Arbitrage is the name given to the practice of exploiting price differences across a market in order to generate a profit. This can be done by buying and selling the same asset across different exchanges, or taking advantage of differing rates between platforms.
Given its relative immaturity and dynamic nature, DeFi’s markets tend to be fragmented, with small, temporary price differences common between assets that are traded on multiple exchanges. This allows an arbitrageur to buy a slightly undervalued asset on one exchange and quickly sell it again on another exchange where it is trading at a slightly higher price.
Decentralised exchanges use liquidity pools to facilitate trades between pairs of cryptocurrencies and each swap in a pool has an impact on the price, however small. These imbalances are usually temporary, as a corresponding trade in the opposite direction will rebalance the price. Price impact is higher for larger trades and in pools with lower liquidity.
To take stablecoins as a simple example, a large transaction swapping 50,000 USDT for DAI on Exchange A would slightly devalue the price of USDT in that pool. Both being dollar-pegged stablecoins, the ideal price between the assets should be 1:1, which is currently true on Exchange B. Due to the large transaction on Exchange A the relative price there may drop to 0.99:1, and an arbitrageur could therefore buy 10,000 USDT on Exchange A for 9,900 DAI, take it to Exchange B and sell it again for 10,000 DAI, making a profit of 100 DAI, minus gas fees, in the process.
In this simplified example, we can see how a profit can be made off relatively small price differences. However, the practice of arbitrage requires great speed to take advantage of these opportunities before they disappear (lost to a competing arbitrageur). This can be achieved by writing code to create bots that identify and exploit differences as they occur, often between multiple assets.
In this way, arbitrage provides a service across the entirety of DeFi by keeping prices somewhat stable or at least aligned with market sentiment.
There are many ways to profit from the concept of arbitrage. In addition to taking advantage of differences in asset prices, skilled arbitrage strategies can also exploit differences in interest rates for lending, borrowing and staking across different platforms.
Stake DAO has recently launched DeFi's first-ever arbitrage vault: Avalanche Arbitrage Strategy, which takes advantage of Avalanches’s fast transactions and low fees to deliver impressive returns on Ethereum without the need for bridging assets between chains.
