Cryptocurrency arbitrage is a trading strategy that takes advantage of price differences between identical cryptocurrency assets in different markets or different pairs of cryptocurrencies in the same market to generate profits with relatively low risk.
The concept of arbitrage or exploiting market inefficiencies is not new or exclusive to cryptocurrencies. Arbitrage has been around for decades, and it is a popular trading strategy used in finance since the first stock, bond, commodity, and forex markets.
How does cryptocurrency arbitrage work?
Before explaining how arbitrage trading works, we must first examine how cryptocurrency exchanges create markets, quote prices, and why the same coins can sometimes have different values on different exchanges.
The first important concept to understand is order books.
Order books are dynamic, real-time electronic records used by centralized cryptocurrency exchanges to record and display traders’ interest in specific cryptoassets at any given time.
Although at first the order books may seem daunting with all their changing numbers and constant blinking for no apparent reason, the basic concept is quite simple.
Order books have two sides and display four key data points. The two sides are the buy side and the sell side, and the four points are supply, bid, amount, and price.
What is a customer?
The buy side of the order book shows all pending buy orders below the last traded price. The prices at which buyers are interested are also called bids. In other words, a bid is essentially a statement indicating: “I am ready to buy X units at Y specific price.”
The value of one cryptocurrency is usually indicated relative to another cryptocurrency (also known as a trading pair). Thus, a request in the order book would look like this: “I’m ready to buy 1 BTC at 40 ETH”.
What is the selling side?
Conversely, the sell side of the order book contains all pending sell orders (also known as “requests”) above the last traded price. A seller’s request would look like this: “I’m ready to sell 40 ETH at 1 BTC”.
In addition to displaying supply and demand in real time, order books also provide information about the “market depth” or liquidity of crypto assets on the exchange.
What does liquidity mean?
In this context, liquidity refers to the rate at which an asset can be bought or sold at different prices on an exchange. One of the best ways to measure liquidity is by trading volume, which is calculated by multiplying the price of an asset by how many times it has been traded in a certain period of time. High liquidity means that a large number of people are actively trading an asset. The more buyers and sellers available, the easier it is to find someone to trade with. It also reduces the likelihood of slippage (having to trade at the next best price because there isn’t enough liquidity at your target price). On the other hand, low volume and low liquidity make trading and arbitrage much more expensive or difficult.
Why do exchanges have different prices for cryptocurrency?
Now that we understand order books – or how cryptocurrency exchanges quote prices and create markets – it’s easier to understand why identical cryptocurrencies can have different prices and how arbitrageurs can use these discrepancies to profit.
The two main reasons for these price fluctuations are the lack of standard prices and the difference in liquidity between cryptocurrency exchanges.
Because cryptocurrencies are not typically governed by sovereign nations and are not tied to fiat currencies, they have no universally recognized standard prices. Instead, their price is determined entirely by market supply and demand. Since each cryptocurrency exchange is essentially a separate market with different levels of liquidity in their order books, it is normal that one asset may be priced differently on multiple exchanges.
If supply and demand for cryptocurrency differ from market to market, the price will also change.
How do traders make money with cryptocurrency arbitrage?
An arbitrage trader’s job is to take advantage of that price difference and profit no matter which direction the market is headed. For example, if at one point the price of Bitcoin is $23,000 on Binance and $22850 on Phemex, the arbitrageur would quickly buy BTC on Binance to sell it on Phemex for a profit of $150 minus commission.
Of course, this performance works only theoretically, under ideal conditions.
Is cryptocurrency arbitrage profitable?
In practice, cryptocurrency arbitrage is not a very competitive strategy, and opportunities last only a few seconds. Arbitrageurs must consider much more than just price differences; Speed of execution, time, commissions, taxes, liquidity, position size and withdrawal procedures are all factors that play a critical role in the profitability of a trade.
To understand a more realistic arbitrage trading process, we must dig deeper.
Types of crypto-arbitrage
Simple or cross-exchange cryptocurrency arbitrage
Simple or cross-exchange cryptocurrency arbitrage refers to buying and selling a coin as described above. As the name implies, cross-exchange arbitrage involves buying a cryptocurrency at a lower price on one exchange, transferring it to another, and selling it at a higher price for a profit.
Although the transaction seems simple in theory, in practice it is much more complicated and involves several steps and problems.
To even begin the process, a trader must first fund several exchange accounts. Spread arbitrage opportunities (the gap between the highest bid and lowest ask price) exist only for a few seconds, while transfers and withdrawals between exchanges can take hours or even days. Interchange arbitrage requires simultaneous or nearly instantaneous buying and selling, making it virtually impossible without prepaid accounts.
The next step is to identify and quantify these arbitrage opportunities. This involves constantly monitoring and comparing the highest bid price to the lowest ask price on multiple exchanges, looking for matches in values. Even when an opportunity does arise, it must then be measured by calculating the spread, taking into account the liquidity of the asset, as well as producer, receiver and withdrawal fees on both exchanges. Often such commissions result in loss-making trades, despite the marked difference in prices.
Finally, only after all favorable conditions have been met will the arbitrator execute trades. However, as mentioned above, if this is not done in a hurry, the participant may have already ruled out the possibility.
Triangular cryptocurrency arbitrage
Triangular cryptocurrency arbitrage is a trading strategy that uses price differences between three different cryptocurrencies on the same exchange to make a profit.
In this scenario, there is the possibility of arbitrage, when a particular cryptocurrency is overvalued compared to one coin, but undervalued compared to another on the same exchange.
For example, Bitcoin may be overvalued compared to Litecoin, but undervalued compared to Ethereum. In this case, the arbitrator would use Bitcoin (the so-called “base” cryptocurrency in this transaction) to buy Litecoin, use that Litecoin to buy ethereum, and then do a full cycle and sell ethereum to buy back Bitcoin. If the calculations were correct and each transaction was performed as planned, the final amount of Bitcoin will be higher than the original amount.
The advantage of triangular arbitrage over simple arbitrage is that it allows the trader to stay on the same exchange, avoiding additional withdrawal fees.
On the other hand, the disadvantage is that the spreads between several currency pairs on the same exchange are usually very narrow (less than 1%), which means that profits from a single trade are incredibly small. Moreover, triangular arbitrage opportunities usually do not exceed a few seconds. Identifying and quantifying them usually requires special software for advanced automatic trading.
Cross-border cryptocurrency arbitrage
Cross-border cryptocurrency arbitrage, also known as regulatory arbitrage, is a trading strategy that exploits the difference in price between the same cryptocurrency on multiple exchanges located in different jurisdictions.
Sometimes, due to regional restrictions and the complexity of cross-border transactions, cryptocurrency prices vary greatly from country to country.
The most famous example from real life is so-called premium kimchi.
So, what is premium kimchi?
The kimchi premium means significantly higher Bitcoin prices on South Korean cryptocurrency exchanges. In particular, this is due to capital restrictions and the lack of other high-yield investment opportunities in the country. In late 2017 and early 2018, the price of Bitcoin on these exchanges rose sharply and was 30-50% higher than the rest of the world. This created significant international arbitrage opportunities for foreign investors. Foreign arbitrageurs would buy Bitcoin on Western exchanges, transfer it to South Korean exchanges, and sell it at a significant profit.
Like all cryptocurrency arbitrage opportunities, the kimchi premium did not last long. Within a couple of months, the spread narrowed considerably, and South Korean Bitcoin prices returned to the global average.
Is cryptocurrency arbitrage legal?
In terms of legality, arbitrage trading is no different from any other type of cryptocurrency trading.
That said, cryptocurrency regulation varies by country and jurisdiction, so it’s best to check your local laws before acting.
The most important consideration is the tax implications of cryptocurrency trading. Some countries, such as the U.S. and Australia, classify bitcoin and other similar cryptocurrencies as property, which means that these transactions are subject to capital gains tax.
On the other hand, Germany, Switzerland, Japan and China treat cryptocurrencies as private money, foreign currency, legal tender and virtual goods, respectively. In these jurisdictions, cryptocurrency transactions are not subject to capital gains tax, but may be subject to other tax rules.
Cryptocurrency markets are still young, unstable, poorly regulated, and often populated by unsophisticated investors. This makes them significantly more inefficient than their traditional counterparts. And while this certainly has its drawbacks, it also means that traders can get much more out of cryptocurrency arbitrage.
While there are certainly opportunities, arbitrage trading is definitely not risk-free. The process can be quite complex and requires considerable knowledge and experience to master.
However, cryptocurrency markets never sleep; they are global, open 24/7 and accessible to almost everyone. Once mastered, cryptocurrency arbitrage can become an extremely profitable practice that can be further automated and scaled with special tools.