Good Arbitrage is a Myth

tldr

• "Good arbitrage" is a myth. You don't need arbitrage to equalize prices in defi. 
• Arbitrage holds defi back from matching cefi prices and efficiency – by bleeding LPs and traders. 
• Retail – with the help of smart routes – can heal prices better than arbitrage. Keeping value in the ecosystem.
• Without arbitrage – DEXs can lower their fees, attract more liquidity, improve prices, and compete with cefi.

Introduction

Here’s a widespread and rarely tested myth: “Arbitrage keeps markets efficient and so it’s good.” 

This article will test this hypothesis – and find things are a bit different in defi: Defi is self-healing, making arbitrage obsolete.

First, a brief look at defi arbitrage. 

Arbitrage is a net-loss to the ecosystem

Arbitrageurs look for free lunches: profitable defi trades with little-to-no risk. Buy cheap on one pool, sell high on another – for instant profit.

The effect from arb trades is that it brings prices of different pools closer together. And when prices are closer together, traders on different venues get more or less the same deal. Hence the claim: arbitrage makes markets efficient.

But let's look more closely.

Arbitrage only roughly equalizes markets

Like you, the arbitrageur needs to pay DEX and gas fees. He can arbitrage pools to the point at which distance in price equals fees – beyond that the trade is not profitable.

Usually, fees between two pools sum up to 0.1–2% (most frequently 0.6%). So arbitrage only aligns prices to within 0.1–2%. This leaves a significant gap.

If you look at prices across chains, this gap will be even bigger, as arbitrageurs then also need to cover hedging and capital costs.

Arbitrage is a loss to the ecosystem

Arbitrage is so severe that LPs lose more to arbitrage than users pay them. E.g. Uniswap USDC/WETH LPs have paid > $ 250mio to arbtrageurs, and made at least a net $ 30mio loss.

If none of the fees users pay stay with the LPs and get extracted by arbitrageurs – then the ecosystem won’t be able to sustain itself. 

Arbitrage is a risk to defi adoption

If LPs continue to leak to arbitrage, liquidity will move out of defi. Also, DEXs won’t be able to reduce fees and make prices competitive to attract more order flow.

Which raises the question, do we really need to pay the cost of arbitrage?

Defi is better off without arbitrage

Let's say we could magically eliminate arbitrage. What would happen?

First, LPs would be profitable. This would draw more liquidity to defi and improve prices. DEXs could also afford to charge radically lower fees (e.g. Balancer reduced their fees by 80% for arbitrage free CowSwap flow). This makes defi prices more competitive for traders.

And next – would prices diverge and efficiency be lost? Interestingly, no.

Defi is not a set of isolated trading venues – but an open, interoperable system with abstraction layers that can self-heal any inefficiencies between pools.

Retail traders can fully align prices with solvers

Let's say a few trades happend, and some pool prices now diverge from the market a bit.

Thanks to solvers - the next trades in the opposite direction will heal these dislocations, completely.

Every trade that goes through a solver – and optimizes for price – also optimally heals any price-divergence: Pool that diverge from the market offer a better price and are therefore the first to which a solver routes flow, just as much until its price matches the next best pool – until all pools have the same price. (For a more rigorous introduction to this effect check the Balancer Smart Order Route v1 docs).

This means retail trades through solvers makes defi prices self-healing. And the more flow defi gets, the more robustly it can heal prices.

Not only do retail trades heal prices, but also more completely than arbitrage. 

Solvers heal prices fully; arbitrage does not

We saw earlier, arbitrage aligns prices until the price gap is equal to the sum of DEX fees (0.1–2% gap).

But solvers align prices fully. All the way to a 0% gap. Because users, as opposed to arb bots, aren’t looking for atomic profits; they are just looking for better prices.

Even the smallest pool dislocations still improve prices. So solvers will route until pool prices (net fees) completely align.

This also means that solvers heal prices earlier.

Solvers heal prices earlier and at lower cost to LPs

Because solvers don't need to wait for a price gap big enough for arbitrage, they heal price differences immediately.

When prices heal at lower divergence, LPs can capture more fees and suffer less LVR and PriceImpact Losses. This significantly reduces their loss to arbitrage.

Value goes back into the market

Earlier we saw how arbitrage takes the fees out of the ecosystem and dries up defi yields and hence liquidity.

When users, not arb bots, equalize prices – what changes?

First, the retail traders that facilitate the healing, get a better rate on their trade. So the retail trader captures some of the value of the service they provide.

Secondly, the retail traders pay fees for the swap, which turns into revenue for the LPs. With small dislocations, and early healing – most of the value goes to LPs.

And, if LPs set dynamic fees, e.g. based price difference to the market price, then they can internalize even more of the value (for more details see our last article Arbitrage Loss and How to Fix it).

How do you move value from arbitrageurs back to the ecosystem

So if retail can heal price differences earlier, at no cost to the ecosystem and more completely – then why is there still so much arbitrage today?

For a few reasons:

• Solver Adoption: Many retail trades still directly trade with DEXs, overpay and dislocate prices enough to invite arbitrage. To help, we’re launching a frontend for our Solver: PropellerSwap. You can sign up for the Alpha whitelist here.
• Defi retail volume: Self-healing relies on frequnt retail traders. As long as cefi has more volume – defi will, in many cases, not be fast enough to catch up.  
• Block times: A lot can happen in 12 seconds, and create large enough gaps for arb bots to take value from DEX LPs. Shorter block times on L2s will improve price efficiency and reduce arbitrage opportunities.
• Market makers: Defi market makers, that transfer liquidity and pricing between venues, are only starting to become more efficient. There is still a lot of room for improvement.

Good arbitrage is a myth

Arbitrage is a negative-sum game for retail traders, LPs and the ecosystem. It's the reason for high DEX fees, low LP profits, and slower adoption of defi. While contributing less to market efficiency than people think.

Thankfully, arbitrage isn’t needed for markets to be efficient. Retail flow, with the help of solvers and market makers, can heal any price divergence by itself, and even earn rewards in the process.