Limits to Arbitrage in Markets with Stochastic Settlement Latency

Abstract

Distributed ledger technologies replace trusted intermediaries by 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 instantaneous cross-market price differences. Consistent with our theory, periods of high latency risk exhibit large price differences, while asset flows chase arbitrage opportunities. Replacing centralized clearing by decentralized consensus protocols thus introduces a non-trivial friction that affects market efficiency.

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