Liquidity and Arbitrage
Last updated
Last updated
One of the easiest ways to provide liquidity to an exchange (in a liquid market) is the maker-taker arbitrage.
Setting up: A Market Maker watches the orderbook on exchange A, then places market orders (bids and asks) on exchange B, providing liquidity there.
In the image above, a bid order is placed at a lower price on exchange B than the corresponding bid on exchange A.
Similarly, ask orders are placed at a higher price on exchange B than the corresponding asks on exchange A. These maker orders are updated whenever price/liquidity changes on exchange A.
As a result, the market maker quotes a spread on exchange B (7$) that is slightly higher than the one on exchange B (5$). Nevertheless, this increases the liquidity on exchange B.
Success case: Whenever the bid is executed at exchange B, a taker order is sent to exchange A. The second order executes at a slightly higher price, generating a small profit.
Similarly, whenever an ask is executed, a taker order is sent to buy one exchange A for a profit as well.
Failure case: Price/liquidity on exchange A has changed by the time the order is executed on exchange B. The second order fails to execute. Some fallback mechanism is then used to close the position (immediately or after some time). This usually results in expected loss for the arbitrage strategy.
In a competitive environment, unless the failure case is very common, the profit margins will be very small. In this scenario, the Maker-Taker arbitrage will end up “duplicating” the liquidity from exchange A into exchange B.
However, failure is indeed quite common! Here is how it can happen.
Sniper failure: In the above scenario, price falls quickly on exchange A. The Market Maker tries to cancel/update its bids on exchange B according to the new price. However, several “Snipers” compete with each other and arrive first at exchange B. They can profit by selling there at the old price. This generates profits for the snipers (at the expense of the Market Maker).
Sniper failure, and other forms of latency arbitrage, generate losses to market makers. Facing wider spreads as a result, and realizing that traders would end up displeased, most crypto exchanges decided to find creative ways to reduce their visible spread. They started first to reduce/exempt fees for maker orders, orders that are executed after previously resting on the order book providing liquidity. Soon they started to actively subsidize them, with so called maker rebates (or negative maker fees).
This worked to create apparent tight spreads, but it ended up being nothing more than a clever marketing trick. These maker subsidies had to be paid for with increased taker fees charged on the regular traders.
