The DeFi ecosystem is taking the centralized financial industry by storm. DeFi does away with unfair policies, record-low deposit rates, and business process cast in stone, ushering in an era of effective resource allocation, inclusiveness, and constant revenue opportunities for all.

Arbitrage trading is a low-risk trading strategy that takes advantage of price differences across markets, and it involves buying and selling the same asset (like Bitcoin) on different exchanges. From the law of one price, the price of Bitcoin should, in theory, be equal on Binance and on another exchange, where differences exist between the two, an arbitrage opportunity is presented.

The challenge an arbitrageur has, is not only finding these pricing differences, but also being able to trade them quickly. Since other arbitrageurs also have access to the price information, the window of profitability usually closes very fast. This means arbitrage traders need to act quickly, as well as have enough capital to make it worth while.

High-Frequency Trading (HFT) is an algorithm based trading that involves using financial data to process large number of transactions in fractions of a second.

Price determination

How does an AMM determine its price? Most Automated Market Makers use the constant product formula, it follows that the price of that token A is simply price_token_A = reserve_token_B / reserve token_A. With an Example, If Uniswap’s ETH/WBTC pool has 2,700 WBTC and 86,000 ETH in it. The reserve ratio implies that ETH’s market price at the time of writing is 2,700 / 86,000 = 0.0314 WBTC.

Risks associated with arbitrage

While arbitrage trading is considered relatively low-risk, that doesn’t mean it’s zero. Without risk, there’d be no reward, and arbitrage trading is certainly no exception. The biggest risk associated with arbitrage trading is execution risk. This happens when the spread between prices closes before you’re able to finalize the trade, resulting in zero or negative returns. This could be due to slippage, slow execution, abnormally high transaction costs, a sudden spike in volatility.