Arbitrage: Where does the Value come from?

No such thing as free money, amirite?

• Money doesn't grow on trees.
• A day late and a dollar short.
• A fool and his money are soon parted.
• A light purse is a heavy curse.
• A penny saved is a penny earned.
• All that glitters is not gold.
• If you can't explain the yield, you might be the yield.
• So on and so forth.

So I was thinking about this post I wrote on CUB the other day...

About all the wrapping fees + buy & burns.

And I had to ask myself...

Where does the money come from?

The new fees being generated used to buy and burn CUB are massive. The network is essentially burning just as many tokens as it prints. CUB could end up going deflationary given enough volatility in the markets, even with massive linear inflation printing. Money doesn't just appear out of nowhere... where it is coming from?

It must come from the users?

Normally in cases like this where a fee gets imposed on users, we'd assume that obviously the money is coming from the users. 0.25% is charged to wrap or unwrap, thus that expense is outsourced to the users who pay the fees that then gets used to buy and burn the governance token.

This is a simple enough explanation, and it makes sense, but it also isn't accurate. We already know that most of the money comes from arbitrage. Prices change on outside markets and it becomes profitable for people or bots to equalize the markets.

It must come from the arbitragers?

Again this is right, and also wrong, just like the previous assumption. Arbitragers are paying the majority of the fees and doing all the heavy lifting, but again that's not where the money comes from. This is proven by the fact that arbitragers make money in this process, to the point that the 0.25% fee becomes more than worth it to pay. So again we must go down another layer of the liquidity waterfall to see where the value ACTUALLY comes from.

Wait... so the value comes from... other exchanges?

More accurately: it comes from the users on other exchanges in the form of slippage. That's where all value from arbitrage is generated. CUB just taxes the arbitragers for equalizing the market on CUB, so they make 0.25% less than they would otherwise.

This is a double edged sword. On the one hand, it generates a lot of money for buy and burns. On the flip side, it means the derivative tokens on CUB will be 0.25% less pegged to the actual asset due to the 0.25% fee (which is actually slightly advantageous if you want to take the other side of the trade and bet against the market). I'd say this is an acceptable loss and a good trade for the network as a whole. 0.25% is a small number.

Say a whale wants to buy Hive.

There are a few options here.

The main ones are:

• Binance/Mandala
• Huobi
• Bittrex
• Blocktrades
• Upbit (Korean only)

If a whale makes a big splash on any of these exchanges without buying from all the pools at once, arbitrage occurs. If the whale doesn't want to be bothered to buy from every liquidity pool at once with a bot (or awkwardly by hand) then the price of Hive on the exchange they are buying from bumps up a little higher than the other available sources of Hive. This creates a liquidity stream of free money for any arbitrager who can buy Hive cheaper on another exchange, transfer it to the one that has artificially overpriced Hive and dump tokens on that market until the price is equalized across all the available markets. Whatever leftover is profit. This is just the classic definition of arbitrage.

It gets a little more complicated when looking at a decentralized exchange with wrapping fees. In all likelihood, the vast majority of people looking to buy Hive wouldn't even know that the CUB LPs to buy wrapped Hive even exist. However, that ignorance is irrelevant. The option is still there, whether they know it or not.

Within this context, we can see that the value from the CUB buy and burns and wrapping fees is being extracted from people on centralized exchanges that have no idea these pools even exist. Pretty crazy when you think about it.

But even this explanation isn't accurate.

Because even if everyone knew about the CUB LPs and even if they were buying from all available sources of Hive at once... they'd still have to pay the wrapping fee regardless. The wrapping fees extract value from volatility automatically, which is even weirder than all the explanations I've given thus far. Simple price ratio shifts create value generation like some kind of weird electrical generator in the ocean creating power from the tide going in and out.

So it sort of is basically just free money.

Or rather more efficient money. CUB was allocating yield to LPs that were providing less value back to the network than the new pools do. A lot of inflation is used to incentivize these liquidity pools, now a good chunk of that value is being kicked back to the network and used to burn the inflation that it created. It's a much more sustainable model.

Essentially the only reason there is liquidity within the CUB LPs is that inflation and yield are allocated to them. The wrapping fees can't exist without this liquidity in play. We can think of the wrapping fees as a kickback of value from the original amount we spent incentivizing the pools in the first place. Liquidity is incentivized by yield, and then that liquidity is leveraged into a value-capture mechanism that extracts a revenue-stream from the volatile market. The more volatile the market is, the more fees will get generated.

Within this context CUB wants both Hive and HBD to be extremely volatile because our money-generator is silently extracting value from those movements (even though that would technically not be great for Hive or HBD). Looking at the current volatility of the market... it's actually pretty quiet and not very volatile at all. We have to expect that the revenue will increase exponentially given big pumps or big dumps. The direction doesn't matter, only the price differences.

Conclusion

This is just a classic example of how complicated economies can get after stacking up just a few basic variables on top of each other. Each variable, no matter how simple, adds exponentially more complexity to the final outcome. This is akin to the Traveling Salesmen Problem.

The CUB arbitrage model is working shockingly well, especially at these low valuations. Obviously we LEO degens could use a win after so many slaps to the face. Soon™

Posted Using LeoFinance ^Beta