Being able to participate in arbitrage opportunities is one of the main incentives for holding RSR. Yet, a lot of misconceptions exist about what exactly arbitrage is and how it will work.
While the Reserve whitepaper explains the concept in detail, I believe the explanation to be too technical for the general public. The Reserve website & Medium blog do a good job in trying to simplify the concept, but I feel they don’t quite yet hit the nail on the head.
This post serves to explain what RSR arbitrage is and what role it plays in the Reserve ecosystem in an ELI5 manner. For this reason, this post will purposely focus on RSR-powered arbitrage and its impact for the RSR holder. For a more elaborate explanation of Reserve arbitrage, please refer to the Reserve whitepaper.
What is arbitrage?
Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.
Let’s say Bitcoin is trading at $50.000 on Coinbase while it is trading at $50.100 on Binance, one could take advantage of this price difference by buying X amount of Bitcoin on Coinbase and immediately selling it on Binance, making a guaranteed profit of $100 per Bitcoin.
Why is arbitrage used in the Reserve protocol?
The Reserve protocol has something called the Vault. For every 1 RSV in circulation, the Vault holds a basket of assets that represents the same value of that 1 RSV. The Reserve protocol allows everyone to trade their RSV to a basket of assets of the same value at all times.
In other words, if there would be $100 worth of RSV in circulation, then $100 worth of assets will be stored in the Vault. RSV holders can, at any time, exchange their RSV for assets that are worth exactly the same value.
“Why does the Vault need to hold assets to back RSV up?”
Because (a) this guarantees RSV holders that they will at all times be able to trade their RSV for something of the same value. If for some reason they don’t like RSV anymore - or if the Reserve project would fail - they can still receive a basket of different assets worth exactly what their RSV is worth.
Because (b) money that isn’t backed by assets is (hyper)inflatable. One of the most important reasons that caused hyperinflation in the Weimar Republic, Venezuela, Argentina and many others is because their currency is backed by nothing except the consensus that the currency has value .
In simpler terms, fiat currencies allow governments to use cheat codes to get out of troublesome situations, just like you could in a video game. However, using these cheat codes recklessly and for too long in real life has disastrous consequences.
“What do you mean by a basket of assets?”
RSV will be backed by 50+ tokenized real life assets. For simplicity’s sake, forget the term “tokenized” for now. Just think of it as real life assets such as currencies, gold, silver, grain, oil, real estate, shares, etc.
The RSV holder will indirectly hold fractions of these assets, which can be redeemed at all times.
Just like cryptocurrencies, the price of the assets in the Vault constantly fluctuates. When the average price of the underlying basket of assets rises, the ratio between the value of circulating RSV and the value of assets in the Vault would no longer be 1:1. Since these assets are now worth more, the value of the assets in the Vault is higher than the value of RSV in circulation. This is called overcollateralization.
Since the Vault does not need overcollateralization, the Reserve protocol will mint (= create) new RSV tokens to restore the 1:1 balance between RSV value and assets value. This means that we now have excess RSV circulating that don’t really have much purpose. For simplicity’s sake, think of the Vault now having some RSV laying in it that doesn’t get used.
Before we get to the core mechanism of arbitrage, there is one more way for the Reserve protocol to generate excess RSV in the Vault, and that is by charging a transaction fee for every transaction that happens in the Reserve app. Once mainnet launches, a transaction fee of 0,1% will be applied. RSR holders will later be able to vote on whether this transaction fee needs to remain (and if so, at what percentage).
In short, charging a transaction fee is a second way of generating excess RSV for the Vault. This way of generating RSV might even generate more excess RSV than the rising of the asset prices in the Vault, depending on the popularity of the app.
Now we get to the core of arbitrage. The Reserve protocol allows you to buy that excess RSV with your RSR at the guaranteed price of $1.00 . Let’s say that RSV is trading at $1.02 on secondary markets, you would be able to buy RSV at $1.00 from the smart contract and immediately sell it on the secondary market for $1.02, thus making $0.02 per RSV as profit. Furthermore, all the RSR used to buy RSV will be burned (= forever deleted), making RSR a deflationary token.
“How can RSV be trading at a price different than $1.00? Isn’t it a stablecoin that always holds the exact value of the USD?”
Stablecoins do their best to always be $1.00 but actually constantly fluctuate in price. Not as heavily as Bitcoin, ofcourse, but they do often times range to a few cents above or below the target price of $1.00.
For some examples, take a look at the price of Tether, Paxos Standard or Dai.
In practice, this process will happen continuously and fully automated. Some application will take your RSR and watch for arbitrage opportunities. When it sees one, it will immediately buy the excess RSV, sell it on a secondary market for the best price, and rebuy RSR (including with the profit you just made). One such application could be Upbots.
You know how self-help gurus claim that you shouldn’t work for your money, but let money work for you? This is it. Whether it will be really profitable or not depends on the adoption of the Reserve app.
To add some speculation to the mix: if the Reserve app is really popular, then more transaction fees will be charged. If more transaction fees are charged, there will be more excess RSV in the Vault. If there is more excess RSV in the Vault, there will be more arbitrage opportunities. If there are more arbitrage opportunities, the arbitrage will be more profitable and more RSR will be burned, lowering the supply of RSR. If the arbitrage will be more profitable and the RSR supply will be lower, the demand for RSR tokens will be higher. If the demand for the RSR tokens is higher, its price will logically rise based on the law of supply and demand. I should emphasize that this is all speculation - there is a lot that could go wrong in this project and thus investing in RSR brings along a large amount of risk. Invest cautiously.
- The rising of prices of Vault assets + transactions fees will create excess RSV in the Vault.
- RSR holders can buy excess RSV at the guaranteed price of $1.00 and sell RSV whenever it is trading at a price > $1.00 on secondary markets, thus making a profit.
- The higher the Reserve app adoption, the more profit can be made from arbitrage and the more RSR will be burned - thus lowering the RSR supply.
A visualized version of the TLDR:
I hope this post serves to be useful for atleast some of you. For any more questions, feel free to reply to this thread.
Let’s eradicate hyperinflation!