Arbitrage is about capitalizing on price differentials between markets while leverage is a strategy that relies on using borrowed money to increase the potential return of an investment. This arbitrage vs leveraging debate has often come and there has been no resolution to this arbitrage vs leveraging debate as both are meant to be used in different circumstances. Today, we will understand the basics of this arbitrage vs leveraging discussion and how they apply to DeFi.
Have you ever wondered about the difference between arbitrage and leveraging? Arbitrage is one strategy used to profit from price discrepancies or pricing inefficiencies. However, leveraging Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Here is how they both work.
What is arbitrage?
Arbitrage is described as the simultaneous acquisition and disposal of the same asset in various marketplaces in an effort to profit from minute variations in the asset's quoted price. It takes advantage of brief fluctuations in the cost of identical or comparable financial instruments on several markets or in other forms."
Arbitrage, very simply, is the practice of selling an item for more money than it cost you to purchase it.
Arbitrage comes in a variety of forms in DeFi. Let's take a closer look at the two various arbitrage opportunities.
How does arbitrage work?
The temporary de-peg of USDT is a recent instance of stablecoin arbitrage. Following the panic after the LUNA collapse, USDT fell below its peg. Arbitrageurs bought USDT when it was below its dollar peg and redeemed it for dollars, enabling them to pocket a small but risk-free profit. Because stablecoins are built around arbitrageurs maintaining the balance between the on-chain asset and its real-world equivalent, in this instance the process operated perfectly as intended.
Arbitrage using stablecoins can also become more complicated. For instance, a stablecoin may trade at a marginally different price on one DEX than on another, necessitating the trader to account for gas costs in their arbitrage. Arbitrages across many pools are another possibility for stablecoins. In that situation, arbitrageurs profit from the imbalances in the pool.
Problem associated with stablecoin arbitrage
Identifying the risk associated with the de-peg is the most challenging component. In the case of Tether, the market began to become overly concerned about Tether's capacity to convert USDT into dollars. Arbitrage with algorithmic stablecoins is more riskier and can fail, as the collapse of LUNA demonstrated.
Arbitrage between various assets and/or exchanges is known as yield arbitrage. For instance, you may lend DAI for 10% and borrow it for 5%. (most likely on a different platform). Your profit margin would be the 5% difference.
However, such a spread is unlikely, and variations are more likely to appear across various DeFi and CeFi platforms. You can lend on a CeFi custodial platform but borrow from a DeFi protocol, or the other way around.
An additional illustration would be borrowing from a website like Pando. Consider borrowing ETH from Pando Network for 1% and lending it to a custodial platform like BlockFi for 1.5 percent. Your profit is 0.5%.
Read more about Pando Ring lending and borrowing by clicking here.
What is leveraging in DeFi?
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One of the first and largest DeFi applications is borrowing and lending, which is already dominated by market heavyweights like Aave, and Pando.
Using leverage by borrowing crypto assets makes intuitive sense.
For instance, if you have $10,000 in ETH and are bullish, you might use it as collateral to deposit it in Pando and borrow $5,000 in USDC, then exchange it for another $5,000 in ETH. In comparison to your $10,000 starting capital, you will receive a $15,000 exposure in ETH, which is the same as a 1.5x leverage.
Similarly, if you are bearish, you can choose to deposit stable coins like pUSD or USDT and borrow ETH. If the value of ETH falls, you can sell it back and pay off your debt by purchasing it at a lower cost.
Note that in this case, since you would be borrowing funds from a decentralized protocol, if the value of collateral decreases or the value of what you borrow increases beyond a certain threshold, you might get liquidated.
After talking about breaking down what arbitrage and leverage is, it’s important to know the risks involved in arbitrage and leverage trading investments.
DeFi Arbitrage and leveraging Risks
Arbitrage opportunities may become unprofitable as a result of fluctuating Ethereum gas prices. The fact that these transactions are only initiated at a specific gas price makes batch transactions a requirement. However, until the transaction is completed, the opportunities can be lost.
A stablecoin can also be surprisingly unstable, as the UST example illustrates. The level of risk involved in asset arbitrage is frequently arbitrary. While one individual might be certain that USDT can never fail, another person might not share that belief. This contributes to the initial occurrence of stablecoin de-pegs.
You risk being liquidated if the value of the collateral drops below a particular point or the value of the borrowed funds rises over that point.
Using Pando Product Suite to Navigate Arbitrage and Leverage Trading
Pando is a decentralized network of finance protocols built on the Mixin Network, to give crypto investors an all-in-one platform.
The platform offers a derivatives liquidity pool to generate a stablecoin “pUSD”, the Pando network native token. The stable coin can be swapped on 4swap into any coin of your choice, and used to perform arbitrages outside the network.The Pando lake / 4swap protocol of the network is one of the fastest platform to swap coins.
To perform leverage trade as explained under “leverage in DeFi”, you can visit Pando Ring, a protocol built to implement borrowing and lending.
Bigger gains and higher risks go hand-in-hand with leverage. Different financial products might offer traders leveraged exposure in very different ways. Leveraged products, particularly in DeFi, may be driven by cutting-edge models and fresh approaches to liquidity that are uncommon in conventional finance.
Arbitration may sound exciting but it can be ineffective. Opportunities for simple arbitrage are undoubtedly scarce and transient. Arbitrage in DeFi needs to be done consistently, which calls for understanding of coding to create effective bots and proficiency interfacing with various exchanges and blockchain ecosystems. It requires certain technical skills to perform profitable ones.
Before trading with leverage and arbitrage, consumers should be aware of the models being used and conduct in-depth independent researches.
The information contained in this article is for informational purposes only and does not constitute financial, investment, or other professional advice. The views expressed in this article are those of the author and do not necessarily represent the views of the company or organization they work for or Pando. Any investment decisions made by the reader should be made after consulting with their own financial advisor and conducting their own research. The author and the company or organization they work for and Pando will not be liable for any financial losses incurred as a result of reliance on the information contained in this article.