Persistent Divergence in Crypto Markets: Its Past and Present
Greetings, Ladies and Gentlemen! Welcome back. Our previous article entitled “Hidden Liquidity Arbitrage: An Exotic Approach to Market Making” was the very last article in which we used FTX as real world examples. We are all very sad and shocked by the collapse of FTX. However, life and death are unavoidable parts of natural selections in an ecosystem. Like you, we are convinced that digital assets hold intrinsic values and will become an important pillar in our daily finance. So today we are going to continue our journey and discuss a phenomenon about a digital asset’s values observed on different exchanges: the persistent divergence.
Persistent divergence refers to the phenomenon in finance where two equivalent instruments have very different prices and the difference does not disappear over time, i.e. the difference is not transient, it is persistent. Back in the old days of 2017, the crypto market was highly fragmented and inefficient. The market dynamics was much slower compared to nowadays. Alameda Research once pointed out: back in 2017, it doesn’t matter whether your trading system operates on the one-second time scale or on the one-millisecond time scale. The market sluggishness translated into persistent divergence that could even be observed by eye-balling and arbitrage opportunities that could even be exploited by hand-execution. Back then there was a well-known profitable cross exchange arbitrage strategy variant called cash recycling. For example, when the price of BTC/USD on one exchange became very different from the price of BTC/USD on another exchange and the difference was persistent, an arbitrager can execute atomic arbitrage by buying BTC on the lower-priced exchange and selling BTC on the higher-priced exchange using the maximum order quantity that the market could absorb. Because the divergence was persistent, such executions could be performed repetiviely until the arbitrager have reached the state of having all BTC on one exchange and all USD on the other. At this point, the arbitrager would recycle the assets by transferring BTC and USD between the two exchanges and therefore go back to the original state. The whole execution process could be coded in Python or Node.js: latency wasn’t that important and C++ wasn’t needed at all. We can find a real world example from this medium article entitled “From part-time retail trader to full-time professional cryptocurrency market-maker, the Fourstroke story” by Sander Pluimers. Notice that in order for cash recycling strategy to be successful, one important condition needs to be true: quick and cheap transfer of the involved assets between the involved exchanges. A dozen of startup trading firms made their first bucket of fortune from cash recycling. Coming back to 2023 (🎉), is it still a viable strategy on the crypto markets? Over the years, competitions among arbitragers have brought the markets into a much higher level of efficiencies and drove prices to a state of almost-always-being-equilibrium. The nature of the price divergences has becoming increasingly ephemeral rather than persistent. On the other hand, thanks to infrastructure improvement and proliferation of viable alt coins, asset transfers between exchanges also have become much easier and faster, which further reduces the life span of price divergences on the crypto markets. Therefore we do think that at the current stage it is necessary to make good use of every millisecond in order to capture these very-short-lived opportunities in a consistent manner. What do you think?
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Disclaimer: This is an educational article rather than investment/financial advice.
