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Introduction
Centralized exchange (CEX) - decentralized exchange (DEX) arbitrage is a popular and well-studied area of value extraction in DeFi. Put simply, CEX-DEX arbitrage involves identifying a difference in the prices of a digital asset between two exchanges, purchasing the asset on one exchange at a lower price, and selling it on the other exchange at a higher price to make a profit. This form of arbitrage makes up a significant portion of all arbitrage revenue in DeFi, and many tools/bots for automating this type of arbitrage strategy exist (such as those from Alphador, Perpetual Protocol, and many more) and make it easily accessible for users to leverage.
Yet, other potentially valuable forms of arbitrage exist in the DeFi space and are less well-studied (and less well-supported with tools and documentation). I believe that these forms of arbitrage should be further investigated so that arbitrageurs can make informed decisions about their investments. It is possible that a significant opportunity lies in other forms of arbitrage, but this is just not well-documented.
In particular, cross-chain maximal extractible value (MEV) should be better studied as an alternative to CEX-DEX arbitrage, as it may offer even greater earnings potential to arbitrageurs. At this point in time, we do not understand how cross-chain MEV is valued and what factors contribute to this pricing model (such as latency).
Many people in the industry are of the mindset that there is too much latency involved in cross-chain MEV for it to be worthwhile, though this has not been quantifiably studied. However, I believe that cross-chain MEV is becoming an increasingly important and viable opportunity, with a number of implications such as potentially enabling users to trade for free or at a reduced cost (as I detailed in a previous research forum post). I further believe that it is likely that this type of MEV extraction offers a greater potential yield than CEX-DEX arbitrage, and may even go on to take over CEX-DEX arbitrage as the leading form of arbitrage in DeFi. This is particularly true as the industry is shifting to be increasingly on-chain with less reliance on centralized structures including exchanges.
Given the potential value of cross-chain MEV, we must begin to understand this subject better. We can do this by architecting a pricing model of cross-chain MEV which enables us to assess how cross-chain MEV is valued. This is an area of research in which Composble is actively working.
In this post, I present the background and motivation for such research; I detail CEX-DEX arbitrage in its present state and compare it with other forms of arbitrage including atomic arbitrage and cross-chain MEV extraction. I then present an argument and evidence for a bright future for cross-chain MEV. Finally, I discuss mechanisms for further investigation into cross-chain MEV, so that different forms of arbitrage can be quantifiably compared and traders can determine the best opportunities for themselves.
Existing Forms of DeFi Arbitrage
CEX-DEX arbitrage is a significant form of revenue generation for many DeFi participants. This form of arbitrage is made possible when a digital asset deviates from its fair value (e.g. the current best estimation of its valuation). The exchange where the list price is closest to the fair value is called the venue of price discovery. CEXes are often a good source for determining an asset’s fair value, as they are the most liquid and high volume exchanges in the case of most digital assets. CEX-DEX arbitrage can then be used to bring DEX prices back down towards the fair value, as demonstrated below:
(Diagram sourced from here)
Another major form of arbitrage in DeFi is atomic arbitrage. Atomic arbitrage was an early form of MEV extraction to emerge in the space, and involves trading on two on-chain DEXes until prices reach equilibrium, as depicted below:
(Diagram sourced from here)
When compared to atomic arbitrage, CEX-DEX arbitrage tends to yield better earnings. Moreover, 60% of arbitrage revenue generated in Q1 2023 was CEX-DEX arbitrage (source):
A New Form of DeFi Arbitrage: Cross-Chain MEV
Yet, other forms of arbitrage exist in DeFi. Namely, cross-chain MEV extraction is a relatively new form of arbitrage (made possible by cross-chain bridges such as Composable’s trustless IBC Bridge). Thus, it has been poorly studied but yet may offer significant yield - maybe even greater than that of CEX-DEX arbitrage.
In fact, I would argue that cross-chain MEV can be understood as the next level of CEX-DEX arbitrage. Similarly to CEX-DEX arbitrage, cross-chain MEV involves arbitraging based on the price difference between digital assets in two different locations. However, in the case of cross-chain MEV, these two locations are on two different chains, not just two different exchanges. Thus, the potential for price differences to exist, for these price differences to be larger, and for arbitrage to be extracted are exponentially greater in the case of cross-chain MEV (given the vastly greater number of locations/exchanges available to arbitrage between).
Overcoming the Latency Issue: An Argument for a Bright Future for Cross-Chain MEV
A common line of thinking in the industry is that cross-chain MEV essentially disappears before it becomes extractible, as the bridging time may be prohibitive. Indeed, research from Metrika suggests that latency will play an increasingly significant role in the MEV supply chain.
Yet, as the world of cross-chain DeFi progresses, I believe that the potential for cross-chain MEV will grow. For example, the Inter-Blockchain Communication (IBC) Protocol is speeding up cross-chain bridging. A resultant decrease in latency could increase the number and size of opportunities for cross-chain MEV extraction. Moreover, the industry overall is trending towards being more on-chain and less CEX-dependent. Therefore, the opportunity for CEX-DEX arbitrage may decrease while the opportunity for cross-chain MEV extraction continues to grow.
As a result, I believe that the near future will see cross-chain MEV becoming productively extractible. However, for this to occur, we must first deeply understand cross-chain MEV, how it is priced, and how it relates to latency.
Beginning to Understand Cross-Chain MEV
Composable is presently working on studying cross-chain MEV on this deep level using a number of approaches. Hopefully, this will help improve the industry’s understanding of this form of arbitrage, including the size and scope of the opportunity as well as how to best take advantage of it.
One easy way to quickly compare the value of cross-chain MEV extraction to that of CEX-DEX arbitrage would be to look at the time it takes for CEX-DEX arbitrage to be completed. If this is comparable to the latency of bridging cross-chain (on average), then it is likely worth it for arbitrageurs to participate in cross-chain MEV extraction over CEX-DEX arbitrage; if the same assets are tied up for the same amount of time, yet there are more/greater arbitrage opportunities with cross-chain MEV, this can be presumed to be overall the better opportunity.
Another way that Composable is actively working to understand cross-chain MEV is by creating a pricing model for this form of arbitrage. The first step in doing this is to extract data from MEV-Boost, which should be sufficient to enable us to test cross-chain arbitrage payoff per block. We will take this data and run experimental swaps to Ethereum, to Solana, and between Ethereum and Solana using trustless.zone. We will then measure:
- What these are priced at
- What the payoff is
- What we think this should be priced at in our model
Finally, Composable is working to better understand cross-chain MEV by comparing it with existing arbitrage opportunities, as expounded upon in the next section:
Example Case: Comparing Arbitrage Opportunities
Below, I compare examples of CEX-DEX arbitrage and cross-chain arbitrage.
Example 1: CEX-DEX Arbitrage
An arbitrageur identifies a discrepancy in the price of Composable’s PICA token on the Osmosis DEX and the Binance CEX. To take advantage of this opportunity for CEX-DEX arbitrage, an individual must beat other arbitrageurs in getting their transaction to Binance.
Example 2: Cross-Chain MEV
Similarly, an arbitrager identifies a discrepancy in the price of Composable’s PICA token on the Osmosis DEX (on Cosmos) and the Pablo DEX (on Polkadot). To take advantage of this opportunity for cross-chain MEV extraction, an individual does not need to submit their transaction to a CEX but instead can submit a transaction for a cross-chain swap (for example using trustless.zone).
Comparison & Implications
Composable’s Research Team is working to compare these example cases and others to better understand MEV. When we compare these opportunities, we will assess for variables including time to bridge, time based execution delay cost, and swapping cost, as latency is a critical factor in the value of cross-chain MEV.
Conclusion & Future Investigation
CEX-DEX arbitrage is a well-studied, well-leveraged form of arbitrage in the DeFi space, and offers significantly better earnings potential when compared to atomic arbitrage. However, CEX-DEX arbitrage has yet to be quantifiably compared to cross-chain MEV extraction, as the latter is a relatively novel form of arbitrage.
Composable is presently working to study cross-chain MEV, including by developing a cross-chain MEV pricing model and working to understand (and minimize) the negative impacts of latency. We hope that the results of our research will help arbitrageurs make informed decisions on their investments. Our hypothesis is that cross-chain MEV extraction will yield greater opportunities than CEX-DEX arbitrage, and may even go on to take over the position of the most popular arbitrage mechanism in DeFi. If this hypothesis is found to be true, it may also encourage developers to create more tooling for cross-chain MEV extraction, similar to the many tools/bots that exist for carrying out CEX-DEX arbitrage today. This would make it even easier for arbitrageurs to take advantage of the opportunities in cross-chain MEV extraction.
Whatever the results of our research may show, we look forward to reporting these results with you, and to discussing how to best continue to explore and support the novel practice of cross-chain MEV extraction.