Market Ineffectiveness Value Catcher: How Can the Crypto Asset Market Arbitrage?

Source: BlockVC

Editor's Note: The original title was "The Value Catcher of Market Ineffectiveness: Detailed Arbitrage Strategies"

The arbitrage strategy originates from The Law of One Price, that is, in a completely competitive market, the transaction prices of the same transaction target must be equal. Therefore, when the same transaction target has price deviations in the same or different markets, arbitrageurs can benefit by buying low and selling high; at the same time, it will help complete the reasonable asset pricing process and achieve market efficiency of prices.

Compared to traditional financial markets, the crypto asset market has a relatively small financial instrument, but its overall market value is small. But due to market inefficiency, there are more opportunities for mispricing and fewer arbitrage participants. The arbitrage strategy in the crypto asset market can reach an annualized level of 15-35%, which is much higher than the traditional financial market of 5% -15% Into the income range.

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I. Arbitrage in financial markets

Below we will elaborate on a variety of arbitrage strategies from the level of strategy type and strategy risk:

Futures arbitrage strategy

Futures arbitrage strategies can be further divided into cash arbitrage, intertemporal arbitrage, cross-market arbitrage and cross-species arbitrage strategies;

1.1 cash arbitrage

Cash forward arbitrage is divided into forward cash arbitrage and reverse cash arbitrage according to the direction of arbitrage. Forward cash arbitrage refers to buying short-selling futures when the futures price is higher than the theoretical price of holding costs; Forward cash arbitrage refers to buying futures and shorting the spot when the futures market price is lower than the holding cost theoretical price; to obtain a gain when the futures price and the spot price converge. For most of the spot markets, short selling methods are lacking, so the implementation conditions and costs of reverse arbitrage are strict. Usually, the reasonable undervaluation of futures prices is generally higher than its overestimation, and the probability of futures underestimation is relatively high.

Figure 1 Schematic diagram of current arbitrage Source BlockVC

Some points to note in the implementation process are that spot arbitrage requires the cooperation of algorithmic trading methods, and the monitoring and execution of arbitrage opportunities require high sensitivity and low response time. Under the premise of avoiding liquidity difficulties, quickly discover trading opportunities Realize as many open and close positions as possible. At the same time, it is necessary to rebalance the already established spot combination according to the underlying index futures to reduce tracking errors. For changes in the basis, you need to close the position in advance or move the position for rolling arbitrage.

1.2 Intertemporal Arbitrage

Intertemporal arbitrage is a type of statistical arbitrage. The main method is to carry out statistical analysis on the historical prices of contracts with different maturities, and carry out arbitrage transactions when the spread between the highly correlated trading species widens, buying undervalued and high selling prices. In the case of estimated bids, the profit will be closed after the spread is restored.

In practice, intertemporal arbitrage can be further divided into bull arbitrage, bear arbitrage and butterfly arbitrage: bull arbitrage refers to buying the nearest delivery month contract and selling the forward delivery month contract. It is expected that the recent contract increase will be greater than the forward contract increase Bear market arbitrage is the opposite, buying forward delivery month contracts and selling recent delivery month contracts, expecting that the price of the forward contract will fall less than the recent contract.

Figure 2 Schema of intertemporal arbitrage Source: BlockVC

Butterfly arbitrage consists of two inter-arbitrage arbitrage in opposite directions and sharing a central delivery month contract, involving a total of three different delivery month contracts. The trading strategy is to buy (sell) newer month contracts, while selling (buying) middle month contracts, and buying (selling) forward month contracts. Among them, the number of contracts in the middle month is equal to the sum of the contracts in the recent month and the forward month, and the directions of the near-end and far-end contracts are the same. The income source of this combination is that the arbitrageur believes that there is a difference in the correlation between the futures contract price of the middle delivery month and the contract price of the two delivery months. Compared with ordinary intertemporal arbitrage, the risks and benefits of butterfly intertemporal are relatively small.

1.3 Cross-market arbitrage

Cross-market arbitrage refers to the behavior of gaining income by buying low-priced market trading targets and selling high-priced market trading targets when there is a spread between the same trading targets in different markets. Due to the different markets, the conditions of trading time, daily limit, margin requirements, exchange rates, etc. will lead to unbalanced hedging strategies, and the cost of capital flow across markets will also limit the implementation of the strategy.

1.4 Cross-varietal arbitrage

Cross-species arbitrage refers to arbitrage trading on two futures varieties with strong correlations. Usually, the historical price data of the two have a regression correlation, and there are also logical support for the fundamentals, such as the upstream and downstream relationships of the industry chain or substitution Product and complementary product relationship. Different from the first three arbitrage models, the assets in the cross-species arbitrage strategy cannot be closed by delivery, nor is it a risk-free arbitrage. The arbitrage strategy may face losses when the statistical correlation between different varieties disappears.

2.Alpha arbitrage strategy

Alpha arbitrage strategy is also called Alpha strategy, which mainly refers to the originating hedging arbitrage strategy between index options or index futures and securities products with Alpha value. That is, long securities products short index futures or buy put options. Among them, securities products include open-end funds, stocks, and industry index products. Second, they can choose subscription warrants and closed-end funds that have discount rates and can exceed market indexes.

The return of the alpha strategy is derived from the excess return of the expected return higher than the β part in the portfolio theory:

E （Rp） = Rf ＋ β × （Rm-Rf）

Figure 3 Alpha Arbitrage Strategy Source: BlockVC

Compared with general futures arbitrage, Alpha arbitrage has greater strategic flexibility, profit sources are not limited by the market, and the capital capacity is large, and the yield will not be reduced due to market congestion. In practice, because the stock index futures market has been in a state of negative spread for a long time, relative to the spot, the basis spread has been negative for a long time, which has a certain impact on the return of the Alpha strategy. However, with the loosening of stock index futures in 2017, futures discounts Also gradually improved.

3. ETFs arbitrage strategies

ETFs arbitrage strategies are arbitrage between the primary and secondary market spreads for products such as ETFs. They mainly include discount arbitrage strategies and premium arbitrage strategies. When the net value of ETFs is higher than the secondary market price, buy ETFs in the secondary market and then redeem a basket of stocks and sell them through the primary market to realize discount arbitrage. Conversely, when the net value of ETFs is lower than the secondary market price, ETFs are trading at a premium.

According to the difference in the subject of the transaction, there are LOF arbitrage and grading fund arbitrage. The grading fund has two types of AB shares. A synthetic master fund can be constructed by proportion. Make money.

There are two risk points for ETFs trading. The first is that the primary and secondary market transactions are asynchronous. When the change in the net value of ETFs and the secondary market price is greater than the length of the arbitrage transaction, the arbitrage strategy will be larger. Risk exposure; the second is liquidity risk. There is a certain level of liquidity risk in the purchase and redemption of ETFs in the primary market and ETFs in the secondary market. The use of margin financing and securities lending tools can avoid such risks to a certain extent. In the case of discounts, you can sell ETFs' stock portfolios through securities lending and buy ETFs shares in the secondary market. In the case of premiums, you can sell through the integration of ETFs shares. Create a share of ETFs in the primary market.

4. Stock market neutrality strategy

It mainly includes Pairs Trading and Statistical Arbitrage. Paired trading is based on the principle of fundamental analysis. Buying undervalued stocks while selling short and overvalued stocks are also called long-short portfolios. Statistical arbitrage It analyzes stocks based on the volatility and correlation of stock prices, finds stock combinations that have a certain correlation in historical data, longs low-priced stocks, and shorts high-priced stocks, assuming that the spread between stocks returns and obtains arbitrage gains.

This strategy generally limits the construction of selected stocks and portfolios according to the parameters of the model, including ensuring that the overall long and short positions are neutral, the expected beta value of the portfolio is 0, and the portfolio sector and industry are neutral. , There is no excessive exposure to net investment style and so on. A neutral strategy can reduce the volatility of the investment portfolio, increase the Sharpe ratio, and strip the impact of the overall market environment on investment returns.

5. Option Arbitrage Strategy

Option arbitrage strategies mainly include simple strategies, spread strategies and portfolio strategies.

Figure 4 Classification and explanation of option strategy Source: Guodu Securities

For specific strategy description and profit method, please refer to BlockVC's previous article "New Blue Ocean of Crypto Asset Derivatives, Detailed Explanation of Options Trading", which will not be repeated here.

From the perspective of strategic logic, the arbitrage strategy is the opposite of the trend strategy, which has a high winning ratio and a low profit-loss ratio. Because the arbitrage strategy's profit source mainly comes from small changes in the spread between assets, this also determines that the arbitrage strategy's profit margin is limited and there is a limit on the strategic capacity. When the market becomes more efficient or the number of traders with the same strategy increases, it will cause a congestion effect and reduce the rate of return on the strategy.

Figure 5 Global Hedge Fund Strategy Size Index Source: Eurekahedge

Figure 6 Proportion of Global Hedge Fund Strategy Size Source: Eurekahedge

From the hedge fund size index calculated by Eurekahedge, it can be found that the scale of arbitrage strategy development has remained unchanged over the past few years, and it has a shrinking trend compared to the proportion of other strategy management scales. The main reason is that with the development of programmatic trading and the improvement of the effectiveness of various trading markets, the arbitrage space has been squeezed, and the management scale and profitability have declined year by year.

Figure 7: Hedge fund strategies and other yield index sources: Eurekahedge

However, the arbitrage strategy also has its own advantages. There are two main points. The first is that it has a low correlation with returns such as stock strategies and CTA strategies. The overall market is neutral, there is no directional trading, and the market will not rise, fall or fluctuate. Arbitrage strategies have a greater impact, so they can form complementary effects with other trending strategies to optimize the investment portfolio. Second, the strategy has stable returns, low volatility, small retracements, and high Sharpe ratios.

Figure 8 Global Hedge Fund Strategy Revenue Analysis Source: Eurekahedge

Figure 9 Yield analysis of domestic CTA products Source: Wind

By comparing the data of domestic and foreign fund strategy returns, it can be found that the comprehensive return of the arbitrage strategy is stable between 5% and 15%. Compared with other strategies, the arbitrage strategy has relatively high Sharpe ratio and Sotino ratio. Retreat lower. Adding arbitrage strategies can effectively diversify risks and improve the return-to-risk ratio of the strategy portfolio. Therefore, arbitrage strategies have also appeared in asset allocation and portfolios as a role to stabilize yields and increase Sharpe ratios.

With the development of financial engineering and the increase in the variety of financial products, arbitrage opportunities between various financial assets are constantly emerging, and the increase in arbitrage participants will inevitably lead to the enhancement of market effectiveness, so arbitrage opportunities and arbitrage profits will also increase. Then it decreases. For the crypto asset market with limited market participants and low market effectiveness, the arbitrage trading strategy still has a lot of room, which has also become the first step for most programmatic traders to enter the crypto asset market.

Crypto assets market arbitrage

Because the trading varieties and trading environment of the crypto asset market are significantly different from traditional financial markets, and the types of financial derivatives are not as rich as those of traditional financial markets, only some arbitrage strategies can be practiced in the crypto asset market. Below we analyze the specific arbitrage strategies in the crypto asset market:

Cash arbitrage

The futures arbitrage in the crypto asset market is mainly through arbitrage of the difference between the digital currency futures delivery contract and the spot value, that is, the basis difference. When the futures premium is short, the futures are bought into the spot. Close the position to obtain the return when the delivery due date or the basis return.

Here we take the BTCUSD futures delivery quarter contract launched on the OKEx platform as an example. The contract uses the BTC USD index set by the platform as the target price, and the settlement is settled at 4 pm on the last week of each quarter. The difference between the transaction price and the spot index reflects the traders' expectations of the future Bitcoin price and the comprehensive added value of futures liquidity and transaction costs.

Figure 10 OKEx Quarterly Delivery Contract Basis Source: OKEx

From the historical data of quarterly delivery contracts, it can be seen that during the time period from September 2017 to February 2018, the bitcoin market has been extremely volatile in terms of monthly volatility, with the contract basis as low as -787 at the beginning of November and at 12 The peak of the bull market in the middle of the month reached a maximum of 1515. During the rise, the positive basis spread continued to increase, and during the decline, the negative basis spread continued to accumulate.

This period of time is a period when the arbitrage strategy is more profitable and the risks are also extremely great. Futures arbitrage traders will start to open positions after the contract basis reaches a certain threshold, and expect the contract value to converge with the spot price to obtain a return. In order to pursue high yields and high capital utilization, arbitrage traders will add leverage to the original arbitrage positions, generally 3-5 times. Traders with strong risk appetite will even adjust the overall position leverage level to 5-10. Times. Under such circumstances, as soon as the unilateral market changes exceed 10% (10 times leverage) or 20% (5 times leverage), a liquidation will occur. If the position is not filled in time, hedging imbalance will result in loss of income. At the same time, due to the platform's settlement mechanism, there will be problems of early liquidation and allocation of positions, and arbitrage gains in actual operation will also result in losses. At present, digital currency futures exchanges have also made corresponding remedial measures for this kind of problem. After the futures price deviates too much from the spot index, it will restrict transactions to avoid pinning. During the period from September 2018 to April 2019, the basis spread varied from -80 to +40, and the market was less volatile, so the yield of the current arbitrage strategy was also limited.

Intertemporal arbitrage

At present, exchanges that have launched delivery contracts generally introduce three types of contract types: current week delivery contracts, next week delivery contracts, and quarterly delivery contracts, which correspond to Friday of the current week, Friday of the following week, and Friday of the last week of each quarter. Of three different contract types with expiration dates. The next week's contract will be automatically converted to the current week's contract on the Friday before the expiration date, and the quarterly contract will be converted to the next week's contract on the Friday two weeks before the expiration date.

There is a certain correlation between the three contract types, so statistical arbitrage can be used to achieve intertemporal arbitrage between these three futures types. There are also some arbitrage strategies to build arbitrage portfolios between delivery contracts and perpetual contracts, and at the same time, adjust the capital rate of perpetual contracts at the hedging level. Intertemporal arbitrage does not close the position with the delivery of the futures contract. Therefore, the position is generally opened when the basis is widened and closed when the basis is reduced. Some arbitrage traders will also use high-frequency trading techniques to frequently trade in changes in the basis to capture volatility gains.

At the risk level, in addition to the same risk of liquidation as the current arbitrage, intertemporal arbitrage may also result in a decline in strategic returns and even losses due to the failure of statistical arbitrage between the trading targets.

3. Cross-market arbitrage

Cross-market arbitrage is the earliest arbitrage strategy that appeared in the crypto asset market, also known as "moving bricks". Its main principle is to buy low and sell high to gain income through the price difference of the same currency between different markets.

According to Coinmarketcap statistics, the number of digital currencies currently reaches 5,154, and the number of digital currency exchanges reaches 20,636, most of which are traded 24 hours a day, so there are many arbitrage opportunities for the same currency across markets. However, due to the serious liquidity problems of most small market value currencies and small exchanges, most of the current cross-market arbitrage is mainly concentrated in the mainstream currencies of mainstream exchanges. In addition to spot trading, the contract mechanism and pricing principles of futures contracts launched by exchanges such as OKEx and Huobi are basically similar, so arbitrageurs can also implement cross-market arbitrage by moving bricks on futures trading platforms.

The main risks faced by cross-market arbitrage are liquidity risk and market risk. The original brick-moving strategy adopted the method of deposit and withdrawal of coins to transfer funds. After buying at a low-priced exchange, it was charged to a high-priced exchange and sold. However, due to the limitation of on-chain transfer time, the deposit and withdrawal review of the exchange will also affect the account time. Therefore, the arbitrage opportunity due to price changes may disappear during the withdrawal process. In order to improve the time lag of fund flow, traders adopt the method of simultaneously opening accounts and establishing a short position in two exchanges to carry out cross-market arbitrage, ensure the consistency of bilateral operations, and transfer funds to each other within a fixed time period. To ensure that the bilateral margin is sufficient to avoid market risks caused by drastic market changes.

Triangle arbitrage

Triangular arbitrage is a form of arbitrage that is mainly used in the foreign exchange market. The income mainly comes from cross-exchange rate pricing errors. There are also many types of trading currencies in the crypto asset market. Arbitrageurs usually use mainstream currencies with better liquidity for triangular and even multi-angle arbitrage.

5. Rate Arbitrage

Rate arbitrage mainly refers to the arbitrage of the perpetual contract funds rates of various digital currency futures exchanges. Crypto asset market perpetual contracts are pioneered by BitMEX, and swaps for spot price index are anchored through the adjustment of capital rate. Funding costs are incurred every eight hours and paid by the opposite party to the other party. When the fund rate is positive, the longs are paid to the shorts, and when the fund rate is negative, the shorts are paid to the longs.

Since the main role of the fund rate is to stabilize the consistency between the price of the perpetual contract and the spot index, the size of the fund rate is also related to the discount and premium of the contract. In order to facilitate understanding, we use the XBTUSD contract as an example to explain:

• The fund rate is composed of interest rate and discount / premium. The interest rate is the difference between the quoted currency interest rate (USD) and the base currency interest rate (XBT):

Interest rate (I) = (denominated interest rate index-base interest rate index) / fund rate interval

* Including capital rate interval = 3 (occurs once every 8 hours)

• The discount / premium is the discount and premium of the price of the BitMEX platform perpetual swap contract compared to the marked price: the premium index (P) = (Max (0, depth-weighted buying price-marked price)-Max (0, marked price- Depth-weighted selling price)) / Spot price + Reasonable basis for marked price;
• BitMEX calculates the premium index P and the interest rate (I) every minute, and then calculates its minute-time weighted average every 8 hours. Funding rates are calculated based on the interest rate and premium / discount components every 8 hours, plus a +/- 0.05% buffer.

Funding rate (F) = Premium index (P) + clamp (Interest rate (I)-Premium index (P), 0.05%, -0.05%)

The interest rate is relatively fixed. When the discount premium level is low, the fund rate is equal to the interest rate. In a market with a clear trend, a large number of long positions will cause a contract premium. At this time, the capital rate will become positive, and the long positions will be paid to the short funds. Therefore, the open-hedging method can be used to realize the rate arbitrage, and vice versa. .

By observing the chart below, it can be found that, with the rise of digital currencies some time ago, the capital rate of perpetual contracts of major exchanges has reached a high level, so there are a large number of arbitrage traders to obtain profits by opening shorts.

Figure 11 Perpetual Contract Funding Rate Source: SKEW

Figure 12 Bitmex Perpetual Contract Funding Rate Source: SKEW

The main risk of fund rate arbitrage is that as the market environment changes, the fund rate is not stable, so only short-term transactions can be performed under specific market conditions.

6. Option Arbitrage

Arbitrage strategies in the traditional options market can basically be applied in the crypto asset market. Arbitrage strategies are also mainly based on spread strategies and portfolio strategies. The early options trading platforms were Deribit and LedgerX. OKEx's recently launched options trading volume and positions have also grown rapidly. Currently, more than 89% of Bitcoin options transactions in the market are conducted on Deribit, with OKEx occupying 10%.

Figure 13 Bitcoin Option Positions and Trading Volume Source: SKEW

Figure 14 Proportion of Bitcoin Option Trading Source: SKEW

The development of options in the crypto asset market is still at an early stage, and there are relatively few traders and options traders. Therefore, the liquidity of options trading products in the crypto asset market has limited the arbitrage of options to a certain extent, and some trading teams also encountered losses in the early arbitrage process because of liquidity restrictions that prevented them from closing positions. However, with the improvement of the trading market, the liquidity and trading volume of options transactions have greatly improved last year. In the future, option arbitrage will also occupy one of the important parts of the crypto asset market arbitrage strategy.

Conclusion

Currently limited by the size of the overall market value of crypto assets, the number of teams engaged in quantitative trading of crypto assets is still small. The management scale of a single quant team is mainly concentrated between millions to tens of millions of dollars. Some top cryptos The management scale of the asset quantification team can reach hundreds of millions of dollars in market value. There are about hundreds of global crypto asset quantification teams with stable asset management capabilities. According to the average management scale of 10 million US dollars, the overall global crypto asset management market is about 1 billion US dollars. The strategies of the crypto asset quantification team are mainly concentrated in two categories, such as trend-following and neutral arbitrage strategies. Among them, the proportion of quantified teams focusing on different types of arbitrage strategies is relatively high, which can account for about 60-70% of the overall market size.

Although the overall management scale of encrypted digital asset quantification is very small compared to the traditional quantitative market management scale, due to the characteristics of 7 * 24 hours of tradable crypto assets, high volatility, and poor effectiveness, the focus on arbitrage strategies in the field of crypto assets The annualized rate of return is significantly higher than that of traditional market neutral strategies. Judging from the data of the most common arbitrage strategies in the crypto asset field, according to BlockVC's due diligence results on dozens of arbitrage strategy funds in the crypto market, the annualized arbitrage strategies of crypto assets are distributed at 15-35% In between, the average annualized rate of return can reach about 24%, which is much higher than the average annualized rate of return of 10% on traditional market arbitrage strategies.

With the increase in the size of the crypto asset market and the innovation of trading products, more emerging arbitrage opportunities will be continuously explored. The increase of arbitrage traders will also help improve the stability and effectiveness of the crypto asset market.

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