Limits to arbitrage impose costs on cross-market trading and harm informational efficiency in fragmented markets. I quantify the impact of blockchain-related trading frictions that arise from the time-consuming settlement process in the market for Bitcoin. The estimation rests on an error correction model that exploits the notion that arbitrageurs suspend their activity when arbitrage costs exceed price differences. I estimate substantial arbitrage costs that explain 63% of the observed price differences, where more than 75% of these costs can be attributed to settlement latency. I also find that a 10 bp decrease in technology-related arbitrage costs simultaneously results in a 3 bp increase of the spreads. I embed this finding in a theoretical model in which liquidity providers set larger spreads to cope with the higher adverse selection risks imposed by increased arbitrage activity. Consequently, efforts to reduce the latency of blockchain-based settlement might have unintended consequences for liquidity provision. In markets with substantial adverse selection risk, reduced technology-related arbitrage costs may thus even harm informational efficiency.
Job Market Paper, 2019.

We theoretically and empirically study portfolio optimization under transaction costs and establish a link between turnover penalization and covariance shrinkage with the penalization governed by transaction costs. We show how the ex ante incorporation of transaction costs shifts optimal portfolios towards regularized versions of efficient allocations. The regulatory effect of transaction costs is studied in an econometric setting incorporating parameter uncertainty and optimally combining predictive distributions resulting from high-frequency and low-frequency data. In an extensive empirical study, we illustrate that turnover penalization is more effective than commonly employed shrinkage methods and is crucial in order to construct empirically well-performing portfolios.
Journal of Econometrics, Vol 212, Issue 1, 221-240, 2019.

Distributed ledger technologies replace trusted intermediaries with time-consuming consensus protocols to record the transfer of ownership. This settlement latency imposes limits to arbitrage and hinders price discovery. We theoretically derive arbitrage bounds that increase with expected latency, latency uncertainty, volatility and risk aversion. Using Bitcoin orderbook and network data, we estimate arbitrage bounds of on average 90 basis points, explaining 81% of the observed cross-market price differences. Consistent with our theory, periods of high latency risk exhibit large price differences, while asset flows chase arbitrage opportunities. Decentralized settlement without centralized clearing thus introduces a non-trivial friction that affects market efficiency.
Working Paper, 2018.


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