This article explores the dynamics of CEX/DEX arbitrage trading, focusing on Automated Market Maker (AMM) execution. We analyze how block times, base fees, and participants (LPs, searchers, etc.) interact in arbitrage trades, supported by simulation results.
Key Concepts in CEX/DEX Arbitrage
Loss Versus Rebalancing (LVR)
The LVR model quantifies arbitrage-driven losses for liquidity providers (LPs). However, most LVR research overlooks transaction costs as a critical factor. Post-EIP-1559, arbitrage trades incur ETH burns via base fees, creating "friction" that:
- Eliminates marginal trades
- Reduces LP income
- Distributes profits among searchers, builders, and proposers (SBP)
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Price Action Mechanics
When CEX prices diverge from DEX prices:
- Arbitrageurs compute target prices adjusted for pool fees
- Swaps occur only if expected profits exceed base fees
- Prices converge but maintain a "non-arbitrage gap" due to fees and friction
Example State Transitions:
| Scenario | CEX Price Change | LVR | LP Fee | LP Loss |
|---|---|---|---|---|
| 0.1% rise | $3000 → $3003 | $93.66 | $62.46 | 33.3% |
| 1% rise | $3000 → $3030 | $12,406 | $1,185 | 90% |
Simulation Insights
Testing ETH/USDC 0.05% pools ($1B virtual liquidity) reveals:
Block Time Impact
- Without base fees: LP losses ≈ √(block time)
- With $10 base fees: Short blocks lose advantage
- Optimal: 30bps fees at 120s blocks outperform 5bps at 2s blocks
Volatility Effects
- 50% annual ETH volatility → $3M-$8M yearly LP losses
- Oscillating prices worsen outcomes in short-block environments
LVR Distribution
def calculate_lvr(price_change, basefee): lvr = price_change**2 * liquidity lp_loss = lvr - (swap_fee - basefee) return lp_loss
Blockchain Design Implications
Layer 1 Considerations
- Short blocks increase MEV but raise centralization risks
- Base fees act as stabilizing friction
Layer 2 Opportunities
- Appchains could exempt arbitrage from base fees
- Preconfirmations may reduce reliance on block times
FAQ
Q: Why don't LP losses always follow √(block time)?
A: Base fees introduce non-linear friction—each arbitrage burns ETH proportionally to blockspace demand.
Q: How do LPs benefit from frequent trades?
A: Gradual price changes (multiple small arbitrages) distribute LVR more equitably than single large trades.
Q: Should chains prioritize fast blocks for DEXs?
A: Not exclusively—user experience and builder decentralization often outweigh marginal LP gains.
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Conclusion
CEX/DEX arbitrage complexity arises from interacting factors:
- Base fees redistribute LVR to ETH holders
- Liquidity depth determines trade viability
- Block times have limited impact versus fee structures
These insights help LPs and chain designers optimize for sustainable liquidity provision.