quite so easy, or people would have taken all the potential profit, but what exactly makes crypto arbitrage hard?
We think there are a couple reasons, not all of them because arbitrage is inherently hard to execute. However, when compared against all the possibilities of crypto, it’s no surprise that arbitrage is often ignored and those who do try it are dissuaded by a number of barriers, the most significant of which we describe here.
Reason 1) Most pro arbitrageurs aren’t in the market yet
Disciplined, systematic trading is the domain of trading firms and banks, very few of which have entered the market so far. Goldman Sachs will be one of the first trading shops to open a crypto desk in mid-2018, and even then its participation will be limited to certain exchanges and currencies. While many readers have likely been following Bitcoin for years, the fact is that cryptocurrencies are still a speculative, unproven asset to most of the investing world. In addition, while banks are no stranger to creating speculative and unproven assets of their own, cryptocurrency occupies a very undefined regulatory space that makes it incredibly difficult for an established, highly regulated industry such as financial services to expand its operations into.
Not very appetizing to a fat cat.
2018 will be a pivotal year where crypto proves that it’s here to stay, and clear regulations will likely be announced across the world sometime this year or next. All this, however, is basically the starting gun for crypto becoming the sort of well-established asset that can be traded by the old boys of Wall Street, which means that markets are open for more nimble, smaller operations like Starscape to make an early play.
Reason 2) Transaction fees destroy profits
Exchanges typically derive most of their income from charging transaction fees on trades. These fees vary between exchanges but are usually around 0.1-.25% of the trade, and active trading effectively doubles that cost due to every trade being a round trip. With a pay-to-play cost of several tenths of a percent on each trade, the bar for profitability of an arbitrage trade is set fairly high. While swing traders may not blink at transaction fees, arbitrageurs seeking out consistent profits lose a lot of potential low-return trades to transaction fees.
One way to think about transaction fees is as a tax on profits — if the typical arbitrage trade returns 0.6%, an average round trip transaction expense of 0.4% is effectively a 66% tax on profits. Unsurprisingly, this has a dampening effect on traders’ interest in pursuing arbitrage opportunities.
The obvious way to minimize this problem is to focus trades on low-fee exchanges, but those exchanges also tend to have smaller mispricings due to those fees (market efficiency!), roughly washing out that advantage.
However, Starscape and other traders with access to substantial funds have a strict advantage over smaller traders on some exchanges due to fee schedules that reward trading volume. One such schedule is shown below:
Gemini’s fee schedule
By focusing trades volume on exchanges that reward heavy trading, it is possible to minimize the ‘tax’ of transaction fees and capture as much of the price difference as profit as possible. While this method of overcoming the transaction fee barrier is also very straightforward and well known, the simple problem of having enough funds to generate sufficient volume is a large reason why smaller traders are at a disadvantage to those with greater capital, particularly in arbitrage. The transaction fee tax is heaviest on those with the fewest funds, while funds such as Starscape are rewarded for having more money to trade.
Reason 3) Many crypto investors are return-obsessed and risk-blind
Consider this comic. (credit to The Economist)
Animal spirits, irrational exuberance, tulip mania. These are just a few of the many phrases saying that people are highly motivated by fear and greed when it comes to finances. There’s a consistent tendency overreact to events and cause wild market swings as a result, which is only exacerbated in red-hot but precarious conditions like those of today. When most participants agree that there’s a bubble, but money continues to pile in, the resulting volatility has created a generation of traders who don’t blink at prices changing 10% or more in an hour. As most market participants are busy pursuing huge overnight profits, the trader who pursues consistent but small profits is nearly invisible in the huge crowds of new investors running in, life savings and second mortgages in hand. This plays to the advantage of Starscape, as we operate in a limited opportunity space where profits will decrease as more competitors join in.
Reason 4) The time-to-effort ratio is unappealing
Active trading takes a lot of time, and with markets open 24/7 any time off is time spent not making money. This results in crypto trading being a high-stress activity for many, even more so than trading traditional securities such as equities, futures, or even forex. Arbitrage may be a reliable source of profit, but even the 50%+ monthly profits that can attained pale in comparison to the prolonged bull market in progress.
An arbitrage trader watching the profit pot boil.
This is more of a behavioral reason than a market-related one, so market conditions will likely need to change for investors to realize the advantages of investing in volatility hedges such as an arbitrage fund. As for the time required, Starscape is able to optimize time spent trading by automating much of the trade discovery with algorithmic models that monitor markets and identify the best opportunities. That said, all trades are manually reviewed prior to execution to mitigate the risk of unexpected model error, so there is still a substantial time and effort investment required of the team on an ongoing basis.
Reason 5) Exchanges and coins are unreliable
One running joke in crypto circles is that GDAX, the trader-focused sister exchange of Coinbase, should rename itself to ‘Minor Service Outage’ in honor of the ever-present banner adorning its site.
Business as usual.
With GDAX actually being one of the more reliable exchanges available, markets have a very long way to go before realizing the stability that underpins exchanges offering traditional securities today. Of course, flash crashes happen in stock markets as well, but a crypto exchange temporarily freezing wallets or experiencing crashes during high volume (when its services are most needed) is an almost daily event. Most recently XRB, a new-generation crypto that experienced unparalleled growth leading up to 2018, has languished in price due to repeated service outages and delayed/missing transactions in its listed exchanges.
Tokens themselves also encounter issues as well, with Bitcoin and Ethereum both running into major transaction time and cost problems over the past several weeks.
The ETH network congestion culprits.
The impact of all this on arbitrage is to introduce price exposure to arbitrage trades requiring transfers prior to selling a position. A typical Bitcoin transaction takes over 30 minutes (for this reason, we only trade Bitcoin under exceptional circumstance), which is more than enough time for a typical arbitrage window of less than 1% to close or even reverse. Add on exchange processing times, and trades in even very fast currencies such as XLM can take upwards of 10 minutes, which is more manageable but still uncomfortable.
Fortunately, there are a few ways to manage this problem. Short selling via margin trading removes this price exposure entirely, and as such exchanges with margin trading are the most desirable to sell on. Restricting trading activities to reputable exchanges with a track record of reliability avoids situations such as the XRB fiasco, where a number of traders have had funds locked up for over a week with no resolution in sight. Finally, the most difficult but most rewarding solution is to carefully manage selection of which exchanges and tokens to arbitrage based on real-time data and historical trends. The simplest version of this is to trade on the most popular exchanges using only the fastest coins, i.e. XLM between Bittrex and Binance.
Starscape’s more involved but also more profitable approach is to maintain a trade recommendation algorithm, also mentioned previously in this article, that identifies trades that are highly likely to be profitable after taking into consideration characteristics such as the price gap, exchange, and token. A large price gap between exchanges that have historically had one exchange price higher than the other could justify trading a slower token such as Bitcoin, which is exactly what we did to achieve our most profitable single trade for a 10% arbitrage return. That said, one red flag that kills any potential trade on is a spike in exchange processing times, as it is very difficult to anticipate the impact of exchange deposit or withdrawal delays.
About Starscape Capital: We seek to exploit pricing inefficiencies through arbitrage. The upcoming Arbitrage Flagship Fund will raise capital for this purpose.
About the ICO: Opens Jan 19. Ends after 1 week or when 2,000 ETH has been raised. Tokens are used to receive profits and reclaim invested ETH. Tokenholders will also be able to contribute to future funds ahead of the public.