Title: Limits to Arbitrage in Markets with Stochastic Settlement Latency,
Abstract: Distributed ledger technologies rely on consensus protocols confronting
traders with random waiting times until the transfer of ownership is
accomplished. This time-consuming settlement process exposes arbitrageurs to
price risk and imposes limits to arbitrage. We derive theoretical arbitrage
boundaries under general assumptions and show that they increase with expected
latency, latency uncertainty, spot volatility, and risk aversion. Using
high-frequency data from the Bitcoin network, we estimate arbitrage boundaries
due to settlement latency of on average 124 basis points, covering 88 percent
of the observed cross-exchange price differences. Settlement through
decentralized systems thus induces non-trivial frictions affecting market
efficiency and price formation.