Arbitraging
What is Arbitrage
In economics and finance, arbitrage (/ˈɑːrbɪtrɑːʒ/, UK also /-trɪdʒ/) is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices at which the unit is traded.
An Example of how liquidity pools maintain a ratio relative to the price of the rest of the market
Imagine that the DAI:ETH pool is expressed in terms of a scale and when the scale is balanced the pool is appropriately priced relative to the market price of a centralized exchange. Let’s say that the current price for ETH in USD on a centralized exchange is $150 and the ratio in the ShibaSwap DAI:ETH pool returns 150 DAI for 1 ETH. As a result, our scale is balanced because the pool matches the current market price on the centralized exchange.
Now let’s assume that there is a movement in the market that pushes the price of ETH to $100 on the centralized exchange. Due to the price movement, we can now see that our scale is off balance relative to the market price because people can now swap 1 ETH for 150 DAI on ShibaSwap when the market price on a centralized exchange is $100 for 1 ETH.
In response, someone can now put ETH into the pool, draw out DAI, then sell the DAI back for ETH on the centralized exchange for profit, and then repeat. They can do this until the pool has balanced out and reflects the current market price on a different exchange.
As a result, third party arbitrages play a large role in maintaining the correct ratio of token to Ether or any ERC-20 token in ShibaSwap pools.
Sourced from Graphical Guide to Understanding Uniswap
Last updated
