What is arbitrage trading?
Long before the rise of cryptocurrencies, arbitrage opportunities existed in traditional financial markets. As the crypto market developed, hype grew around the potential of digital assets for arbitrage opportunities. Because of the high volatility and the ability to trade digital assets around the clock on hundreds of exchanges worldwide, arbitrage traders have more opportunities to find profitable price discrepancies in the cryptocurrency market than in traditional markets.
Arbitrage trading strategy provides a mechanism to ensure that prices do not deviate significantly from fair value over an extended period of time. Ineffective pricing systems are usually quickly adopted, and the opportunity is eliminated, often within seconds. Of course, arbitrage trading has changed dramatically with technological advances, as many traders have installed computerized trading systems to track fluctuations in financial instruments.
What is arbitrage?
Arbitrage can be used whenever an asset, such as stocks, commodities, or currencies, can be bought in one market and sold in another at a higher price. In this way, a trader can profit from the temporary difference in the asset’s value. For example, a trader may buy stock on a foreign exchange where the asset’s price has not yet been adjusted to the constantly changing exchange rate and sell it on the local market. In this way, the cost of the foreign currency stock is undervalued compared to the local exchange, allowing the trader to profit from this difference.
There are various arbitrage opportunities on the cryptocurrency market, such as trading between two centralized exchanges or between centralized and decentralized.
Identifying cryptocurrency arbitrage opportunities
Arbitrage opportunities in the cryptocurrency industry can be found in many places. In addition, cryptocurrency prices tend to be highly volatile, meaning that their price is constantly moving up and down. This leads to price differences between cryptocurrency exchanges and thus arbitrage opportunities.
Looking at the prices in the order book of different exchanges simultaneously can reveal the divergence between those exchanges’ buy and sell prices. The buying price is the highest price someone is willing to spend to buy a cryptocurrency, and the selling price is the lowest price someone is willing to sell. The difference between the buy and sell price is called the spread, and this is where traders can identify arbitrage opportunities.
A typical order book will give you information about the buy and sell prices for different cryptocurrencies and the volume of potential trades. This will allow you to measure crypto arbitrage opportunities because the amount you can buy is limited to how much another trader is willing to sell and vice versa.
Let’s look at an example. The following screenshots for the Ethereum bitcoin market were taken simultaneously. The first one is from PointPay; the second one is from Binance.
Pay attention to the current market price for both exchanges. The price for 1 ETH on PointPay is 4,550.01 USDT and on Binance — 4,559.27 USDT. So there is a possibility of arbitrage if you buy ETH on PointPay and immediately sell it on Binance. If this trade is executed correctly, you will benefit from the spread, which is 9.26 USDT.
Why are the prices of cryptocurrencies different?
The price of assets on centralized exchanges depends on the last agreed buy and sell order on the exchange’s order book. Therefore, the most recent price at which a trader buys or sells a digital asset on an exchange is viewed as the real-time market price of the cryptocurrency.
For example, if an order to buy Bitcoin for $56,642 is the most recent agreed order on the exchange, that price becomes the most recent Bitcoin price on the platform. The following agreed order will also determine the next price for the digital asset. Thus, exchange pricing is an ongoing process in which the market price of a digital asset is determined based on its last sale price.
Note that the price can also fluctuate because investor demand for the asset varies on each exchange.
However, decentralized crypto exchanges use a different method to price crypto assets. This system, known as an “automatic market maker,” relies directly on crypto-arbitrage traders to keep prices in line with quotes from other exchanges.
Instead of matching buyers and sellers, a decentralized platform matches transactions within AMM crypto liquidity pools. For example, if someone wants to trade Ether (ETH) for a Tether (USDT), they need to find the exchange’s ETH/USDT liquidity pool.
Each pool is funded by liquidity providers who deposit their crypto assets to provide liquidity in exchange for a share of the pool’s transaction fees. The main advantage of this system is that traders do not have to wait for the counterparty to buy or sell assets at a specific price. The trade can be executed at any time.
In most popular decentralized exchanges, the prices of the two assets in the pool (A and B) are supported by a mathematical formula. This formula balances the assets in the pool. This means that a trader who wants to buy Ether from the ETH / USDT pool must add USDT tokens to the pool to remove ETH tokens from the pool. When this happens, the asset balance changes — more USDT tokens in the pool and less ETH. The protocol automatically lowers the price of USDT and raises the price of ETH to restore the balance. This encourages traders to remove the cheaper USDT and add ETH until prices adjust to the rest of the market.
If a trader changes the ratio in the pool significantly (makes a large trade), this can lead to significant price differences between the assets in the pool and their market value (average price on all other exchanges).
Types of crypto arbitrage strategies
While many arbitrage trading strategies exist, the two most common in the cryptocurrency industry are simple and triangular arbitrage.
Simple arbitrage involves direct buy and sells orders between exchanges or assets.
An example of a simple arbitration scenario:
- The selling price of Bitcoins on exchange A is $56,900.
- The buying price of Bitcoins on exchange B is $57,100.
If you buy Bitcoin on exchange A, you can immediately sell it on exchange B for a profit of $200. Note that the difference between the buy and sell prices on different markets does not have to be that large. Instead, the prices often differ only slightly. Therefore, an extensive trading portfolio is usually required to profit from an arbitrage strategy. When a trader does not have enough free funds, he/she can use cryptocurrency loans or Flashloans.
Triangular arbitrage, a slightly more sophisticated trading method, involves identifying price differences between three different assets that you can use to make a profit. To do this, you need to make three transactions between assets that will ultimately make a profit on the original asset.
Let us look at an example. Imagine you are in a stock market and you find the following exchange rates:
In this scenario, there is the possibility of a triangular arbitrage: you use ETH to buy TRX, TRX to buy USDT, and finally,, you use USDT to buy ETH. If you make these trades simultaneously, you can convert 1 ETH into 1,057 ETH (excluding trading fees). The deal should then look like this:
1 ETH → 45,454.55 TRX
45,454.54 TRX → 4,545.45 USDT
4,545.45 USDT → 1,057 ETH
Returning to our previous example:
- The ETH / TRX price can come from exchange A.
- The ETH / USDT price can come from exchange B.
- The TRX / USDT price can come from exchange A as well.
While this example of triangular arbitrage may occur on one exchange, it is more likely to be spread across multiple exchanges where price discrepancies are found. Remember those triangular arbitrage opportunities are harder to spot and the least common; therefore, they usually require trading algorithms.
Why is crypto arbitrage considered a low-risk strategy?
You may have noticed that, unlike day traders, arbitrage traders do not need to predict future assets’ prices. They do not necessarily need to analyze market sentiment or rely on other price forecasting strategies. By identifying and taking advantage of arbitrage opportunities, traders base their decisions on the expectation of a fixed profit. Moreover, depending on the resources available to traders, it is possible to open and close an arbitrage trade in seconds or minutes. Taking this into account, we can draw the following conclusions:
- The risk associated with cryptocurrency arbitrage trading is somewhat lower than other trading strategies, as it usually does not require predictive analysis.
- Arbitrage traders need to make trades that do not last more than minutes, so the trading risk is much lower.
However, this does not mean that crypto arbitrageurs do not take risks.
Risks of crypto-arbitrage trading
Certain factors can reduce the chances of winning in arbitrage. The low risk of arbitrage opportunities affects their profitability; less risk means less profit. For this reason, crypto arbitrageurs need to execute large volumes of trades to make significant profits. Furthermore, arbitrage trades are not entirely free.
Please note that trading on two exchanges may incur withdrawal, deposit, and trading fees. These commissions can eat away your profit. In the original example, let us calculate how much Alice will need to pay for trading fees. The commission for a trade transaction on the PointPay exchange is 0.05%.
In total, Alice will pay 4 550.01 USDT * 0.05% = 2.275 USDT for buying Ethereum on the PointPay exchange
To sell assets on the Binance exchange, she will need to withdraw money, and the commission for withdrawing funds on the PointPay exchange is 0.015 ETH:
4 550.01 USDT * 0.015 ETH = 68,250 USDT
In addition, she should sell ETH on the Binance exchange and pay a commission of 0.1%:
4 559.27 USDT * 0.1% = 4.559 USDT
Thus, in this case, you will make a loss, as the potential profit is only 9.26 USDT from 1 ETH, while the cost of commissions will burden you in total:
2,275 USDT + 4,559 USDT + 68,250 USDT = 75,084 USDT
Arbitrageurs typically restrict their trades to exchanges with competitive fees to minimize the risk of paying excessive commissions on their transactions. They could also place funds on multiple exchanges and reallocate their portfolios to take advantage of market inefficiencies.
For example, Alice notices the price difference between Ether on PointPay and Binance and decides to jump in fully. However, instead of transferring funds between the two exchanges, Alice already has committed funds (USDT) on PointPay and 1 ETH on Binance. So all she needs to do is sell her ETH on Binance for 4,559.27 USDT and buy 1 ETH on PointPay for 4,550.01 USDT. At the end of this transaction, she will still lose some profit due to the trading fees, but she will profit as the withdrawal fees are eliminated.
9.26 USDT — 2.275 USDT + 4.559 USDT = 2.426 USDT
It is worth noting that trading fees are relatively low for traders who execute large trades.
Crypto arbitrage is time-sensitive. The more traders benefit from a particular arbitrage opportunity, the sooner the price difference between the two exchanges disappears.
Let’s consider the difference in profitability for Alice and Alex due to the timing of their trades. Alice is the first to spot and take advantage of the arbitrage opportunity from our original example in this scenario. Then Alex tries to do the same.
If Alice buys Ethereum at $4,550.01 USDT on PointPay and sells it at $4,559.27 USDT on Binance, Alex will no longer make this trade at the same price. Due to competition in the market, Alex will have to buy Ethereum on PointPay at 4,552.0 USDT and sell it on Binance at 4,557.0 USDT. The convergence of Ethereum prices on both exchanges will continue until the price imbalance is profitably resolved.
If you would like to explore arbitrage opportunities, you should consider the following factors that can impact the time taken to complete transactions:
Blockchain transaction speed: Since you may need to execute cross-exchange transactions, the time taken to validate such transitions in the blockchain can affect the effectiveness of your arbitrage trading strategy. For example, it takes anywhere from 10 minutes to an hour to validate transactions on the Bitcoin blockchain. In that time, the market may have already moved against you. So you should avoid blockchains with slow transaction speed; or those that are not prone to network congestion.
AML checks on exchanges: exchanges typically conduct anti-money laundering (AML) checks when traders move large amounts of money. In some cases, these checks can take weeks. Therefore, you should consider the tendency of crypto exchanges to implement additional controls at the point of withdrawal before moving to cross-exchange arbitrage.
Offline exchange servers: Crypto exchanges can go offline due to server issues. In some cases, crypto exchanges may even restrict the withdrawal and deposit of certain digital assets for one reason or another. When this happens, arbitrage opportunities are immediately limited.
Security: since arbitrage traders have to place large amounts of money on exchange wallets, they are exposed to security risks associated with exchange hacks and exit fraud. Therefore, you should always research when looking for a reputable crypto exchange. Be sure to choose an exchange that cares about security and constantly monitors potential security breaches, like PointPay.
Arbitrage trading is one of the lowest risk trading strategies. If all markets were perfectly efficient, no arbitrage opportunities would be left. However, since markets are rarely perfect, you have the chance to capitalize on price differences. Our next articles will look at the various crypto arbitrage opportunities, particularly between centralized and decentralized exchanges.
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