The Twin Coin ArbitrageShort Selling, Arbitrage & Funding Risk
Bill Taylor finds a textbook arbitrage opportunity in two cryptocurrencies guaranteed to converge. His logic is airtight — but he nearly loses everything in 48 hours. A case by Prof. Ioanid Rosu, HEC Paris.
The Setup
The Mispricing Bill Taylor Found
Bill Taylor, a Manhattan pianist turned crypto trader, discovers that RedCoin and BlueCoin — two cryptocurrencies contractually guaranteed to be worth the same amount in June 2022 — are trading at very different prices. RedCoin trades at $1.10, BlueCoin at $0.90, a gap of $0.20.
The reason: an announcement that RedCoin would be included in a major ETF had driven speculative buying, pushing its price above fair value. BlueCoin, which would also be included but later, had not yet benefited from the same demand.
The Arbitrage Logic
Bill's mentor Sam, a professional arbitrageur, validates the trade and even participates himself. The logic is airtight — convergence is contractually guaranteed, not just probable.
RedCoin vs BlueCoin Price
RedCoin surges on Day 2 before eventually converging with BlueCoin — but the journey nearly wipes Bill out.
The Risks
Why a "Risk-Free" Trade Almost Destroyed Bill
Bill only had $45,000 in his account. When RedCoin surged to $1.80 on Day 2, the unrealized loss on his short position triggered a $69,000 margin call — more than he had. He was forced to either inject new capital or close the position at a massive loss.
Sam, who knew Bill's position, could deliberately buy large amounts of RedCoin to push the price up, forcing Bill to cover his short at a loss. This is a classic short squeeze — a predatory strategy used against known short sellers.
If many other traders had the same arbitrage position, they would all face margin calls simultaneously. Their forced selling of BlueCoin and buying of RedCoin would amplify the price move — making the situation worse for everyone.
Even though convergence was contractually guaranteed, the two coins could diverge further before converging. Bill needed enough capital to survive the interim losses — which he did not have.
Bill's Unrealized P&L Over Time
The trade was always going to be profitable — but the path to profit nearly forced a catastrophic early exit.
The Central Lesson
Being Right Is Not Enough
The most striking insight of this case is the gap between the theoretical perfection of the arbitrage and its practical fragility. Bill's logic was airtight — convergence was contractually guaranteed — yet he nearly lost everything in 48 hours.
Not because he was wrong, but because he ran out of cash to fund his margin account. This is the central paradox of arbitrage: being right is not enough; you also need to survive long enough for the market to agree with you.
Keynes' Insight
Any arbitrage strategy requires sufficient capital to survive adverse price moves before convergence. Bill's $45,000 buffer was far too small for a $200,000 position.
Sam — Bill's mentor — may have deliberately exploited his position. Markets are not just mathematical systems; they are populated by strategic actors who will exploit known vulnerabilities.
Even contractually guaranteed convergence can take time. The arbitrageur must be able to finance the position for the full duration — which requires planning for worst-case interim losses.
Pre-Class Assignment
Draft Answers — Click to Expand
These are draft answers grounded strictly in the case material. Question (c) requires your personal opinion — please revise before submitting.