Merge arbitrage is a trading strategy that takes advantage of price discrepancies when a cryptocurrency undergoes a network upgrade or ‘merge’. It aims to profit from the price divergence between the old and new versions of the crypto asset.
How Merge Arbitrage Works
When a blockchain project announces plans to transition to a new network, it usually involves creating a duplicate version of the blockchain with upgrades applied. This new chain runs in parallel to the original for a period of time before the merge finally occurs.
During this transition phase, the original token and the new token versions essentially represent claims on the same underlying network. However, their prices can diverge based on market expectations of the merge.
Arbitrage traders look to profit from any price differences between the original and new tokens. For example:
- If the original token is trading at $1 but the new token is priced at $0.90, an arbitrageur can buy the new token and sell the original for a $0.10 risk-free profit.
- If the new token is trading higher than the original, they can do the reverse trade — buy the original and sell the new at the higher price.
The goal is to capture mispricing between the two markets as participants gradually shift over to the new network.
Key Risks and Challenges
Merge arbitrage can be risky if the price differential does not converge by the time the merge occurs. Potential downsides include:
- Technical delays — The merge timeline could be pushed back, leading to extended exposure to divergent prices.
- Market skews — Speculative manias could skew prices so the differential persists even after the merge.
- Short selling difficulties — Shorting the overvalued token may be impossible without leverage.
- Ethereum-specific risks — On Ethereum, staked ETH cannot be traded freely before the merge. This reduces liquidity and widens spreads.
To manage these risks, arbitrageurs have to closely monitor announcement timelines, hedge exposures, and account for changing market conditions.
Merge Arbitrage During the Ethereum Merge
A high-profile example of merge arbitrage recently occurred during Ethereum’s major upgrade from proof-of-work to proof-of-stake consensus mechanisms.
In the months before the merge, a new proof-of-stake Beacon chain ran in parallel to the existing proof-of-work chain. ETHPOW tokens trading on the original chain diverged significantly below the new ETH staked on the Beacon chain.
At the widest spread, staked ETH traded over 50% higher than ETHPOW. Arbitrage traders could profit by minting ETH on the Beacon chain and selling the original ETHPOW.
However, the complexities of the Ethereum merge introduced risks. To interact with the Beacon chain, ETH had to be staked in validating nodes rendering it illiquid. Technical delays were also possible.
Nonetheless, as the merge drew closer, the ETHPOW/ETH spread narrowed as markets converged. Following the successful merge event, the original and new tokens were fused into a unified ETH.
In summary, merge arbitrage aims to profit from price discrepancies when blockchain networks upgrade. While risks exist, traders can earn profits by taking advantage of mispricings between legacy and new tokens during transition phases.
The strategy requires closely monitoring merge timelines and market dynamics to manage exposures. When executed properly around major events like the Ethereum merge, merge arbitrage can produce market-neutral returns.