What Is Cryptocurrency Arbitrage?
Cryptocurrency arbitrage, also known as crypto arbitrage, is a trading strategy that involves buying a digital asset on one exchange at a lower price and then selling it on another exchange at a higher price. This is done in order to take advantage of price discrepancies that can occur across different crypto exchanges.
The crypto market is highly decentralized and is composed of hundreds of different exchanges, each with their own order book and trading pairs. As a result, the price of a cryptocurrency can vary significantly from one exchange to another. By identifying these price differences and executing trades accordingly, traders can potentially earn a profit through crypto arbitrage.
However, it is important to note that crypto arbitrage is not without its risks. Factors such as transaction fees, withdrawal limits, and market volatility can all affect the profitability of an arbitrage trade. Additionally, the fast-paced nature of the crypto market means that arbitrage opportunities can disappear quickly.
Traders who wish to engage in crypto arbitrage should be prepared to act quickly and have a solid understanding of the crypto market as well as the various exchanges and trading platforms available. Additionally, it is important to carefully evaluate the fees and limitations associated with each exchange, as well as to have a risk management strategy in place.
Why Are Crypto Prices Difference Across Exchanges?
Crypto markets are not regulated, and cryptocurrencies are decentralized, which means that, except for stablecoins, they are not tied to government or fiat currencies like the dollar. This is one of the main reasons why the prices of different crypto can vary widely: there is no standard price for any particular coin or token.
Additionally, some crypto exchanges have higher trading volume than others, which means that supply and demand on one exchange could be vastly different from another, impacting the price. Furthermore, crypto trading fees vary, and these can add to the cost of your trades. These factors all contribute to the potential for crypto arbitrage opportunities.
What Types of Arbitrage Exist?
Investors can take advantage of price differences in different cryptocurrencies by engaging in crypto arbitrage through various methods.
Spatial Arbitrage
Spatial arbitrage is a type of crypto arbitrage that involves buying and selling virtual currencies on two different exchange platforms. This approach is straightforward, but it also comes with risks such as transfer delays and fees.
Spatial Arbitrage Without Transferring
To minimize the risk of transfer delays and fees associated with spatial arbitrage, some traders may opt for a different approach. For instance, they may simultaneously go long on Bitcoin on one exchange and short on another, and wait for the prices to converge. This eliminates the need to transfer coins and tokens between platforms, but trading fees may still apply.
Triangular Arbitrage
Triangular arbitrage is a strategy that leverages pricing discrepancies among different cryptocurrency pairs on a single exchange. In this approach, an investor begins with one cryptocurrency and exchanges it for another that is undervalued in relation to the first. Then, the investor exchanges the second cryptocurrency for a third that is overvalued in relation to the first. Finally, the investor exchanges the third cryptocurrency back to the first, potentially earning a profit.
How to Take Advantage of Crypto Arbitrage Algorithmically
Cryptocurrency arbitrage may appear on the surface as a simple task of identifying price differences between different exchanges, and then buying and selling accordingly. For example, in 2017, there was a moment when the price of Bitcoin on Kraken was $17,212, while it was only $16,979 on Bitstamp, creating an arbitrage opportunity for an investor to potentially make $233 per Bitcoin by buying on Bitstamp and quickly selling on Kraken. While such gaps in price may not always be as significant, there may be other, less well-known cryptocurrencies that offer even wider spreads. Since cryptocurrency prices can vary across exchanges, arbitrage opportunities can emerge at any time with thousands of cryptocurrencies trading on hundreds of exchanges. Investors can also use apps that track the prices of Bitcoin and other cryptocurrencies for arbitrage opportunities, and use automated algorithms that scan for arbitrage across different crypto exchanges to take advantage of multiple price discrepancies.
How to Find a Crypto Arbitrage
Different cryptocurrencies may present varying opportunities for arbitrage, and there are various methods to identify such opportunities.
Method 1: New Software
With the abundance of cryptocurrencies and exchanges, identifying arbitrage opportunities can be a challenging task. To simplify this process, many traders rely on software applications that monitor multiple cryptocurrency exchanges in real-time.
To cater to this growing demand, there are several companies that offer software specifically designed to automate crypto arbitrage. These companies provide tools that enable investors to select an automated arbitrage strategy and execute it across different exchanges.
Method 2: Less Popular Cryptocurrencies
Investors may find larger price discrepancies for the same cryptocurrency among less popular and less frequently traded forms of crypto. However, due to their lack of popularity, these cryptocurrencies tend to experience more significant price fluctuations, which can result in both potential gains and losses, and thus adding an additional level of risk to an arbitrage strategy.
What Are the Dangers of Crypto Arbitrage?
Similar to any form of arbitrage, engaging in crypto arbitrage involves certain risks.
Losses
In order to be successful in crypto arbitrage, investors must act quickly to capitalize on price differences between exchanges while they are still profitable. With thinly traded forms of cryptocurrency that offer the largest spreads, traders must also be cautious not to disrupt the market by buying at a higher price and selling at a lower price with their own trades.
Volume
Crypto exchanges operate similarly by determining the price of cryptocurrency based on the last trade on that particular exchange. However, it’s crucial to understand that not all exchanges are the same, some have substantial trading volumes while others have less activity.
The trading volume on each exchange impacts the liquidity and prices available on the exchange. Low volume may mean that the exchange cannot execute a trade of sufficient size to provide the profit an investor is seeking, or that the trade is possible but would take too long to take advantage of the pricing opportunity.
Transaction Costs
Simultaneously, traders must monitor the transaction fees associated with buying cryptocurrency across different platforms. These fees change frequently as the cryptocurrency market evolves and vary among different exchanges.
Fraud, Hacks
It is important to be aware that cryptocurrencies are largely unregulated, which is a key factor to consider before investing in them. Due to this lack of regulation, trading in crypto comes with added risks such as hacking, fraud, and the potential collapse of the currency. This highlights the importance of securely storing your cryptocurrencies, a crucial concern among investors.
Taxes
In the United States, where the use of cryptocurrency has grown rapidly in recent years, the Internal Revenue Service (IRS) has classified cryptocurrencies as property, similar to stocks, bonds, and other capital assets. This means that investors are required to pay capital gain taxes when they sell, trade, or dispose of their crypto holdings. Additionally, if an individual receives cryptocurrency as a gift, from mining, or as payment for services rendered, it may be taxed as income. This means that investors must include any capital gains on their federal income tax return and may also be able to claim deductions for any losses.
It’s worth noting that the IRS’s classification of cryptocurrency as property is not consistent across all federal government agencies. There is ongoing debate about whether crypto should be considered a security or a commodity. The Securities and Exchange Commission (SEC) has referred to cryptocurrencies as securities, while the Commodity Futures Trading Commission has referred to them as commodities. As of August 27, 2022, different bills have been proposed in Congress to make the regulation of cryptocurrencies consistent.
The Takeaway
Arbitrage, the practice of buying and selling the same asset at different prices in different markets, is a common strategy in the stock, bond, and commodity markets. However, the digital nature of cryptocurrencies and the lack of a underlying asset to determine their value make it more difficult to execute arbitrage with these currencies. Despite this complexity, crypto arbitrage is legal and has the potential to provide high returns, but also poses high risks. Investors should conduct thorough research and consider lesser-known cryptocurrencies and the use of software to track real-time prices across different exchanges before engaging in crypto arbitrage.
