Arbitrage, Liquidity and Price Informativeness

Abstract

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.

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Job Market Paper
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