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FTX collapse means there’s free money in bitcoin arbitrage

By Tim Worstall

11:26, 21 November 2022

FTX logo and markets
Can arbitrage be made between the price of an ETF and its underlying assets? Tim Worstall explains - Image: Shutterstock

There's a certain joyous circularity in the idea that the FTX collapse – Sam Bankman-Fried's implosion at FTX and Alameda – means that there's now, again, free money to be picked up in Bitcoin arbitrage.

Note that this is arbitrage, this is nothing to do with BTC/USD, the actual price of Bitcoin or even of the US dollar.

Also, note what we've said before about arbitrage. Buying and selling something at the same time, in different markets, in order to lock in a profit. That's pure arbitrage but this is a little different here, this is time arbitrage.

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Déjà vu all over again

So, as background, Bankman-Fried's ludicrous attempts to keep a set of accounts – heck, the evidence is that he can't fill in a spreadsheet – have meant that FTX has collapsed into Chapter 11 bankruptcy and no one at all expects it to avoid full liquidation, or Chapter 7.

OK, well, good riddance to bad rubbish then. As I've been saying for a decade now, crypto allows us to see every mistake, fraud and scam ever perpetrated upon money pass before our eyes again at warp speed. This isn't because crypto is such, but because this new form of money allows everyone to play the same old games again.

But, and here's the important part here: this also means that all the old lessons become true again. In this specific case we're going to use the Grayscale Bitcoin Trust (OTC: GBTC) as an example. Please note, it's an example, not a recommendation for a trade. It doesn't quite work directly, for the Financial Times is slightly wrong here, but it's a good example all the same.

GBTC owns, according to the FT, 3% of Bitcoin. This isn't quite so – GBTC holds options and derivatives to that value if we believe others possibly more informed. So, it has exposure to, not owns. But on to the major point here. As the FT points out, GBTC now trades at a 40% discount to net asset value. Ah, well, there's a trade, an arbitrage.

We have an asset, here, which is one price. We've got something over here, the same asset in a different wrapper, which is a different price. There is therefore the trade to short one, go long the other and await the prices equalising. Here the asset is Bitcoin. The ETF is trading below the bitcoin value within it, we would expect the two prices to converge.

Free money isn’t necessarily free

But it is necessary to be careful, of course. This is not a pure arbitrage, it's a time one. That requires being able to finance the trade until prices do move – and as Keynes said, markets can stay irrational longer than you can remain solvent. That risk means that time arbitrage isn't in fact free money however tempting any specific trade is.

But the other thing we need to work out is why are these prices diverging? Only with that can we make a decision upon whether we would be rational to try to beat it.

BCH/USD

369.50 Price
+5.710% 1D Chg, %
Long position overnight fee -0.0753%
Short position overnight fee 0.0069%
Overnight fee time 21:00 (UTC)
Spread 2.50

BTC/USD

57,966.30 Price
+0.630% 1D Chg, %
Long position overnight fee -0.0616%
Short position overnight fee 0.0137%
Overnight fee time 21:00 (UTC)
Spread 106.00

ETH/USD

3,135.85 Price
+0.610% 1D Chg, %
Long position overnight fee -0.0616%
Short position overnight fee 0.0137%
Overnight fee time 21:00 (UTC)
Spread 6.00

XRP/USD

0.48 Price
+6.140% 1D Chg, %
Long position overnight fee -0.0753%
Short position overnight fee 0.0069%
Overnight fee time 21:00 (UTC)
Spread 0.01168

The initial cause is obvious – SBF took billions from investors and invested badly. Well, that's hardly new. But it's what has happened next which is also an old lesson.

Some versions of Bitcoin – or crypto more generally – are more liquid than others. So, when there's a rush to the door some versions will decline in price first. The entire point of an exchange traded trust, an ETF, is to provide a more liquid version of a less liquid underlying asset. We might think that Bitcoin is really liquid and in one sense it is. We can still trade however much of it we want. But we can only do that within an exchange.

Getting money out of an exchange these days can be quite tough. I'll not provide a list of those that we can't make withdrawals from because it will be out of date by the end of the next paragraph.

Trading Bitcoin can still be done. Trading in derivatives – CFDs and so on is easy. But if you're actually on a crypto exchange and trying to get out, well, there might be some delay at present. Making an ETF in the same asset is a great way to make that run for the door. Therefore, the ETF trades below net asset value simply on the basis of the greater liquidity.

Time arbitrage – a big risk

So, without taking a price view at all – which is again what arbitrage means – there's a gap there. The asset in this form, here – the ETF – costs less than this same asset over here. In this case either Bitcoin on an exchange or the derivatives based upon those exchange prices. We've a gap in prices for the same thing, an arbitrage. 

Just to insist, again, this is not an instruction for a trade. That's why other ETFs, funds, and so on which are directly in Bitcoin aren't identified. This is an explanation of the basic economic and financial background to what is going on.

Exactly and precisely because FTX is down, done and gone, other exchanges are following (or getting slower on withdrawals), there's a price gap opening up between exchange prices of crypto and more liquid manners of trading crypto. 

Assuming that we've the finance to be able to straddle the time period before reversion there's a speculation to be made here. Don't forget, when speculating that prices will converge the base idea insists that one leg of the trade will lose money continuously as they do. So, it's necessary to be able to finance that. It's also not truly risk free, for who knows how long the nervousness will persist?

The joyous circularity here is that SBF started Alameda as true arbitrage. The price of Bitcoin in Japan was different from that in the US. So, buy in the one, sell in the other, collect. That the end of that little empire produces this different price gap, one based on liquidity, does have a certain joy to it, doesn't it?

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Bitcoin / USD
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362 +0.630%

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