Building Trust Takes Time: Limits to Arbitrage in Blockchain-Based Markets
52 Pages Posted: 2 Jan 2019 Last revised: 25 Mar 2020
Date Written: March 25, 2020
Distributed ledger technologies replace trusted clearing counterparties and security depositories with time-consuming consensus protocols to record the transfer of ownership. This settlement latency exposes cross-market arbitrageurs to price risk. We theoretically derive arbitrage bounds that increase with expected latency, latency uncertainty, volatility and risk aversion. Using Bitcoin orderbook and network data, we estimate arbitrage bounds of on average 121 basis points, explaining 91% of the observed cross-market price differences. Consistent with our theory, periods of high latency-implied price risk exhibit large price differences, while asset flows chase arbitrage opportunities. Blockchain-based settlement thus introduces a non-trivial friction that impedes arbitrage activity.
Keywords: Arbitrage, Market Frictions, Blockchain
JEL Classification: G00, G10, G14
Suggested Citation: Suggested Citation