What Is Crypto Arbitrage And How It Works: Complete Guide
What do you know about arbitrage crypto trading? First, you probably think it is a low risk trading strategy that will bring you thousands of dollars in minutes. Well, that’s a discussion!
Arbitrage is one of the oldest investment strategies existing in the market. Traders have been exploiting it for years, profiting from price discrepancies in different markets.
The cryptocurrency market has already been with us for some time, but it still is considered young. So, arbitrage opportunities must have been easier to find in the crypto market than in any other market like stock exchange or derivatives, right? - Yes and no, it is rather complicated.
In this article, we will define what is arbitrage trading in crypto, how arbitrage works, and how to profit from it. We will also cover the impact arbitrage trading has on the cryptocurrency market and open up the not so-obvious drawback of arbitraging.
Without further ado, let’s begin!
What Is Arbitrage Crypto Trading?
Crypto arbitrage is, in essence, the process of buying low on one platform (or market) and selling high on the other. Trading arbitrage is a prevalent strategy in both crypto and stock markets. The only notable difference between traditional arbitrage and cryptocurrency arbitrage is the type of asset that is being traded.
Traders who employ arbitrage strategies are called arbitrageurs. They aim to profit by finding market inefficiencies: buying and selling the same asset in different markets and pocketing the price difference as a reward. In theory, the difference between two identical financial instruments should be zero, but, in reality, it is not.
Why does the price of the same token differ around crypto exchanges?
The thing is, each crypto exchange has some people buying and selling on it (the main part of them differs from one exchange to another), which means each crypto trading platform has its own liquidity. Therefore, in most cases, the token price on one exchange is a few dollars different than the price on another since supply and demand vary depending upon the time and the market. Indeed, arbitrage trading contributes to market efficiency by drawing attention to price disparities between various exchanges, and stabilizing prices.
Now, you might be wondering what types of arbitrage are available for cryptocurrency traders and investors. There are a lot of variations, but we narrowed them down to three main crypto arbitrage strategies. Let’s dive right into it.
Types of Cryptocurrency Arbitrage
When it comes to crypto arbitrage, there are several ways traders can capitalize on market inefficiencies. First, we will look at the most efficient and widely used arbitrage trading strategies.
Spatial Arbitrage Crypto
Spatial arbitrage, also "pure arbitrage," is the primary arbitrage concept traders have exploited for years. It involves arbitrageurs taking advantage of small price discrepancies that exist in two different exchanges.
Here is how spatial arbitrage works:
- A trader buys a token on Binance for a lower price.
- A trader sells a token on FTX for a higher price.
Triangular Arbitrage
So, what is triangular arbitrage? Triangular arbitrage spans three different markets. In this type of arbitration, traders are taking advantage of mispricing between three pairs of coins.
How does triangular arbitrage crypto work in practice? The trader sells, for example, BNB for ETH, then sells ETH for BTC, and finally sells BTC for BNB, ending up with no position once again. In the end, the amount of BNB tokens they possess will increase due to the market inefficiencies within three trading pairs. This technique can be applied even within one exchange.
Convergence Arbitrage
Convergence arbitrage is purely based on the idea that market inefficiencies eventually will force prices to converge. Arbitrageurs are practicing buying on an exchange where the token is undervalued and then short selling it where it is overvalued.
P2P Arbitrage
The ban on crypto activities in some countries’ banks drives the growth of p2p exchanges, and therefore, p2p arbitrage. A p2p arbitrageurs can either buy and sell crypto assets using only p2p trading or acquire cryptocurrency on the low fee centralized exchanges and sell it on p2p marketplaces.
Here are 2 most common schemes that bring p2p arbitrageurs money:
- They are selling on a p2p marketplace with a higher asset exchange rate and buying on another platform with a lower asset exchange rate.
- They are from the difference between official assets’ exchange rates and exchange rates on crypto exchanges. During the last six months, such a scheme was popular in Ukraine due to the war-related economic restrictions. To give you an idea, you can buy 1 dollar for 36,5 UAH at the official NBU exchange rate for the transaction day, transfer it to Binance and then sell it on p2p exchange for 40 UAH. Such a loop provides a trader with almost a 10% premium.
How to Identify an Arbitrage Opportunity?
In order to capture crypto arbitrage opportunities, you have to either constantly check order books or use specialized software that will find and execute trades automatically.
In the first case, monitoring multiple exchanges all day can be challenging. There are around 200 exchanges and even more cryptocurrency pairs in today's crypto world. Manual observation doesn't seem like a solution, solely judging by the amount of fast-changing data to keep an eye on. If you still want to seek arbitrage opportunities by yourself, the following tips will come in handy for you:
- Check out less popular cryptocurrencies. Tokens that have less trading volume are susceptible from a volatility standpoint. However, since these crypto assets are not traded frequently, your orders can take a lot of time to fill, resulting in significant slippage.
- Keep an eye on newly listed tokens. Every time the cryptocurrency gets listed on the exchange, it pumps up majorly creating a perfect chance for arbitrageurs to take advantage of.
- Monitor small exchanges. Smaller exchanges don’t have a lot of liquidity to balance the prices quickly. They have less trading volume, so the risks of experiencing big slippage when executing a transaction are very likely.
The best and yet the easiest way to identify сruptocurrency arbitrage opportunities is to use a dedicated software or bot. However, as arbitrage opportunities exist for a very short (milliseconds) period and are barely visible to human eyes, detecting and taking advantage of them has become nearly impossible for a retail trader. That's why to compete with large computers traders started exploiting arbitrage bots.
Modern technology has significantly reduced crypto arbitrage opportunities. The advancement of technology has led to the advent of automated crypto arbitrage trading systems to monitor fluctuations or price differences in similar financial instruments. Such systems can detect and act on inefficient pricing setups so rapidly that the price difference of identical financial instruments and arbitrage opportunities are quickly eliminated.
What Is a Crypto Arbitrage Bot?
Crypto bots are indeed an integral part of today’s arbitrage crypto trading. However, when it comes to algorithmic trading, computers are way ahead of the game compared to humans: they are constantly searching for arbitrage opportunities, and when they finally find them, the transactions are executed in a blink of an eye.
Arbitrage trading bots have been running the market for a while. Having an automated cryptocurrency arbitrage software conducting trades for you can bring consistent passive income and free you from constant screen checking.
But the thing with arbitrage bots is that the more people use them, the less effective they become.
How to Arbitrage Crypto for a Profit?
If you are wondering how to arbitrage cryptocurrency, don’t be surprised to discover that it may be hard to do it for a living.
To be able to profit from a cryptocurrency arbitrage, you need to:
- Acquire both fiat and crypto on the platforms you are operating on since you can’t know for sure where the opportunity arises.
- Check which exchanges require KYC verification. It is common for crypto exchanges to have withdrawal limits and AML checks whenever greater sums of funds are being moved. Such examinations might run for weeks in some cases.
- Be aware of transaction costs. Moving assets from one exchange to another incurs withdrawal, deposit, and trading fees - all negate any potential profits you were supposed to make.
That's being said, the concept of arbitrage may sound easy at first, but if you dig deeper into the process, you'll face all the obstacles that are hard for a regular trader to conquer but are pretty easy for trading bots as they manage to keep all the variables in mind 24/7.
Arbitrage Example
If you want to find arbitrage opportunities, one good place to look is CoinMarketCap. First things first, you have to choose a token, then click on the “Markets” tab, and the whole list of exchanges the token is being traded on will appear on your screen.
In our example of arbitrage opportunity, we chose specifically ETH/USDT trading pair.
We can immediately see that Bitfinex and Binance are showing an opportunity for crypto arbitrage. The images below represent the order books of two markets - Bitfinex (ETH/USDT) and Binance (ETH/USDT). The shared crypto asset between both markets is Ethereum (ETH):
To spot the opportunity, look at the highest bid (highest prices in green table) and lowest asks (lowest prices in red table). For example, you can buy from Binance (light screenshot) for $1,548.02 per 1 Ethereum and sell on Bitfinex (dark screenshot) for $1,551.30 per 1 Ethereum. In theory, you could have earned $3.28 on every 1 ETH, but in practice, your net premium would be slightly more than $1, because Binance would charge you $2 withdrawal fee.
Note that your buy order corresponds to the ask side (red), and your sell order corresponds to the bid side (green).
The Amount column showcases the cumulative volume of orders waiting to be filled. For example, on the Binance ETH/USDT order book, we can see that you can buy a max of 3.4941 ETH. On the Bitfinex exchange side, you can sell 12.83 ETH.
Sometimes the selling order can not fully cover the number of tokens you have. In this case, you must determine how much volume is favorable for this trade. Take a look at Bitfinex bid orders - 24 rows down, the price is still favorable if we buy ETH at $1,548.02.
If you have ever seen an order book in your life, you know how difficult it is to understand the subtle price trends and dramatic jumps. And don’t even get me started on executing such transactions, it is truly an unrealistic task for a human. For example, the Binance order book has changed at least 5 times while you were reading this sentence. Bitfinex orders, on the other hand, are not filled as fast as the ones on the largest crypto exchange. Nevertheless, without decent software, taking advantage of crypto price discrepancies is the same as asking for the moon.
How Arbitrage Trading Crypto Keeps Financial System Healthy
Arbitrage cryptocurrency trading makes all the counterparties involved act as financial intermediaries, more precisely - market makers - that are always trying to detect and resolve market inefficiencies.
Unlike all familiar day trading or swing trading, crypto arbitrage doesn’t impose such risks because it is based on real-time opportunities and not possible price fluctuations in the future.
One of the best things about arbitrage trading is its impact on market efficiency. Arbitrageurs help various financial markets become more liquid and robust. Thanks to arbitrage trading, the prices of relative securities across the world stay in sync with each other resulting in better price discovery and tight spreads.
It is difficult to overestimate the role of crypto arbitrage in keeping global financial systems healthy. The fewer opportunities that exist in the market, the more fair and liquid it becomes.
The Dark Side of Crypto Arbitrage Trading
Many traders call arbitrage a low-risk strategy. But is that really so?
In fact, arbitrage trading can be easy in theory but tricky in practice. Certain factors may significantly reduce an arbitrageur's chances of profit. So, the biggest arbitrage risks associated with crypto are:
- Low liquidity - due to low liquidity on the exchange, the trade may not be executed at the desired price, which results in price slippage when a trade gets executed at a different price than expected.
- Required deposits - since the difference in price between two or more similar assets is usually insignificant, arbitrageurs have to execute a huge volume of trades in order to generate substantial revenue. Moreover, you should also know that as demand and supply in two or more markets are affected, the price of the same asset changes respectively to the point where you can’t make a profit from the difference in asset’s value since there is any. However, even with huge deposits, you can’t make a lot of profit on one arbitrage deal. The thing is, the more you arbitrage the more balanced exchanges become. The shift in demand and supply of two or more markets influences order books and liquidity pools - they are affected respectively to the point where you can’t make a profit from the difference in asset’s value since there is any.
- Abnormally high fees - maker/taker, withdrawal, fiat deposit, credit card payment, etc. These charges have to be taken into account when calculating the profits.
- Taxes - these only apply to certain countries.
- Frozen assets - if you are trading your assets back and forth, the exchange may eventually freeze money.
Given these risks, arbitrage is more generally carried out by major financial institutions and skilled traders and investors with sufficient resources, infrastructure, and expertise. Investors should have a well-thought-out plan to back up their investment decisions.
Is Arbitrage Legal?
Both traditional and cryptocurrency arbitration is considered legal and has been encouraged in most developed countries worldwide. When the prices of two or more connected securities diverge, arbitrageurs purchase and sell the assets until the correlation returns to normal.
Arbitrage is the reason why today's markets are typically tight, deep, and liquid. Acting as market makers, arbitrageurs actively equalize several markets and promote market efficiency. They are an inherent component of the crypto market system that is repeatedly exposed to price manipulation and volatility fluctuation.
Market Maker’s Arbitrage Solutions
What does an institutional market maker do for a project if retail arbitrageurs stabilize the price?
Well, the perk of having a market maker arbitraging for you is being able to capitalize on the spread between the asset's bid and offer price. Just like a regular arbitrageur, a market maker buys and sells your cryptocurrency on various exchanges to support its exchange rate in real time. However, instead of making no money from this activity, the percentage of the profit made by a hired trading firm will go to your project's account. So, in the end, you'll have more money at your disposal to invest in the growing startup.
