Arbitrage is the strategy of instantly trading an asset (Example: Bitcoin) in different markets (exchanges) to profit from small differences in the asset's listed price. Traders can move between different exchanges looking for small differences in the prices of different assets.
Observe that the BTC/USDT pair is trading on Binance at $26578.45, while the same BTC/USDT is trading on Bitfinex at $26575.46. That's a $2.99 difference. A trader can buy BTC on Bitfinex and sell on Binance for a profit of $2.99 dollars per BTC.
The same applies to decentralized exchange (DEX) protocols like UniSwap, PanCakeSwap, etc. Flash loans are used to take advantage of price arbitrage on DEX, this is due to their instant nature and applicability on Blockchain.
All of the above actions are performed using smart contracts through a single transaction (About 3 seconds for the BSC network). We don't need working capital to do that and you don't risk losing capital. Once you submit the trade, you win or the trade is rolled back. You only pay a small gas fee, usually less than $0.1
In reality, an arbitrage transaction looks like this:
We can easily observe that this transaction performed a series of actions: From 9.74 USDT → WBNB → GFAL → 12.90 USDT. The GFAL token at the end of the transaction is often used in arbitrage for burning and it can reduce Gas fees significantly. The above trade generated a profit of: 12.90 - 9.74 = $3.16! In just about 3 seconds! Of course we need to subtract the transaction's Gas fee: 3Gwei = 0.04$ (0.000000003 BNB) and get the final profit: 3.12$. This is a significant amount of money relative to the time efficiency.
Check link: https://bscscan.com/tx/0x10ea9efdab54d100e6c70844ebe35716c9874cdb7ae9f976e80b43ee7d7bb51f
Arbitrage trading on Defi protocols has the following characteristics:
It is done through the exchange of Tokens through many similar and cyclical protocols: A → B → C → A. The length of this cycle is not fixed and it is proportional to the difficulty of calculation. The longer the cycle, the more difficult it is to detect due to higher requirements for computing processing power and Gas fees have a large impact on the profit in each trading order, some orders only bring in a profit of a few cents because Gas fees had to be amortized. Even for transactions where the Gas fee is higher than the reward earned, it is no longer an arbitrage opportunity worth taking. Competition grows over time, but that doesn't mean opportunities won't exist. The nature of the Defi space is very large, the number of trading pairs operating across protocols is very large and difficult to quantify. Therefore, popular trading pairs are usually reserved for experienced and strong arbitrageurs, less popular or new trading pairs still provide many opportunities for new traders to enter the market
The process of arbitrage trading is carried out in 5 steps:
Step 1: Prepare infrastructure and network. Investment cost items covered here include:
Costs for RPC providers, Mempools and computer systems with high computing capabilities that come with strong bandwidth, geographical distance in peer-to-peer connections between Nodes, Peers... also affect transaction speed.
Step 2: Perform a simulation or heuristic estimate for the potential profits generated by every trade. The Bot system listens to events in Mempool and analyzes to detect arbitrage opportunities, determining the order of actions to take to gain profit from the difference. This step will perform transaction data extraction techniques, comparing a series of lists of similar or connected trading pairs in different protocols to calculate profits and determine the existence of profits. . This is the most difficult step to do because it requires a lot of computing power in the infrastructure.
Step 3: Use smart contracts to synthesize the series of actions that need to be performed into a single transaction. Every single operation command to exchange tokens across protocols is compressed.
Step 4: Put the aggregated transactions into Mempool and compete on cost, speed and infrastructure power including calculating Gas costs. This is an important step because it determines the success of the transaction. Raising Gas fees high to get to the top of the mempool can erode all profits, the speed of sending requests to the mempool makes a big difference in rankings. Arbitrageurs will have to race to optimize in the above aspects or implement special techniques to gain an advantage.
Step 5: The transaction is entered into the Blockchain by the block miner or block validator and successfully receives the return or the transaction is reverted due to competition failure or difference calculation error, it can be Spending a few cents on insignificant Gas fees.
Flash lending in arbitrage trading in DeFi.
Borrowers do not need to provide the usual requirements such as proof of income, reserves or collateral.
This lending protocol is possible using smart contracts in DeFi Trading. Smart contracts set the rules for flash loans. It requires the borrower to pay back the entire loan amount, possibly with additional fees, before the transaction is completed.
If this rule is not met, the smart contract automatically reverses the transaction and the loan is canceled as if it never happened.
Flash loans usually take place in a matter of seconds, which is how they are able to provide unsecured loans, and the borrower must pay back the entire loan amount almost immediately.
Risks associated with MEV bots and arbitrage trading in DeFi
The risk of arbitrage in DeFi is very low because you do not invest capital. If the transaction is not carried out, you will lose a few cents in gas fees, this is also considered the biggest risk.
The cause of unfilled trades occurs when the spread closes before you can complete the trade, resulting in zero profit. This could be due to slippage, slow execution speeds, unusually high transaction costs, spikes in volatility, and more.
Subjects who can use Mev bot are people or organizations with appropriate, complete facilities and high professional qualifications.
Summary:
Trading off orders is an opportunity to help Traders make good profits and very low risk.
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