Blockchain: The Next Great Arbitrage Opportunity, Part 1.

I was introduced to the concept of arbitrage at my first job on a convertible arb trading desk, 32 years ago.  Back then, arbitrage meant exactly what it was supposed to – a riskless opportunity to extract profits from a relative mispricing of multiple securities.  In plain English, when information is scarce, buyers and sellers tend to price similar assets inefficiently. That results in an opportunity where one could simultaneously buy and sell the same thing at different prices, generating a guaranteed profit.

This was free lunch.

The advent of trading technology, speed and transparency has virtually eliminated every arbitrage opportunity in the public securities markets.  Many fund managers retained the moniker “arbitrage” in describing their strategy. The nomenclature became more of a marketing tool to gather assets from gullible investors rather than a repeatable, robust investment strategy Proper arbitrage was then in turn labeled, “bona fide arbitrage”, as if to separate truth from fiction.  Being old-fashioned, I will drop the “bona fide” from the name – it’s either arbitrage, or it’s not.

Arbitrage breeds well when a number of conditions are present.  First, there has to be lots of participants in a marketplace. Second, the information available to these participants should be difficult to obtain and hard to analyze.  And third, the product being priced should not be homogenous. Arbitrage opportunities go back thousands of years, with coins-by-weight arbitrage in ancient Babylonia as an early example, and continue to appear regularly in different markets: bills of exchange arbitrage in 17th century Europe, geographical stock exchange arbitrage in the late 19th century in London and New York, and more recently, convertible arbitrage in the 1970’s and 80’s, and ETF and index arbitrage in the 90’s.  By and large, these opportunities for riskless profits are gone.

One thing we know for sure: technology is a great enemy of arbitrage.  Technology creates efficiency, equal access to information, and enough transparency to eliminate mispricing.  It democratizes inefficient markets, whether it’s paper money printing in Tang Dynasty China in 700 AD, advent of telegraph in late 1800’s, or the ubiquitous Bloomberg terminal in late 20th century.  

Over the past decade or so Internet 1.0 provided an amazing opportunity to address certain arbitrage opportunities by means of centralized marketplaces.  Amazon, Airbnb, Uber, OpenTable, Yelp – every one of these tech businesses seized on pricing and informational inefficiencies existing in specific markets, and as a result became multi-billion dollar behemoths.

Oddly, as some arbitrage opportunities are eliminated by certain technology applications, others continue to exist.  

Similarly to many previous opportunities, arbitrage can still be observed in ecosystems with scarce information, multiple participants, mutable and opaque pricing structures, and unequal access to the underlying asset.  Examples are numerous – money transfers for the unbanked, pricing of water resources in emerging economies, identity theft, voter fraud, and medical records systems, to name a few. Like it or not, these are all arbitrage opportunities that exist today (another question is whether capitalizing on some of these is entirely risk-free as they may actually carry a stiff prison sentence).  

In the past couple years, we have seen the emergence of a new technological revolution: blockchain.  For too many people this is a cool buzzword, usually preceded by words “I don’t understand the first thing about… “.  I’d imagine that most of us could easily replace the word “blockchain” in that quote with “cell phone technology”, “global positioning systems”, “telegraph”, “electricity”, or even “the printing press”.   Yet, all of the above acted as great arbitrage busters and provided massive rewards for those with the foresight to use these technologies toward elimination of specific arbitrage phenomena.

Much like revolutionary technologies of the past, blockchain’s main reason to exist and its main benefit is the elimination of specific economic arbitrage cases created by various human activities.  Nothing more, nothing less.  There are now millions of ideas of how to identify various arbitrage use cases and eliminate them, and thousands of applications attempting to experiment with this new technology.  Most of them will prove futile, as is often the case when mankind gets a shiny new toy.  Just like the telegraph and Internet 1.0, blockchain is not an answer to all problems of humanity.  It can, however, address certain specific arbitrage use cases very elegantly and efficiently.  Those who identify real-world, practical cases where meaningfully large arbitrage can be eliminated by blockchain applications, will reap massive rewards in the process.

In the follow up to this article, I will provide a specific numerical example of how one arbitrage opportunity which, shockingly, continues to exist in the investment world, expresses itself.  Stand by.