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While crypto may still be seen by some as “underground”, a place for enthusiasts and tech nerds, DeFi is something that everyone should be paying closer attention to.

It could be that in a relatively short time the way we bank, borrow, lend, carry out financial speculation and even buy insurance could radically change.

Welcome to the world of DeFi!

DeFi stands for decentralised finance. It offers a decentralised financial system that eliminates the need for traditional middlemen: banks, payment providers, exchanges, insurance etc

DeFi today is still very much in its infancy but has a very promising future, potentially providing a more financially accessible and egalitarian possibility for millions, maybe one day even billions, of people around the world.

That sounds like a good thing indeed!

TradFi vs DeFi

Traditional Finance is, as the name suggests, traditional financial players like commercial and investment banks and brokerage houses that can often be hundreds of years old and are involved in every aspect of finance from banking to trading and everything in between.

On the opposite of that spectrum are the young new upstarts starting a revolution by throwing hand grenades into the traditional and gentile world of TradFi.

These DeFi upstarts envision a world where there are no organisations controlling access to the world of finance and where the rule book is literally set alight and unceremoniously thrown out the window.

In this article we are looking at the highly innovative world of DeFi and how it contrasts and potentially threatens the cosy and highly entrenched world of traditional finance (TradFi ).

DeFi vs TradFi, a historically monumental shift

Today’s financial systems might feel antiquated when compared to the wonders of the technology-driven world we live in.

The world of TradFi tries to keep up with consumer needs by building on top of an existing closed system and open finance has helped somewhat to drag TradFi into the modern age.

We must however keep in mind that even open finance whilst fresh and innovative is still constrained by the rules and limitations of traditional finance and their way of doing things.

DeFi on the other hand is starting from scratch in many ways and building something totally new and free from the constraints of TradFi.

The inescapable fact is that times and consumer habits, needs and expectations have changed and now technology exists that can facilitate the kind of monumental shift we are seeing in the crypto world.

It is no different to automobiles challenging the horse and cart or online travel agencies such as Expedia or Booking.com challenging traditional travel agencies during the early internet boom.

So, what does DeFi potentially have in store for us?

First, do note that this is a revolution and not an evolution.

The automobile wasn’t a horse that could go faster, the automobile eliminated the horse completely from the picture.

In much the same way DeFi is not an evolution in TradFi but rather a true revolution, a re-start from scratch, in a sense.

Of course, people’s core financial needs are still pretty much the same: earn, hold, pay, save, borrow, lend, invest, convert, trade, insure, donate.

But the infrastructure to do those “basic” things is about to be re-written completely!

Just as in the early days of automobiles when there were plenty of accidents along the way, no speed limits, no speed cameras or speeding tickets, DeFi is currently a bit of an unregulated, free and “wild-west” of finance.

It’s basically doing everything that traditional finance does, and more, without re-using a single piece of it.

DeFi explained

Decentralised Finance is the “money” arm of the crypto world.

Think of it as Wall Street 2.0, where decentralised companies go public and services like lending, borrowing and derivative trading can all be accessed by anyone.

How Defi Started

In many ways, Bitcoin could be seen as the very first example of DeFi even though the term DeFi hadn’t been coined yet, if you pardon the pun!

Bitcoin was and still is a decentralised monetary system independent of any government or central organisation, the very essence of DeFi.

But the only use cases were “hold” and “pay”. There was no lending, borrowing, trading or anything else natively built on the Bitcoin blockchain.

The first example of what we would today consider to be Decentralised Finance started in 2015 with Maker.

Maker had a vision to create a decentralised financial system that would be governed by its user community and, in doing so, give borrowers more control of their assets.

Maker allows users to borrow Dai, the platform’s native token which is pegged to the US dollar.

This is one via a set of smart contracts on the Ethereum blockchain, which govern the loan, repayment, and liquidation processes

So Maker lends money against collateral, like a pawn shop or a real estate mortgage dealer.

That was DeFi use case #1.

In 2018 Uniswap was released and allowed the exchange of any token for another token without the need for a central exchange and in 2020 AAVE made lending and borrowing decentralised.

From then on things went crazy and today you can earn, hold, pay, save, borrow, lend, invest, convert, trade, insure, and donate with Decentralised Protocols.

Whereas in open finance fintech apps are interfacing with established financial institutions to provide consumers with a greater ease of use, developers in the DeFi world are rewriting the rule book completely.

They are not looking for ways to integrate with traditional intermediaries but rather eliminate them from the picture completely!

Why connect to a bank’s back end if everyone can hold their own keys and be their own banks?

How can this be possible you might be asking, don´t we need these very solid financial establishments like banks to provide us with lending, borrowing, derivative trading facilities and so forth?

Well, it turns out that we maybe don’t.

As mentioned above, the majority of DeFi applications are built on top of very sophisticated blockchain technology called Ethereum which had a market value of $225 billion as of 2nd August 2023.

To put this into perspective, Barclays Bank had a market cap of $31 billion on the same day.

So the market cap of Ethereum was nearly 7x that of Barclays Bank!

Considering that Ethereum came into being in 2015 and Barclays Bank was founded way back in 1896, Ethereum is certainly no financial lightweight when compared to the big boys in TradFi.

There are four main tenets that all DeFi apps share

DeFi apps use a blockchain as their core ledger

All DeFi apps use blockchains for their underlying technology, a few of the most prominent blockchains used to build DeFi apps include Ethereum, Solana, Terra, and Binance Chain. The blockchain performs the central task of recording a ledger of all transactions in the form of blocks.

DeFi apps are open source and transparent by design

Being open source and transparent by nature allows a level of auditability making it possible to delve into smart contracts to see exactly what a smart contract is doing in terms of functions, user data and permissions. Lastly, the entire flow of funds is auditable, this is pretty major when compared to TradFi where everything is hidden away behind proprietary systems accessible only by people on the inside.

DeFi apps are interoperable and programmable

We often hear about “money legos” when looking at DeFi. This is a reference to their composability. Each individual DeFi app can be seen as a “Lego brick” for a specific financial service or product that can be freely combined with others. These “Lego bricks” are in a sense clicked together for each individual transaction in real-time enabling a level of speed, flexibility and innovation that would be unthinkable or even impossible in the way more closed-off and proprietary world of TradFi.

This is why innovation happens so fast: if you want to build a service that requires “swapping” tokens and “lending tokens” as fundamental building blocks and then adds some value on top, you don’t need to rebuild those two building blocks, you can just “plug into” Uniswap” and “AAVE”, and you only need to build the small thing that is unique to your app.

In traditional finance that could take months of negotiations; in DeFi it takes the minutes required to connect to an API.

DeFi apps are open and accessible to all

One of the most underappreciated aspects of DeFi products is the inherent equality of accessibility. No institution or intermediary can deny service which is also known as being permissionless.

If you have sufficient funds within your wallet for the transaction that you wish to carry out, you can do it irrespective of where you are from or who you are, it’s as simple as that.

Compare that to TradFi where an individual can still decide whether a person gets approved for a loan or can even open up a bank account!

The DeFi world does not care about these sorts of things.

As long as you have enough coins or tokens in place to carry out the desired transaction there is nobody there to stop you.

In a world where discrimination sadly still exists and where so many people around the world still do not have access to basic banking facilities let alone sophisticated financial services it´s clearly about time!

The DeFi ecosystem now

Some examples of DeFi apps include:

Decentralised Exchanges – also known as DEXs – such as Uniswap where trades can be executed without the DEX having to hold on to your funds to execute trades.
Decentralised Derivatives Trading – On Synthetix for example, you can trade in commodities, something akin to derivative trading without the need to have and hold the commodities in question, instead you trade something called Synths that are synthetic assets.
Lending – Compound is a decentralised peer-to-peer (P2P) lending platform where users can earn interest or borrow assets against collateral. AAVE too.
Insurance – Nexus Mutual is a decentralised autonomous organisation that provides smart contract insurance.

Risks and opportunities with DeFi

By now the opportunities of using DeFi are probably apparent: Autonomy, speed and opportunities previously unavailable.

But there are also quite a few risks still associated with Decentralised Finance that you should consider before rushing into anything. Here is an overview of the types of risks you are looking at:

1. The risk linked to the “smart contract”

The risk linked to a “smart contract” (the computer code on the blockchain) you are using (AAVE, Uniswap,…). For example, we have seen the following happen in the past:

Oracle Attacks &/or Clever Arbitrage Execution: Manipulate the price through oracles, volumes or both, get lots of stuff for cheaper than it is, and then sell it at its real value.

Example: bZx, Cheese Bank, Harvest

Contract Design: if you let them print tokens, they will.

Example: PickleFinance

Reentrancy Attack – happens if a contract makes an external call to another untrusted contract before resolving. For example, if it transfers funds before setting its balance to zero, an attacker can beat the withdraw function to death and essentially drain the entire contract.

Example: Akropolis, dForce, and Origin

Front-end issues: bugs in hosting or domain leads to attacks – not specifically DeFi, but still a problem faced by NiceHash. If you go to app.uniswap.org trusting that it’s Uniswap when it’s in fact an attacker, it doesn’t matter how safe the Uniswap smart contract actually is, because that’s not who you are interacting with.

2. The financial risk

As in the risk of not being repaid when needed, or at all, even if everything keeps mostly working

While most lending platforms use over-collateralisation to reduce credit risk, over-collateralisation does not completely remove credit risk – The collateral assets that back loans on DeFi platforms have a high level of variation, in liquidity & stability of price.
Liquidity: if all the money in a lending pool is lent out, you can’t withdraw, and you need to wait until some loans are repaid.
The yield is still mostly variable today. If you deposit at 11% today, it might be 2% tomorrow. 1 year low is 0.68%
If you rely on EUROS for spending but lend out USD, there is a bit of an exchange risk too.

3. Blockchain or stablecoin risks

If the Ethereum Virtual Machine or Parachains or, your blockchain of choice breaks or gets hacked. But at that point, we potentially have a bigger problem.
Ethereum transaction fees and congestion leads to the inability to move in/out.
Your stablecoin of choice proves to be worthless, gets hacked…and your unit of value = 0

4. You make a mistake

You are your own bank, so your mistakes are your mistakes: Hacked keys, hacked notepads, metamask hacks, paper wallets lost in the wash or giving your money to a fraudulent project could all see you lose your money.

As wikipedia says, “Inexperienced investors are at particular risk of losing money using DeFi platforms due to the sophistication required to interact with such platforms and the lack of an intermediary with a customer-support department.”

Conclusion

Throughout human existence there have been events that have significantly shaped our societies, discovering fire, the wheel, horses for farming & transportation, the industrial revolution, the internet and most recently web3/crypto and DeFi.

While DeFi may still be the new kid on the block, this kid isn’t messing around!

Whichever way we look at it, a shift in the status quo in finance and financial equality is urgently needed at a global level and now seems like the perfect time to throw that proverbial hand grenade!

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Cryptocurrencies have grown into a mainstream phenomenon. As with virtually all types of global commodities, opportunities exist to make money but lose it as well.

Bitcoin may not be as well established as other trading assets, but it does have the advantage of being ‘open’ 24 hours a day, 365 days a year and is perhaps a little more accessible to everyday people.

Bitcoin is global and not bound by borders or national restrictions. Bitcoin and other crypto can also be found on multiple exchanges across the globe whereas traditional assets are much more limited, although generally more robust for trading purposes.

From futures trading, leverage and margin, to simply buying and holding, people entering into the cryptocurrency space are always looking for sure-fire ways to make their cryptocurrency grow, even beyond what its famed volatility will allow for.

This is where crypto arbitrage comes in. Due to the volatile nature of cryptocurrencies like Bitcoin, traders can take advantage of price discrepancies across multiple global exchanges.

Seeing as there are so many crypto exchanges and even more buyers and sellers across these markets, there will undoubtedly come a time when the price of Bitcoin is different from one market to another producing the perfect opportunity for crypto arbitrage.

So what exactly is crypto arbitrage, and is it as easy as buying low in one place and selling high somewhere else?

What is Crypto Arbitrage?

Simply put, arbitrage is when a person purchases an asset in one place and sells it in another to profit from a slight deviation in price between markets.

As an example, if 1 BTC costs $30,000 on Binance but it’s currently also trading at $30,100 on Kraken, there is a $100 opportunity for arbitrage.

In this instance, if you purchase your Bitcoin on Binance and hopefully sell it quickly enough on Kraken you’ll make a $100 profit — easy enough, right?

Unfortunately, while the mechanics are as easy as that, there is a lot more to consider before jumping fully into crypto arbitrage as a sure way to make quick profits.

How crypto arbitrage works

As explained above, crypto arbitrage is looking for the same asset selling at different prices and taking advantage of that.

There are mainly two types of crypto arbitrage: Arbitrage between exchanges and Arbitrage within the exchange.

The former is the most basic way to make crypto arbitrage work for you as different exchanges will have slightly different markets. However, with arbitrage between exchanges, some variations help you take advantage of price differences.

Once you have identified the two exchanges you want to play off each other, it is time to enact the trades to make a profit. However, one also needs to be aware of the workings that can cause issues in trying to be profitable.

It takes around 15-20 minutes for major coins to confirm the transaction. If the market price drops within this time frame, you may run a risk of generating less arbitrage profits.

Factors like geographic location, time of day, and even different news cycles can all move the price of a coin within those 15-20 minutes and destroy your hopes of being successful in an arbitrage trade.

Can crypto arbitrage be profitable?

Arbitrage is a well-known and established practice in the world of finance. It can be profitable. However, it will require dedication and persistence to succeed.

Crypto arbitrages are usually quite small. You can earn profits from market differences, from about 0.2 – 2.5% ($10 to $100) every day. If you focus on around ten such spreads every day, you could make upwards of a thousand dollars per week.

However, you need to know what you are doing, and you have to be prepared with the right tools and platforms.

If you are a day crypto trader, and there is not much market movement, you can always earn some profit from arbitrage.

If you are persistent and quick to take action on profitable opportunities, it is possible to earn a decent profit from arbitrage.

It will generally be a factor of just how much money you are able to put to work. Making 2% off of 500€ is nowhere near the same as 2% off of €1 million!

Crypto arbitrage comes down to awareness and speed. It is up to you to recognise the differences across various exchanges, and you need to access multiple listings at once, given that cryptocurrency exchanges operate 24/7/365, it can be very time-consuming.

Pros and Cons of Crypto Arbitrage

As with everything, there are certain pros and cons to crypto arbitrage, and a lot of it depends on you as a trader and what knowledge and access you have.

There are indeed a lot of pros to crypto arbitrage, but it is not as simple as it sounds and many things need to be considered before jumping in.

Pros of Crypto Arbitrage

Quick Profits

Because you can buy at one exchange and sell at another in a matter of minutes, the potential for profit in crypto arbitrage is fast. This is much quicker than traditional trading where you buy and hold cryptocurrency to sell at a later date.

A Wide Range of Opportunities

The cryptocurrency space is bursting with new markets, coins and exchanges and all of this gives rise to new potential avenues for crypto arbitrage.

According to Coindesk, there are more than 391 cryptocurrency exchanges in the world today and these will all have a slightly different price for different cryptos.

The Crypto Market is Growing

Because crypto is still very much in its infancy and has not been totally adopted or accepted, it is not a mature and steady space.

Due to this, there is quite a bit of irregularity, disjointing, and lack of information transfer between exchanges. There are also a fewer number of crypto traders than in the traditional markets, and thus less competition in the market, which leads to potential price differentials.

Cryptocurrencies are Incredibly Volatile

While volatility is often frowned upon in investing circles, it is the one aspect of crypto that makes it so enticing to risk-takers and traders.

For crypto arbitrage, it also means more opportunities as there can be huge price changes between exchanges and this makes for a more lively opportunity for bigger arbitrages.

The Cons of Crypto Arbitrage

Anti-Money Laundering Rules and Restrictions

While not really a con, and quite acceptable with crypto, using multiple exchanges will often call for you to adhere to the KYC regulations that are in place. This will involve things like potentially holding a bank account in the same country where the exchange is based

Fees

This can be quite a hidden barrier for arbitrage. Because users are operating with often small profits, any fees for trading crypto, withdrawal fees, network fees or exchange fees, can impact the profitability of arbitrage, or could even lead to a loss.

High Start-Up Capital

In order to really profit from crypto arbitrage, and make it worthwhile with the tiny profit margins there is a need for a relatively large amount of trading capital to make it worthwhile.

Withdrawal Limits

With large trades and bigger capital amounts, there also comes an issue of withdrawal limits. Exchanges can have set limits for traders which means you may not be able to get the access you want to your profits right away.

Slow Transactions

Crypto transactions are also susceptible to market volatility in terms of their speed and accessibility. When the markets are on the move, the best time for arbitrage, it is not uncommon to have slower transactions, or even downtime on exchanges which could hurt profits.

Things to Know and to Watch Out For

Understanding the pros and cons of crypto arbitrage will help you decide if this is the right option for you, but if you do decide to go down this route, there are a few more things to watch out for.

A number of pitfalls can trap unsuspecting traders.

Similar Sounding Coins

The cryptocurrency space is large and constantly expanding. New coins are being created and brought to market all the time and they can often have similar-sounding names which can trick traders.

A good example of this is the project ‘SIA’ which is an application for decentralized cloud storage solution and its symbol is very close to another project called ‘SAI’.

Even when it comes to the different coin tickers there can be issues — such as $HNC (HellenicCoin) and $HNC (Huncoin), or ($BTCS) Bitcoin Scrypt and ($BTCS) Bitcoin Silver.

Scam Coins And “Pump & Dump” Schemes

While the cryptocurrency space is certainly getting better and more regulated, there are still instances where people are being scammed out of their money.

Many coins can come to the market with the express purpose of stealing money from investors. If you arbitrage such coins, you could get burnt. The same thing happens with pump and dump schemes where projects purposefully inflate the price of their coins only to sell high and collapse the market; this can also be devastating for arbitrage.

A Lack of Trading Volume

Often when looking for arbitrage opportunities, you may be led to smaller, lesser-known coins with good potential for arbitrage.

However, these coins can also lack trading volume. This can hamper large trades of the coin and lead to serious consequences such as delisting. You could avoid running into that issue by keeping an eye on the exchange order book and making sure that you see transactions happening or not.

Is Crypto Arbitrage Worth It?

Having considered all of the above, it is time to decide if crypto arbitrage is actually worth pursuing. Certainly, it is a viable opportunity, especially in the cryptocurrency space, but what needs to be understood is that it is not a silver bullet for making easy money.

Buying a coin low, moving it across to where its price is higher, and selling it on to collect a profit sounds easy, but there are many considerations that need to be looked at.

Dealing with crypto is still challenging and often lacks an easy user interface. More than that, the lack of full regulation means there are issues surrounding scams and schemes.

Besides all of that, crypto arbitrage can be difficult to master and requires a lot of prior knowledge and experience, not to mention a decent amount of starting capital to ensure viable profits and some good coding chops if you are hoping to do it on a decent scale because if you are doing it manually, you are not going to be efficient.

Crypto arbitrage is certainly an option to make money but to be successful it requires access to capital, hard work, a tolerance for risk and a thirst for knowledge. If you’re prepared to put in the work and have some skills it could prove profitable.