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Cardano Ecosystem

Paribus

10/07/2023

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Chasing Free Lunches

In 1969, the renowned economist Milton Friedman achieved notoriety for coining the phrase, “There’s no such thing as a free lunch.”

Chasing Free Lunches

In 1969, the renowned economist Milton Friedman achieved notoriety for coining the phrase, “There’s no such thing as a free lunch.” This oft-quoted adage has since been a cautionary reminder for life in general. However, it carries a distinct connotation in the intricate landscape of financial markets.

The notion of “free lunches” in this context is closely associated with arbitrage opportunities, and it presupposes that in an efficient financial market, such opportunities should be exceedingly scarce, if not nonexistent. For the uninitiated, arbitrage refers to the exploitation of price disparities in equities or commodities across different markets.

Consider this hypothetical scenario: If shares of Apple Inc. were trading at a 10% lower price on the London Stock Exchange compared to the New York Stock Exchange, automated trading systems would swiftly swoop in to purchase these discounted shares in London and sell them in New York, profiting from the price differential.

In a well-functioning and efficient market, the windows of opportunity for arbitrage are narrow and fleeting. Even a 1% price disparity can yield a swift profit, especially in high trading volumes.

This is why numerous trading firms strategically relocated their offices near the stock exchanges, thereby minimizing the time lag between price changes and their awareness of these fluctuations. They were also pioneers investing heavily in cutting-edge telecommunications systems to stay continuously updated.

The result of these efforts is that any arbitrage opportunity is promptly seized in an efficient financial market, ensuring price consistency across markets. Conversely, price disparities persist between various exchanges in an inefficient market, and arbitrage opportunities abound.

In the early days of cryptocurrency adoption, we witnessed such inefficiencies, with significant variations in demand among different countries. A striking example is the “Kimchi Premium” that emerged in the 2019 Bitcoin markets.

The Kimchi Premium manifested in Korean markets due in part to the strict regulations surrounding the Korean Won (KRW) and the challenges associated with exchanging it into US dollars in substantial quantities. Consequently, whenever there was a surge in demand for an asset on Korean exchanges, its price could surge considerably higher than its equivalent on a US exchange.

Sam Bankman-Fried attributed his initial success in crypto to this premium, among others. During that period, Bitcoin traded at a staggering 50% premium in KRW compared to USD, enabling him to exploit this arbitrage consistently and accumulate substantial wealth in record time.

Around the same time, a 10% arbitrage opportunity existed for Bitcoin on Japanese exchanges. These substantial price differentials resulted from the inefficiencies associated with transferring assets on a large scale between markets.

As time has progressed, the global cryptocurrency market has evolved into a more efficient entity, resulting in a reduction of arbitrage opportunities. This transformation is welcomed, as the efficiency of cryptocurrency markets is crucial for their growth and broader acceptance.

While some may cast aspersions on traders who actively seek out arbitrage opportunities and create automated trading algorithms to exploit them, it is imperative to recognize their valuable role in the industry. The swifter these arbitrage opportunities are capitalized upon, the more stability is infused into market prices, bolstering the confidence of seasoned investors in the sector.

Understanding the role of arbitrage in financial markets also underscores the significance of interoperability within Web3. The era of walled gardens and maximalism is fading, as it impedes the prospects of mainstream adoption.

Increased interoperability among projects, blockchains, and exchanges minimizes friction for users as they navigate the digital landscape. Consequently, the prevalence of arbitrage opportunities rises, enticing traders to leverage them, and the market progressively expands in size and efficiency until the era of easily accessible “free lunches” comes to a close.

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Disclaimer: Cardano Feed is a Decentralized News Aggregator that enables journalists, influencers, editors, publishers, websites and community members to share news about the Cardano Ecosystem. User must always do their own research and none of those articles are financial advices. The content is for informational purposes only and does not necessarily reflect our opinion.


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