Arbitrage

⭐ 1. What is Arbitrage?

Arbitrage = buying an asset where it’s cheap and selling it where it’s expensive to make risk-free profit.

In crypto:

Buy ETH on Binance for $1000
Sell ETH on Uniswap for $1020

Profit = $20 (minus fees)

No risk. No holding. No speculation.

Just exploiting a price difference.

⭐ 2. Why Arbitrage Exists in DeFi?

Because AMMs do NOT sync with real market prices automatically.

Example:

Uniswap price = 1 ETH = $1000
Binance price = 1 ETH = $1050

There is a price mismatch.

→ AMM does NOT magically update its price.
→ The pool still thinks ETH = $1000 because reserves haven't changed.

This is where arbitragers step in:

They buy cheap ETH from AMM
Sell at higher price on Binance
Profit
In doing so, they fix the AMM price.

⭐ 3. Arbitrage Is the “Invisible Mechanism” Balancing AMMs

Let’s say ETH price rises in the global market:

Binance = $2000
Uniswap pool still = $1000

Arbitrager will:

Buy ETH from Uniswap for $1000
Sell ETH on Binance for $2000
Profit = $1000 per ETH
Repeating this many times…

→ ETH in pool reduces
→ USDT in pool increases
→ Price on Uniswap rises naturally via x*y=k
→ price eventually becomes ≈ $2000

This mechanism fixes the pool price.

⭐ 4. Why Arbitrage MUST Exist in AMMs

Because AMMs use a pure mathematical formula for price:

x \cdot y = k

This formula cannot fetch market prices from Binance, Coinbase, etc.

Only arbitrage trades can adjust:

Reduce one reserve
Increase other reserve
Shift price until balanced

Without arbitrage, AMMs would be permanently mispriced.

⭐ 5. Arbitrage Example (Step-by-Step)

AMM pool:

10 ETH
10,000 USDT
Price = 1 ETH = 1000 USDT

Global price jumps to 1500 USDT.

🧠 Arbitrager sees opportunity.

Buy ETH on AMM:

If arbitrager buys 1 ETH from pool:

New reserves:

reserveETH = 9
reserveUSDT = 11,111

New price inside pool:

Price = 11,111 / 9 = 1234 USDT/ETH

Still cheaper than $1500.
Arbitrager continues.

After enough trades, internal price ≈ external price.

⭐ 6. Arbitrage Creates Impermanent Loss

This is important:

When ETH price changes, LPs lose value because arbitragers extract profit.

Example:

ETH rises → arbitragers buy ETH cheaply from pool
LP ends up with less ETH (the appreciating asset)
This is the mechanism behind impermanent loss

So:

👉 Arbitrage protects AMM pricing
👉 But LPs pay the cost

LPs hope to earn fees to compensate.

⭐ 7. The Arbitrage Equation

To profit:

Profit = Price_{sell} - Price_{buy} - Fees

If:

AMM price < market price → buy from AMM, sell on CEX
AMM price > market price → buy from CEX, sell on AMM
Continue until no profit is possible.

AMMs always give arbitragers risk-free opportunities when prices diverge.

⭐ 8. Arbitrage Bot Behavior (How real bots work)

Real arbitrage bots:

✔ Monitor dozens of DEXs
✔ Monitor dozens of CEXs
✔ Look for price mismatches
✔ Compute profit potential
✔ Submit transaction instantly
✔ Pay high gas (priority fee)
✔ Use Flashbots / MEV protection
✔ Execute atomic multi-step swaps

If two trades happen in one block, bots bundle them.

Example in 1 transaction:

Buy 100 ETH on Uniswap
Sell 100 ETH on Binance
Repay flash loan
Keep profit

⭐ 9. What gives arbitragers “power”?

Because AMMs have no idea what the market price is.

They only know:

price = \frac{reserveY}{reserveX}

This price will be wrong until someone moves tokens.

That “someone” = arbitragers.

Arbitrage is not optional → it’s essential for AMMs to function.

⭐ 10. Are arbitragers bad?

NO. They are necessary.

Arbitragers:

✔ Keep AMM price accurate
✔ Prevent price manipulation
✔ Minimize slippage for traders
✔ Enable DeFi to integrate with CEX markets
✔ Maintain pool balance

They are the market maintenance crew of DeFi.

⭐ 11. Arbitrage and IL (Why LPs Lose)

Let’s see why impermanent loss exists:

ETH price rises globally:

Arbitragers buy ETH from pool
ETH leaves the pool
LP ends up with more USDT, less ETH
LP misses some of ETH’s price appreciation
That difference = impermanent loss

So arbitragers:

Win
LPs: lose a bit
But LPs earn fees from all the trades

The battle is:
Fees earned vs IL taken.

⭐ 12. Arbitrage Code Example (Conceptual)

A basic arbitrage bot in pseudo-code:


async function arbitrage() {
    let uniswapPrice = getPriceFromUniswap();
    let binancePrice = getPriceFromBinance();

    if (uniswapPrice < binancePrice) {
        // Buy cheap on Uniswap, sell on Binance
        buyFromUniswap();
        sellOnBinance();
    }

    if (uniswapPrice > binancePrice) {
        // Buy cheap on Binance, sell on Uniswap
        buyFromBinance();
        sellOnUniswap();
    }
}

Real bots add:

Flash loans
Gas estimation
Slippage calculations
Multiple route optimization
MEV protection

⭐ 13. Real Example (ETH Price Differences)

Binance: 2000
Uniswap: 1910
Difference: 90 USDT

Arbitrager buys ETH on Uniswap at 1910, sells at 2000.

Profit:

Gross: 90
Minus gas: ~5–10
Net: ~80 USDT per ETH

They keep doing this until price = 2000 inside AMM.

⭐ 14. Summary Table (Interview Level)

Topic	Explanation
Arbitrage	Buying cheap + selling expensive
Why needed	AMMs don’t know real market price
Who arbitrages	Bots →
flash-loan empowered
Effect on pool	Changes reserves → updates price
Effect on LP	Causes impermanent loss
Effect on market	Keeps DEX prices equal to CEX prices

⭐ 15. One-Line Summary

Arbitrage is the economic engine that keeps AMM prices correct.
Without arbitrage, AMMs fail.
With arbitrage, LPs face IL but earn fees; the market stays balanced.

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