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Inefficiencies in crypto markets enable arbitrageurs to generate returns with a lower risk-profile than typically seen in crypto-asset trading. This results in a risk/return profile generally considered as highly attractive by wealth managers and family offices planning to enter the crypto-asset space. Arbitrage funds earn money by correcting market inefficiencies. Types of arbitrage trades are explained below. A special property of this class of funds is that they usually have low net exposure to market movements and even to movements of individual assets. Arbitrage funds are usually hedged, thus leading to portfolios that may work in bull and bear markets alike.
Authors: Jan Spörer, Maximilian Bruckner
While arbitrage funds show lower risks than other crypto-asset related investment opportunities, some risks remain, such as the so-called “basis risk”. Enormous spikes in volatility may adversely affect arbitrage funds, and arbitrage funds are subject to sophisticated technical and organizational challenges to keep investors’ funds safe - especially in the context of crypto investments. Less than a fifth of the funds in our database employ arbitrage strategies. Some strategies are so specialized and small in scale that managers choose not to invite outside investors or set up partnerships instead of fund vehicles. While it is hard to pinpoint exactly how much money is managed in arbitrage strategies, we estimate that only a maximum of $1.5bn is in the hands of sophisticated arbitrage traders (based on a PwC study from June 2022). Much more capital is locked into fixed income-style crypto investments such as stablecoin lending, making arbitrage strategies a niche within the market-neutral bucket of crypto hedge funds.
Arbitrage funds may earn positive returns while the market retracts. The magnitude of arbitrage returns is exacerbated by market volatility, which is highest during abrupt crashes. Concluding that returns from arbitrage funds are even increasing when crypto markets turn sour would be reasonable from this logic. However, we have seen since about November 2021 that the future basis trade has not produced reasonable returns despite a volatile market environment. The reason for this is lower demand for (leveraged) futures. Consequently, it is hard to judge which market environment is most beneficial for arbitrage funds; one needs to go deeper into the strategies a particular fund utilizes and make a case-by-case assessment.
Arbitrage strategies are commonly ranked according to their risk profile. Some traders may not consider the more risky arbitrage trades as “true arbitrage,” while others’ definitions can be more lenient. Let’s explain some arbitrage strategies that are on the lower end of the risk spectrum:
Pure arbitrage opportunities exist when there are price differences between markets/exchanges. A trader can, for example, buy Bitcoin on one exchange while simultaneously selling Bitcoin on another exchange. In the crypto context, this is easier said than done due to a lack of institutional-grade solutions for short-selling and due to high margin requirements for short-sellers. Pure arbitrage is thus hardly possible in today’s crypto markets.
Non-instantaneaous cross-exchange arbitrage is therefore much more commonly seen. This type of arbitrage differs from pure arbitrage in that it has a time delay between opening a position (for example, buying Bitcoin) and closing the position (selling Bitcoin again to lock in the price difference and get out of the risky position). This type of arbitrage thus comes with price risk. Cross-exchange arbitrage can also come in the form of triangular arbitrage.
Triangular arbitrage means exploiting mispricings between three different assets. These three assets all can be exchanged into one another, creating three paths between them, i.e., three so-called “trading pairs” or “legs.” For example, let’s take USD, EUR, and BTC. For these three assets, three pairs can exist: USD-EUR, EUR-BTC, and BTC-USD. Triangular arbitrage is possible when it is profitable to rotate through the whole set of trading pairs and get more money back in the original currency (say USD) than one had before. For example, the trade shown in figure 1 would be profitable (so profitable that markets will of course usually not offer such nice opportunities): Buy 1 BTC with 20’000 EUR, sell 1 BTC for 21’000 USD, convert USD back to EUR at a price of 1, and get a profit of 1’000 EUR as a result. This cycle can be repeated. Each cycle through the three legs tends to shrink the mispricing and make the trade less profitable, and the trader can make this trade repeatedly until the mispricing is (temporarily) “arbed out.”
Figure 1: Triangular arbitrage using EUR, USD and BTC for a profitable trade exploiting a mispricing between three assets
Future basis and calendar spread trades exploit funding rates between spot and futures prices and between futures with different expiration dates, respectively. When the market is willing to pay more for a future than for the spot asset, a trader can sell a Bitcoin future and buy Bitcoin spot and pocket the difference between the (higher) futures price and the (lower) spot price (future basis trade). Similarly, calendar spreads work when a trader can take simultaneous positions in futures with different maturities and pocket the difference between the cash inflow from selling a future and the cash outflow from buying another future.
Figure 2: The future basis trade in three steps, using Bitcoin futures.
As hinted at in the introduction of this short article, extreme events can cause arbitrage funds to make significant losses. This is despite their supposed neutrality to market direction. Risks can arise for many reasons, and here are some of them:
We expect further advances in trading frequencies through improvements in hardware and colocation. Furthermore, custodial innovations and trading collaborations between exchanges and OTC counterparties can increase the speed and efficiency of arbitrage trades.
As the crypto market matures, with institutional investors entering the scene, doubts about arbitrage strategies become more prominent. The narrative is that markets become more efficient as market participants become more capable of exploiting arbitrage opportunities. We do not follow this narrative. Top arbitrage traders tend to show persistent performance due to their ability to adapt flexibly to fading and upcoming opportunities. Some niches will continue to stay profitable, and investments into infrastructure and competencies make it hard for new players to enter. A similar pattern can be observed in stock markets. Outperformers tend to stay innovative and are often the first ones to exploit new arbitrage niches. For this reason, we expect that top arbitrage funds will continue to generate attractive returns.
21e6 Capital is a Swiss investment advisor, connecting professional investors with tailor-made crypto investment products. We focus on risk management of crypto and digital asset exposure for family offices and institutional investors. Our expertise in crypto asset management stems from a team combining decades of experience in traditional financial services with native and in-depth knowledge in digital assets.
21e6 Capital has analyzed over 1,000 crypto hedge funds across the world and condensed them into a selection that can yield crypto-exposure with minimized downside risk. Our risk management solution, provided by OpenMetrics Solutions, is also trusted by the largest Swiss pension funds.
The 21e6 Capital team builds upon strong academic roots with a track record of leading crypto asset and decentralized finance (DeFi) publications and research, ensuring state-of-the-art crypto investment solutions for professional investors, family offices and asset managers.
Jan Spörer is Due Diligence Manager at 21e6 Capital. He is involved with the selection of target funds for the 21e6 portfolio. To keep up-to-date with market developments, he is constantly in touch with leading arbitrage traders and CIOs of major cryptocurrency funds.
He holds a B.Sc. in International Management from WHU - Otto Beisheim School of Management, a M.Sc. in Applied Data Science from Frankfurt School of Finance & Management, and is writing his Ph.D. dissertation in Natural Language Processing at the University of St. Gallen.
Maximilian Bruckner is Head of Marketing & Sales at 21e6 Capital AG. Prior to this, he was engaged as Executive Director of the International Token Standardization Association (ITSA) where he focused on research and classification of crypto assets according to the International Token Classification (ITC) framework. He was heavily involved in the creation of the world’s largest token database for classification and identification data on tokens (TOKENBASE). Maximilian also did academic research at the Frankfurt School Blockchain Center. You can contact Maximilian via e-mail at firstname.lastname@example.org to request more information on 21e6 Capital AG or ask any questions regarding this article. You can also follow Maximilian on LinkedIn (https://www.linkedin.com/in/max-bruckner/) to stay up to date.
This article is an informational document and does not constitute an investment recommendation, investment advice, legal, tax or accounting advice or an offer to sell or a solicitation to purchase any securities and therefore may not be relied upon in connection with any offer or sale of securities. The views expressed in this letter are the subjective views of 21e6 Capital personnel, based on information which is believed to be reliable. Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding accuracy or completeness of any information or analysis supplied.
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