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Exploiting Inefficiencies: A Guide to Bitcoin ETF Arbitrage

The advent of spot Bitcoin ETFs has opened the door to compelling arbitrage strategies that are attracting both everyday investors and seasoned traders. However, it is crucial to grasp the basic concepts of these financial instruments to capitalize on the opportunities. That said, readers who are already familiar with these principles can skip ahead to explore the arbitrage operations in the second part of the article.

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Before we delve in the the arbitrage, first, we need to know the role of the Authorized Participants (APs). APs play a critical role in providing liquidity to ETFs. They are typically large traditional finance trading firms or investment banks, such as JP Morgan.

To create or subscribe to ETF shares, APs must transfer the dollar value of Seed Creation Baskets (a set of ETF shares) to the ETF Fund. Suppose each share of an ETF is valued at 0.001 Bitcoin, and a Seed Creation Basket consists of 10,000 shares (equivalent to 10 Bitcoins).

If the price of Bitcoin is $50,000 at 4 PM Eastern Time, the value of the Seed Creation Basket would be $500,000 (0.001 * 10,000 * $50,000). APs must transfer this amount to the ETF. The ETF then instructs its trading counterpart to purchase 10 Bitcoins. Once the Bitcoins are acquired, the ETF credits the ETF shares to the AP’s account.

To redeem ETF units, APs must deliver the ETF shares to the fund before 4 PM Eastern Time. The fund then instructs its trading counterpart to sell 10 Bitcoins. Once sold, the fund credits $500,000 to the AP’s account.

The transactions mentioned above reflect the ETF market information, which is crucial for predicting price trends. To reduce slippage, the fund’s execution traders must align with the fund’s Net Asset Value (NAV). The ETF’s NAV is based on the CF Benchmark (a product of an index provider under Kraken) Bitcoin price at 4 PM US Eastern Time. CF Benchmark collects prices from Bitstamp, Coinbase, itBit, Kraken, Gemini, and LMAX between 3 PM and 4 PM Eastern Time. To minimize execution risk and perfectly match the NAV, one must trade directly on the above exchanges.

Bitcoin is a global market, with price discovery primarily occurring on high-volume exchanges. The leading exchanges are Binance and OKX, which are not part of the CF Benchmark. Due to regulatory requirements, long-term price discrepancies in the Bitcoin market are expected to arise, creating arbitrage opportunities.

Finding the arbitrage opportunities

To profit from these discrepancies, simply sell Bitcoin (BTC) at a higher price on one exchange and buy BTC at a lower price on another. For example, if BTC prices on Kraken are higher than on Binance, one could buy BTC on Binance and sell it on Kraken.

ETF market information is reflected in smaller, less liquid exchanges, while price discovery for other mainstream exchanges occurs at the leading ones. This results in complete information asymmetry and market inefficiency. Spot arbitrage can transfer the trading volume from leading exchanges to smaller ones, providing liquidity to the market, and thus, generating systematic extra returns.

The cryptocurrency market is rife with inefficiencies, a boon for traders. However, retail investors often focus on predicting market direction or short-term holding strategies that may not always work in the short term, lacking a broader perspective. A more careful study of market mechanisms can create a wider range of strategies and returns.

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