The status quo and future impact of atomic arbitrage and CeFi-DeFi arbitrage

Original text from: notion compiled by: Lynn, MarsBit

Summary

• For the same opportunity, more value can be extracted through CeFi-DeFi (EV_signal) than atomic (EV_ordering) arbitrage. Whether arbitrage is performed as an EV_signal or EV_ordering style strategy depends on the cost of taking the risk.
• In the first quarter of 2023, 60% of arbitrage opportunities are captured by CeFi-DeFi strategies.
• For highly liquid tokens (i.e. low cost of risk-taking), EV_signal dominates, while for low-liquidity tokens EV_ordering dominates.
• In many cases atomicity is less important than fluidity. The future of cross-chain arbitrage will not be risk-free atomic execution (eg, chain <> chain), but economically efficient statistical execution (eg, chain <> CEX).

Introduction

This work is an extension of “A New Game in Town”, where we introduce EV_signal and EV_ordering. The difference between these two extractable value (EV) is information (aka α). EV_signal requires information superiority to capture value, while EV_ordering does not. In this article, we introduce the concept of risk into the MEV equation. In theory, a risk-taking trader can extract more value from an opportunity than a risk-free trader.

We examine the theory and market structure behind EV_signal and EV_ordering regarding arbitrage opportunities. More specifically, we study atomic arbitrage and CeFi-DeFi arbitrage—subsets of EV_ordering and EV_signal, respectively—and demonstrate that atomic arbitrage is risk-free, while CeFi-DeFi arbitrage requires risk. We compare them both in terms of theoretical framework and implementation, and then use these findings to make predictions about the future of on-chain transactions.

This article is divided into four main sections:

• First, we define atomic arbitrage and CeFi-DeFi arbitrage, and explore the conditions under which they can be executed on-chain. *Second, we compare them theoretically and examine under which conditions one might prevail over the other.
• Third, we measure on-chain arbitrage activity and empirically compare their market sizes.
• Finally, we use these experiences to make predictions about the future.

Types of arbitrage

Arbitrage refers to the trading of price differences between different trading venues, so that prices can be balanced and profits can be realized. At its simplest, it involves buying an asset on a lower-priced trading venue and selling it on a higher-priced one, or vice versa. In cryptocurrencies, there are thousands of tokens and hundreds of trading venues (both on-chain and off-chain). Any price misalignment between them can create an arbitrage opportunity.

Atomic Arbitrage

Atomic arbitrage was one of the first MEV opportunities we saw in the wild. The simplest example of atomic arbitrage is when a trading pair is listed on multiple DEXs at different prices. The diagram below depicts how an atomic arbitrage strategy trades on two on-chain DEXs until prices are in balance.

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-31ff849ebf-dd1a6f-62a40f)

(Left) The prices of the three exchanges Binance, Uniswap, and SushiSwap are in balance. (Middle) A user order moves Uniswap’s price dramatically. (Right) An atomic arbitrage (back-run) brings the price of the DEX back to equilibrium.

Perform atomic arbitrage

Atomic arbitrage is performed in a single, isolated event - hence the name. Either all parts of the transaction are executed, or none are executed. The arbitrage happens instantaneously, and the trader does not hold any inventory between the two legs of the trade, making this strategy risk-free in hedging inventory. Additionally, the off-chain searcher infrastructure (Flashbots auction under PoW and private RPC for block builders under PoS) guarantees backtracking protection; that is, failed transactions do not land on-chain, posing zero cost to the trader . For the two reasons above, this strategy is theoretically risk-free and has a low barrier to entry.

Since these transactions are risk-free (on mainnet) and have a low barrier to entry, execution is competitive. Under MEV-Boost, the searcher who gives the most hints to the block builder gets included in the block builder’s submission, and the block builder who gives the most hints to the validators wins the block. Currently, 91-99% of extractable value is sent to validators by winning searchers.

Atomic arbitrage opportunities become more complex when we add more DEXs and tokens to the picture. For example, a route may involve more than two trading pairs or two tokens. But the core idea is the same: prices on multiple DEX venues are misaligned, providing arbitrageurs with an atomic, profitable trading opportunity until prices converge.

CeFi-DeFi Arbitrage

CeFi-DeFi arbitrage opportunities arise when the prices of on-chain assets deviate from their fair value. In the simplest terms, fair value is the best current estimate for valuing an asset. The trading venue whose price is closest to fair value is known as the price discovery venue (this venue changes periodically). In cryptocurrencies, fair value can be estimated using the prices of the most liquid or volume trading venues; these are centralized exchanges (CeFi); thus this strategy is called CeFi-DeFi. The diagram below demonstrates how CeFi-DeFi arbitrage leads to parity between on-chain price and fair value (i.e. Binance mid-price).

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-b683d6791e-dd1a6f-62a40f)

(Left) The prices of the three exchanges Binance, Uniswap, and SushiSwap are in balance. (Middle) A user order sent Uniswap’s price substantially higher. (Right) CeFi-DeFi arbitrage brings prices back to CeFi prices.

CeFi-DeFi arbitrage is possible when on-chain prices move due to large transactions, or when off-chain prices move while on-chain prices remain stagnant (e.g. off-chain prices move between blocks).

Execute CeFi-DeFi arbitrage

The simplest form of CeFi-DeFi arbitrage is to conduct two-leg transactions in two different venues. Trade on one leg until the on-chain price reaches fair value. If this trade is successful, the second leg hedges the accumulated position on another (usually) off-chain exchange. CeFi-DeFi arbitrage is not atomic and therefore involves several risks and significant barriers to entry:

1. Risks:
2. **Inventory risk: **The inventory generated by the first transaction must be stored until it is hedged by the second transaction. A sophisticated hedger may exit the resulting position over time, resulting in traders not holding inventory for very long. Holding illiquid tokens is inherently risky as they are more volatile. CEX liquidity providers may also see that DEX trades have landed and move their quotes in anticipation of this flow.
3. **Inclusion risk: **If multiple traders compete for the same opportunity, it is possible that a trader’s on-chain leg is not included. Therefore, traders’ off-chain hedging strategies need to consider not including the on-chain part. This problem is compounded by on-chain rebalancing, which restores historically confirmed transactions.
4. **Adverse selection: **If a CeFi-DeFi arbitrageur trades on-chain, they will outbid all other arbitrageurs’ trades, indicating that they may overestimate the size of the opportunity (i.e. Adverse selection/winner’s curse). Conversely, an atomic arbitrageur is always happy to land their trades because the profits are risk-free.
5. Barriers to entry:
6. ** Inventory Management: ** It is important for statistical arbitrageurs to have an inventory of tokens in both on-chain and off-chain venues. When dealing with illiquid tokens, the cost of acquiring tokens and the risk of holding tokens may outweigh the total opportunity size. Inventory at various venues also needs to be rebalanced in preparation for upcoming transactions and managed according to the cumulative position of revenue legs, which creates additional operating costs.
7. ** Latency: ** Latency is very important because traders need to know the fair value immediately before a block is proposed. This means that the entire path—from CEX to transaction system to bundle relay to block builder to block relay to validator—needs to be optimized.
8. ** High capital requirements: ** A successful CeFi-DeFi arbitrage trader needs high capital and low fees in off-chain venues. Instead, to land a successful atomic arbitrage, a trader only needs a working smart contract and a good bidding strategy (since actual trading capital can often be obtained through flash loans).

Since CeFi-DeFi arbitrage is risky with high barriers to entry, currently 35-77% of expected extractable value is sent to validators by winning searchers.

Atomic arbitrage and CeFi-DeFi arbitrage

The key difference between atomic arbitrage and CeFi-DeFi arbitrage is the concept of fair value. This means that, in theory, the market share of CeFi-DeFi arbitrage will be higher for the following reasons:

1. If the fair value of an asset changes, but the price on the chain does not change (for example, between two blocks), then such an opportunity can only be seized by CeFi-DeFi arbitrage.
2. If the price changes on-chain (for example, through a user’s transaction), then CeFi-DeFi arbitrage has a higher EV than atomic arbitrage due to lower hedging costs.

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-f5d1cebb38-dd1a6f-62a40f)

The graph on the left shows the state of the price after the atomic arbitration; note the difference between the on-chain and off-chain prices. The graph on the right shows the price state after the CeFi-DeFi arbitrage; notice that all three prices have returned to equilibrium.

Let us extend the second claim by considering two trading venues where prices have been misaligned. An arbitrage trade looking to exploit this difference can be broken down fundamentally into: (1) an income leg, which trades until the price dislocation is closed (while allowing for some margins and transaction fees); (2) a hedging leg, which exits A position accumulated in an income leg. This framework for describing arbitrage legs can be extended to trades with more than two legs, while maintaining the same properties.

Atomic arbitrage involves the trader exiting the entire position accumulated on the income portion in one execution, without accounting for slippage or other execution costs; this approach results in a significantly negative expected PnL on the hedged portion. In contrast, in CeFi-DeFi arbitrage and EV_signal execution more broadly, each leg of the arbitrage is evaluated and executed independently of fair value, allowing the arbitrageur to fully exit the hedging leg for a period of time. However, this strategy introduces the risks and costs discussed above—namely, inventory acquisition and management risks associated with illiquid tokens. Thus, we empirically observe the cost of this risk, with CeFi-DeFi arbitrageurs bidding around 35-77% of the revenue portion to validators, and atomic arbitrageurs bidding 90-99% of the revenue.

While holding post-trade risk and maintaining transaction inventory introduces complexity to transactions, CeFi-DeFi arbitrage allows people to realize more income because they can precisely trade dislocations to equilibrium and hedge income portions cheaply.

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-099afdc4b7-dd1a6f-62a40f)

Empirical Evidence

To support the above conclusions, we examine some examples of atomic arbitrage and evaluate how well they perform in the context of CeFi-DeFi arbitrage. To this end, we simulate the expected income of arbitrageurs hedging in a centralized venue.

1. High Liquidity Token Arbitrage

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-71ffc37f7b-dd1a6f-62a40f)

At block 16820372, a user submitted a large number of SNX transactions through FlashWallet, dislocating the price on SushiSwap from $531.285 to $545.292. SNX has a fair value of $533.488 on Binance.

1. An atomic arbitrageur takes advantage of this difference to trade, earning $21.55 on the income portion while paying $5.76 in hedging costs.
2. If we simulate the same opportunity through CeFi-DeFi, the trader extracts more value through the income part - $22.49, and then hedges at almost zero effective cost. Highly liquid tokens, such as SNX, have almost zero hedging costs with a trading volume of 1.4WETH.

The result of atomic arbitrage is $15.79 income (excluding gas), while the result of EV_signal is $22.49 income (excluding gas), this transaction. The EV_signal trade has a large profit buffer as arbitrageurs bid 91-99% of this trade to builders, compared to 35-77% for the EV_signal trade.

1. Arbitrage of illiquid tokens

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-2d16ad5ea3-dd1a6f-62a40f)

We next analyze a two-legged arbitrage involving an illiquid token (DSLA token ranked 758 by market cap).

1. For atomic arbitrageurs, the first leg here is not only a hedging leg, but also responsible for acquiring inventory. This is a common pattern, where arbitrageurs are unlikely to hold long-tail assets, so inventory must be acquired to execute income legs - often at expensive prices. The transaction involved a $5.39 hedging component followed by a $10.58 revenue component. The hedging part here is expensive, costing over 50% of the income, making this trade a prime candidate for EV_signal style execution.
2. If we simulate the same opportunity in the EV_signal framework, the arbitrageur’s income increases to $14.66. However, arbitrageurs must hold DSLA inventory on the chain before executing the transaction, which increases the inventory risk of the transaction; therefore, they have higher requirements for the profit margin of the transaction, and the bid is lower than that of the EV_ordering transaction.

Nonetheless, due to the relatively small notional amount of the DSLA transaction, this is still a compelling case for EV_signal execution.

Today’s arbitrage status

CeFi-DeFi arbitrage can theoretically extract more value than atomic arbitrage. Empirically, we find that 60% of opportunities (by revenue) are executed via CeFi-DeFi arbitrage. Furthermore, the data shows that atomic arbitrage dominates when:

1. The primary (liquidity, price discovery) trading venue is on-chain, or
2. The cost of hedging (risk taking) is significantly higher than off-chain.

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-c29d124633-dd1a6f-62a40f)

A comparison of Atomic and CeFI-DeFi arbitrage Q1 2023. CeFi-DeFi generated $37.8 million in Q1 2023, while Atomic Strategies generated $25 million. 91-99% of the income of atomic arbitrage is paid to validators, while only 37-77% of CeFi-DeFi’s income is paid to validators. The source for atomic transactions is EigenPhi.

While the market size of atomic arbitrage is well researched and easy to estimate, doing the same for CeFi-DeFi arbitrage is more nuanced. First, a dataset is collected containing all exchanges with to_addr’ corresponding to known searchers. Thereafter, swaps identified as atomic arbitrage (or related to sandwich attacks) were filtered out using EigenPhi’s data. Finally, revenue per trade is determined by calculating the instantaneous markup relative to the centralized exchange mid-price (the mid-price used is derived from the most liquid venue for a given token). We note that our coverage of swaps is not exhaustive (approximately 80% coverage), so our estimates are conservative lower bounds.

! [CeFi] (https://img-cdn.gateio.im/social/moments-40baef27dd-320fca50c0-dd1a6f-62a40f)

95% of atomic arbitrage opportunities are executed on illiquid tokens, i.e. the arbitrage includes at least one illiquid token. 91% of CeFi-DeFi opportunities are executed on highly liquid tokens, i.e. all tokens in the arbitrage are highly liquid.

We see a clear relationship between the liquidity of the tokens being traded and the type of arbitrage. Specifically, we found that CeFi-DeFi arbitrage is overwhelmingly transactions involving highly liquid tokens (we define highly liquid tokens as the top 100 tokens by market capitalization), and vice versa. This relationship suggests that the price discovery venue for illiquid tokens is indeed on-chain, while off-chain hedging costs are significantly higher.

In this analysis, we excluded days during the USDC strike as it was an anomalous event. During this period, Atomic Arbitrage revenue was slightly closer to $10 million, while CeFi-DeFi revenue was about $2.8 million. This divergence accounts for the fact that the cost of hedging (taking risk) has increased significantly during this period, resulting in reduced opportunities. That said, CeFi-DeFi arbitrageurs are forced to consider the inventory risk associated with USDC during the destocking period and scale back their operations accordingly.

Conclusion and future implications

In this post, we describe and analyze arbitrage opportunities in the EV_orderering and EV_signal frameworks. We dissect and isolate the notion of risk, and show how, in general, executing EV_orderering transactions with EV_signal increases expected PnL. However, inventory acquisition and management risks limit EV_signal-like execution for illiquid tokens. This conclusion is empirically supported by our observation that illiquid tokens are extremely prevalent in atomic arbitrage, while CeFi-DeFi arbitrage is dominated by highly liquid tokens. Based on these results, we propose the following implications for the future of the industry:

The Future of Cryptocurrency Arbitrage

As seekers continue to gain off-chain complexity and off-chain liquidity continues to dominate on-chain liquidity, more arbitrage will be captured through CeFi-DeFi. Although temporary short-term shocks (such as CEX solvency and liquidity uncertainties) will temporarily increase the cost of risk-taking, thereby favoring atomic arbitrage, we believe that the long-term trend will be EV_signal > EV_ordering. Furthermore, we note that this analysis does not take mezzanine attacks into account. With the rise of OFA and *‘intent’*-based transactions, the proportion of on-chain sandwiches and other cutting-edge strategies will be reduced and transformed into reverse arbitrage opportunities, increasing the overall revenue share of Atomic and CeFi-DeFi strategies.

The Future of Block Construction and Search

Block builders will optimize low-latency connections to exchanges and block relays for more accurate off-chain state prior to block proposals. As EV_signal style trading becomes more competitive, search will need to develop predictive models of fair value (alpha) beyond the median price on liquid exchanges. We have observed this with some Seekers bidding for block space based on the predicted fair value.

The future of cross-chain arbitrage

This analysis also has parallels in the context of cross-chain transactions. Specifically, we believe that concerns about validators proposing blocks on multiple chains simultaneously are overblown, since cross-chain MEV can be withdrawn atomically. In many cases atomicity is less important than fluidity.

In a world where the atomicity of bundled cross-chain transactions is guaranteed, arbitrage of highly liquid tokens will continue to be executed in a cost-effective EV_signal style. Even for tokens traded entirely on-chain, well-capitalized actors are willing to hold capital on multiple chains and execute arbitrage statistically rather than pay for guaranteed multi-chain atomic execution.