Stablecoin arbitrage: Everything you need to know
It keeps the stablecoin cogs in working order, but does a reliance on arbitrage have its issues?
- How does stablecoin arbitrage work?
- Who are the stablecoin arbitrageurs?
- How profitable is stablecoin arbitrage?
- What are the risks involved?
- When the peg drops
- Terra (UST): Aceing the algorithm
Update 13 May 2022: Some sub-headers do not withstand the test of time. This article’s Terra (UST): Aceing the algorithm clearly being one of them. The $17bn question is: How did the ace become the joker? The jury is still out on precisely what caused UST’s depegging.
At the conspiratorial end of the spectrum, some have accused asset-management firms Blackrock and Citadel of market manipulation on a mass scale, an accusation denied by both.
Others have simply shrugged and pointed to the history of algorithmic stablecoins and sighed a collective “I told you so”. For unless it soon recovers, rather than aceing the algorithm, UST now joins a long list of failed algorithmic stablecoin projects.
Their allure of a stable cryptocurrency that is fully decentralised in nature is easy to understand. The problem is, no one seems to have the working recipe.
Eyes now turn to Neutrino USD (USDN), the largest algorithmic stablecoin by market capitalisation behind UST. At the time of writing, USDN was at $0.93. While slightly concerning, the Waves blockchain-based stablecoin recovered 24% against the day.
Asset-backed stablecoins, including Tether (USDT), have mostly retained their peg, although a drop to $0.948 on 12 May worried some. The story continues to evolve. In the meantime, the article’s Terra sub-section serves as a reminder of the unpredictable nature of the crypto markets. Always exercise caution when investing, and make sure to thoroughly scrutinise any project before opening a trade.
In the space of a couple of years, the stablecoin has evolved from a little-understood oddity in the cryptocurrency space to a mainstay of blockchain-based decentralised finance (DeFi).
Even when the wider cryptocurrency market went bearish in the early months of 2022, stablecoins continued to soar in popularity. In April, the total market capitalisation of all stablecoins exceeded $182bn, helped in large part by Tether’s staggering $82bn valuation.
While Tether, the world’s third-largest cryptocurrency, hit the headlines after gaining the ire of regulators because of its opaque reserve holdings, Tether and its constantly expanding set of competitors maintain their steady trajectory into the mainstream.
What is perhaps less well-known among the wider public is that a form of financial engineering called stablecoin arbitrage is one of the key ingredients that keeps these projects in healthy shape. But what is stablecoin arbitrage and how does stablecoin arbitrage work? Currency.com spoke with a range of experts in the field.
How does stablecoin arbitrage work?
Eddie Rajcevic, a market expert and researcher at the live financial network tastytrade, said: “Arbitrage is a practice that is rooted in market history as we know it.” As far back as the 17th century, merchants would exploit exchange rate variations between cities when trading gold, silver and other commodities.
At its core, arbitrage is the process of simultaneously purchasing and selling an identical asset (be that a currency, commodity or security) in two separate markets. Temporary price disparities open up a profit opportunity where traders can buy low in market A and sell high in market B. Although the price difference might be minuscule, arbitrage traders make money by trading in many thousands of units.
The concept found favour in the crypto community, when stablecoins opened up big opportunities for quick-fingered traders (and the bots that they employ). Although stablecoin prices should theoretically be pegged exactly 1:1 to the US dollar (or other fiat currencies, though the US dollar is the most common), market forces result in fluctuations above and below the dollar value.
Let us say Tether (USDT) drops to $0.95 on an exchange. A trader can buy from the exchange at this price, then sell back to the Tether treasury for a guaranteed $1, netting $0.05 in the process (minus transaction fees). It sounds hardly worthwhile, but investors have managed to generate huge sums using the arbitrage process.
Arbitrage is a fundamental component of the traditional and cryptocurrency markets alike. A working paper published in the National Bureau of Economic Research looking into Tether concluded: “We find that stablecoin issuance, the closest analogue to central bank intervention, plays only a limited role in stabilisation, pointing instead to stabilising forces on the demand side.”
In other words, arbitrageurs – rather than Tether itself – are the driving force behind Tether’s stability.
Most stablecoin projects are aware of this power imbalance and, given the necessity of arbitrage as a stabilisation mechanism, actively promote the exercise.
Would stablecoins function properly without profit-driven arbitrageurs? According to Yves Renno, head of trading at digital payment platform Wirex, the answer is no.
“Whether the arbitrage is conducted by external traders or bots, it is essential to preserve the peg price. Traders must be incentivised to buy the stablecoin in the market and redeem it with the protocol when it trades below parity, and borrow the stablecoin to short-sell it if its market price is above parity,” said Renno.
Who are the stablecoin arbitrageurs?
While retail investors can theoretically conduct stablecoin arbitrage between exchanges, the process is typically the preserve of institutional investment firms. This is because of the large volumes at play and the fact that the bigger stablecoin projects have sizeable deposit and withdrawal minimums. Tether, for instance, has a $100,000 price barrier.
In order to be an effective arbitrageur, investors need to be on the supply side of the coin as well as the demand side.
Hamiz Mushtaq Awan, founder and partner at the Dallas, Texas-based investment firm Plutus21 Capital, said: “Most retail investors don’t have access to the supply side.” Awan said that “some of the the algorithmic [stablecoin] projects are more accessible.”
But as will be discussed below, this accessibility comes with another set of issues.
How profitable is stablecoin arbitrage?
In August 2020, one trader netted $45,000 in a matter of minutes by exploiting the minor price variations between USDT and USD Coin (USDC). Through a sophisticated series of transactions across the Uniswap and Curve decentralised exchanges, the trader generated 89% in profit from their initial stake.
More recently, a bot managed to earn 147 ETH (approximately $446,000 at the time of the 24 March 2022 trade). As reported in The Block, the successful trade was contingent on a bribe paid out to the F2Pool mining pool.
Ivan Zhang, founder and chief executive of the blockchain-based investment platform PennyWorks, said: “Most arbitrages are not large because the price discrepancies are small, since stablecoins are by design supposed to trade very close to their pegs. The only time when there are huge deviations is because of either idiosyncratic issues with a particular stablecoin breaking their peg or the marketplace in which it’s being traded.”
So although large sums can be made, stablecoin arbitrage is clearly a numbers game, requiring large stakes on both the demand and supply side of the market.
Given the volumes at stake and investors’ penchant for healthy returns, is there a risk or threat of market manipulation in the stablecoin market? According to Awan, “Obviously it can happen, but I don’t think it happens at any significant scale.”
Given the multibillion-dollar capitalisations of the most-liquid stablecoins, not to mention trading volumes sometimes exceeding $100bn in a single day, price manipulation of the likes of Tether or USD Coin is unlikely to occur, although that risk is greater at the lower end of the stablecoin market.
Rather than stablecoins being susceptical to manipulations, “it’s exactly backwards,” in Zhang’s view.
“Arbitrageurs in general simply synchronise information across disparate market places. When they do that, it brings both marketplaces more in sync,” he said.
Since their valuations are less “nebulous” than stocks or commodities, “stablecoins would be the WORST marketplace to actually participate in to push the price away from its equilibrium value,” said Zhang.
What are the risks involved?
“Some types of stablecoins explicitly rely on arbitrage relationships to keep the price stable,” Zhang said.
Which leads to the question: does relying on this process of financial engineering present risks for the associated stablecoin?
According to Rajcevic, “One of the dangers in relying on arbitrage is that it requires traders to maintain interest in the stablecoin. If that interest subsides, the stablecoin will not see enough trading activity to maintain its pegged price, and that will lead to less and less interest.”
Arbitrageurs, according to Awan, “Are the reason that markets become efficient. They force the price to the place that it’s meant to be, and their incentive for doing that is the spread. The more arbitrage that happens, the tighter the spread becomes, and the better that is for individual investors.”
So rather than financial engineering being a tenuous mechanism, Awan believes that “the opposite is true. Arbitrageurs inherently don’t increase the risk of any market. They actually make markets more efficient, more liquid. And that is all great for everybody.”
Jack Bouroudjian, chairman of the Chicago-based Global Smart Commodity Group, which describes itself as a “multi-asset commodity exchange,” said: “If done properly, it only brings efficiency into the markets.”
But although arbitrage is one of the fundamental principles of free markets, Dr Ryan Clements, at the University of Calgary Faculty of Law in Canada, believes that the emphasis on arbitrage represents a flaw in the design of stablecoins.
In his paper Built to Fail: The Inherent Fragility of Algorithmic Stablecoins, Clements claimed: “Algorithmic stablecoins require a support level of demand for the entire ecosystem to operate. If demand falls below a threshold level, the entire system will fail.” History, Clements said, proves that floor support levels for financial products is never guaranteed, particularly in times of crisis.
Clements noted that “algorithmic stablecoins rely on independent actors with market incentives to perform price-stabilising arbitrage to maintain a so-called ‘stable’ ecosystem. History again reveals that reliance on independent, market-driven actors, without legal obligations, to perform price-stabilising discretionary arbitrage is also fragile.”
When the peg drops
This fragility was made clear in the case of Iron Finance. The soft-pegged IRON stablecoin sustained itself through market-driven stablecoin arbitrage trading between IRON and Iron Finance’s TITAN governance token. There was just one problem: TITAN crashed in value in June 2021, resulting in IRON losing its $1 peg, dropping to below $0.75, effectively sending the project into a death spiral.
This over-reliance on arbitrageurs, Clements concluded, contributed to the “utter lack of stability to date” of algorithmic stablecoins, in contrast to their collateralised cousins.
Iron Finance is not the only algorithmic stablecoin to have run into trouble, although data produced by Blockdata actually suggested that commodity-backed (namely gold) stablecoins have the highest rate of failure. The report also showed that algorithmic stablecoins represent only a small fraction of the wider stablecoin market.
In April 2021, the algorithmic stablecoin FEI fell below $0.50, because of low demand and a market flooded with tokens.
Yves Renno at Wirex pointed to the MIM algorithmic stablecoin, developed by Abracadabra, as an example of “a protocol that suffered an important lack of confidence recently.”
MIM’s declining liquidity could expose the protocol to a flash loan hack. While flash loans are commonly used by arbitrage traders to get their hands on large sums of money instantly, manipulation of the process can lead to a stablecoin moving away from its peg.
But on this point, Awan contended that algorithmic stablecoins are simply flawed in nature. “Nobody’s really been able to figure out, from what I know, how to peg a stablecoin simply using demand and supply. That has not been figured out effectively,” he said. “It’s been tried since I started in crypto: people have been trying to create these algorithmic stable coins for years now. What has become obvious in the market is that the most liquid and the largest stablecoins are the pegged ones.”
Since they aim to control both the demand and the supply side of the equation, algorithmic stablecoins attempt to act somewhat similar to a central bank.
“That’s obviously inherently complex,” according to Awan, “to be able to have the backing and the money and the liquidity to be able to backstop the system at any point. The Federal Reserve can do that because it's the Federal Reserve, but Iron Finance (for example) might be run by two engineers that are in their 30s.”
Terra (UST): Aceing the algorithm
While experts are generally in agreement that algorithmic stablecoins are less secure than their pegged competitors, Terra’s UST token tells a different story. With a market capitalisation of more than $16.4bn, UST is the fourth-largest stablecoin behind Tether, USD Coin and Binance USD. It is also the only stablecoin in the $1bn-plus camp to sustain its peg algorithmically, without being collateralised.
UST relies on an arbitrage system between UST and Terra’s LUNA mining token, not too dissimilar to the processes behind IRON and FEI. Yet barring momentary blips, UST has managed to sustain its $1 peg since launching in September 2020. The question is, why?
For Awan, it is simply because “they have the capital behind them to be able to, at least at this point, backstop their system.” Although, “as their size increases, they will need to continue to make more capital available.”
But things might be changing at camp UST. Given Terra’s recent announcement of a $1bn capital-raising round to purchase a bitcoin reserve, UST could be seeking to move to a hybrid algorithmic/collateralised model.
Regardless, it is evident that, just as digital currencies mirror fiat in many ways, sophisticated, institutional arbitrage traders act as the glue holding the market together. This is a perfectly normal form of financial engineering in a free-market economy, but an over-reliance on profit-driven actors has been shown to have negative consequences for algorithmic stablecoins that lack a substantial collateralised backstop.
How do stablecoins stay stable?
Stablecoins rely on arbitrage trading performed by profit-driven actors to maintain their pegs. This form of financial engineering drives the price of a stablecoin up when undervalued and vice versa.
Collateralised and algorithmic stablecoins act in different ways. While the former are backed by real-world assets (primarily the US dollar or gold), the latter rely on smart contracts to maintain supply and demand. Algorithmic stablecoins tend to be more volatile.
Is stablecoin a good investment?
Stablecoin arbitrage is typically only performed by institutional investors, given the large sums needed to generate decent returns. Holding onto stablecoins for a long-term investment is not very common; they are primarily used for conducting DeFi trades.
Why is stablecoin interest so high?
Stablecoins have become a key focus point in the cryptocurrency space for governments and regulators, because of the large sums of money traded on a daily basis and their potential impact on the wider banking system. Numerous controversies in 2021 surrounding Tether, the largest stablecoin on the market, contributed to this interest.
Since stablecoins have become a mainstay in the DeFi space, they are in high demand. This demand has also driven up interest rates.