Trading and Arbitrage in Cryptocurrency Markets Igor Makarov Antoinette Schoar LSE MIT Sloan Gerzensee, October 10, 2018
Motivation • Cryptocurrencies like bitcoin are built on the blockchain technology • Allows verification of payments in the absence of a centralized custodian • Verification is done by decentralized "miners" • Bitcoin was originally introduced in a paper by Nakamoto (2008) and came into existence in 2009 • First payment transaction on May 22, 2010: A bitcoin enthusiast (Laszlo Hanyecz) bought 2 pizzas for 10,000 bitcoins Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 2
Motivation (cont.) • Since then the market for cryptocurrencies has evolved dramatically • More then 1000 “altcoins” traded on more than 100 exchanges • Market cap: $500B at the peak • Academic research on bitcoin trading is in its beginnings Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 3
This paper • A systematic analysis of the trading and efficiency of crypto markets • Crypto markets are ideal settings for studying price arbitrage: • Markets are segmented across many countries and jurisdictions • Many ‘naive’ investors and few large sophisticated investors (e.g., DRW, Jump Trading, or Hehmeyer Trading) • Blockchain technology alleviates some constraints (e.g., capital mobility) but introduces others (the transfer of value between exchanges is subject to a delay) Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 4
Main results • History of bitcoin exchanges marked by recurring episodes of arbitrage opportunities opening and closing again • The total size of arbitrage profits from December 2017 to February 2018 is well above $1 billion • Arbitrage opportunities persist for several hours or even days and weeks • Market segmentation matters • Arbitrage opportunities are larger across countries (or regions) than within the same country • Arbitrage spreads are much smaller for exchange rates between different cryptocurrencies compared to exchange rates between cryptocurrencies and fiat currencies • Arbitrage spreads across countries show strong co-movement • Countries with higher average bitcoin premium also respond more strongly to periods of ’buying pressure’ • Price deviations are asymmetric: Bitcoin price in rest of world is above US Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 5
Main results (cont.) • Bitcoin returns and arbitrage spreads vary with net order flows • We decompose signed volume on each exchange into a common component and an idiosyncratic, exchange-specific component • The common component explains 80 percent of the variation in bitcoin returns • Buying 10,000 bitcoins raises returns by 4% at the daily frequency • The idiosyncratic components of order flow play an important role in explaining the size of the arbitrage spreads between exchanges Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 6
Overview • Bitcoin price: January 1st, 2016 – February 28, 2018 Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 7
Overview • Daily bitcoin volume to fiat currencies in 2017 Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 8
Data • Tick level trading data from Kaiko, a private firm that has been collecting trading information about crypto currencies since 2014 • The Kaiko data cover the 15 largest and most liquid exchanges: Bitstamp, Kraken, BTCC, Bittrex, Coinbase, OkCoin, Bitfinex, Poloniex, Bithumb, Gemini, Quoine, bitFlyer, Huobi, Binance, and Zaif • The 15 exchanges account for 85% of total bitcoin volume to fiat curencies • Expanded sample of 30 exchanges across 16 countries from additional sources such as bitcoincharts.com and individual exchanges themselves Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 9
Summary statistics: returns Return Std. Dev Skewness Kurtosis ρ 1 ρ 2 ρ 3 cross frequency correlation 5 - Minute 1.40 1.56 365.64 0.07 -0.01 0.01 0.57 Hour 1.22 -0.06 13.86 -0.07 -0.05 -0.01 0.83 Daily 1.07 0.29 3.85 -0.01 0 0.02 0.95 Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 10
Arbitrage index (all exchanges) Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 11
Arbitrage index (within regions) US Europe Japan Korea Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 12
Arbitrage index (between regions) All US vs. Korea US vs. Japan US vs. Europe Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 13 –
Arbitrage profit (between regions) Japan: total profit $116M Korea: total profit $747M Europe: total profit $23M Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 14
– Arbitrage index: ethereum and ripple – – ethereum – ripple Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 15
Ethereum-bitcoin exchange rate across regions Japan Korea Europe Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 16
Extension in Progress • Expanding sample to 30 exchanges in 16 countries allows us to look at the correlation structure between price deviatios across countries • Data from Bitcoinchart.com, Kaiko and several exchanges directly • Calculate arbitrage spread relative to the US for each country • Arbitrage spreads co-move and are asymmetric relative to the US: Rest of the world trades at a premium to the US (and Europe) Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 17
Co-Movement of Arbitrage Spreads • Correlation Matrix: Bitcoin Arbitrage Index Across Regions Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 18
Extension in Progress I • Use standard Hodrick-Prescott Filter to calculate the smoothed Bitcoin price at the weekly level in the US • Calculate deviations of the actual log price from the smoothed log price to provide metric of "buying pressure" in the US • Regress arbitrage spreads of individual countries relative to US price on our measure of buying pressure • We find a strong positive beta: Countries outside the US repond strongly to price pressure in the US Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 19
US Price Deviations from Trend • Difference between US bitcoin price and smoothed btcoin price series using Prescott filter Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 20
Extension in Progress II • Correlate a countriy’s average bitcoin premium realtive to the US Bitcoin price with the bitcoin beta of the country • Countries that have a higher average bitcoin premium over the US, also show larger arbitrage deviations in times when the buying pressure in the US goes up. Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 21
Sensitivity to Buying Pressure in the US • Regression of Regional Bitcoin Premia (to the US) on our measure of Buying Pressure Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 22
The Role of Capital Controls • Regression of pairwise correlation between arbitrage spreads on pairwise measure of capital control: PCont ij = 1 − γ i γ j (1) Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 23
How to Interpret the Findings? • The marginal investor outside the US is willing to pay more for bitcoin in response to positive news. Possibly because the value of cryptocurrencies is higher in countries with poor financial markets • Good news about crypto currencies or changes in sentiment affects buying pressure in the US but even more so in other countries • T o observe sustained price deviations markets must be segemented and arbitrage capital flows slowly Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 24
Implementation of Arbitrage • In a frictionless world if prices are different across exchanges there is a riskless arbitrage: Exch 1: Exch 2: P 1 = 100 P 2 = 200 B 1 B 1 $ 100 $ 200 • Transactions take time ⇒ need to buy and sell bitcoin simulteneously Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 25
Implementation of Arbitrage II • Ideally, an arbitrageur would like to short sell bitcoin on the market where the price is high ⇒ often not feasible, because many exchanges do not allow short-sales • T wo solutions: • Trading on margin ⇒ similar to short-sales, but does not allow for physical settlement ⇒ convergence risk • Hold a positive balance of bitcoin on both exchanges and simultaneously buy and sell bitcoins across the two exchanges whenever the price on one exchange deviates from that on the other ⇒ price risk • T o mitigate the price risk the arbitrageur can • Short-sale bitcoins • Borrow bitcoin from people who hold big amounts of bitcoin without an interest to sell (hodlers) • Use futures contracts (from December 2017) Makarov and Schoar, Trading and Arbitrage in Cryptocurrency Markets 26
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