What is Crypto Arbitrage and How Does It Work?

With tens of billions worth of cryptocurrency changing hands across exchanges, some traders take profits by playing them off against one another.

Cryptocurrency trading sees the exchange of tens of billions of dollars on a daily basis, with millions of trades happening simultaneously. However, unlike traditional stock exchanges, there are multiple cryptocurrency exchanges available, each with varying prices for the same cryptocurrencies. This presents an opportunity for skilled traders and those willing to take on risk to gain an advantage by utilizing the practice of crypto arbitrage, which involves exploiting price differences between different exchanges.

Arbitrage is a technique used in trading where an individual takes advantage of the price difference of an asset in different markets. The process involves buying the asset in one market and then quickly selling it in another market where the price is higher, generating a profit from the difference in prices.

Crypto arbitrage is the practice of buying and selling cryptocurrencies on different exchanges to take advantage of the price differences between them. For example, if the price of Bitcoin on Coinbase is $10,000 and the price on Binance is $9,800, a trader could buy Bitcoin on Binance, transfer it to Coinbase, and sell it for a profit of around $200. This is the essence of crypto arbitrage, it is a strategy that takes advantage of the different prices of cryptocurrencies on different exchanges.

The key to success in crypto arbitrage is speed, as the price differences between exchanges are often temporary. However, when timed correctly, the profits can be significant. For example, when Filecoin was listed on exchanges in October 2020, some exchanges had a price of $30 within the first few hours, while others had a price of $200. A trader who was able to quickly buy Filecoin on the lower-priced exchange and sell it on the higher-priced exchange would have made a large profit.

How do crypto prices work?

The question of how cryptocurrency derives its value is a contentious one. Some argue that since it is not backed by any tangible assets, the value assigned to it is based solely on speculation. Others counter that as long as people are willing to pay for a cryptocurrency, it holds value. The reality is that there is truth in both perspectives. The value of cryptocurrency is influenced by a combination of factors, including demand, adoption, and market sentiment.

Trading on cryptocurrency exchanges is facilitated by order books, which contain a list of buy and sell orders for a particular asset at different prices. When a trader wants to buy an asset, they create a “buy” order, specifying the price they are willing to pay. This order is then added to the order book. If another trader wants to sell the same asset at the same price, they can create a “sell” order, which will match with the buy order, resulting in a trade. This process is known as a trade. The matched buy order is then removed from the order book as it has been fulfilled.

The value of a cryptocurrency on an exchange is determined by the most recent trade. This can be either a buy or sell order. For instance, if a trade of one Bitcoin for $30,000 is the most recent completed transaction, the exchange will set the price at $30,000. If another trader subsequently sells two Bitcoin for $30,100, the exchange will update the price to reflect the new trade, which is $30,100. The quantity of crypto traded does not have any effect, what matters is the most recent price.

Each crypto exchange prices cryptocurrencies this way, save for some crypto exchanges that base their prices on other cryptocurrency exchanges.

Different types of arbitrage

Between exchanges

One approach to crypto arbitrage is to purchase a cryptocurrency on one exchange and then transfer it to another exchange where it is being sold at a higher price. However, this method has a few drawbacks. The price difference between exchanges is often short-lived, but transferring crypto between exchanges can take several minutes. Additionally, transferring crypto incurs fees, such as withdrawal, deposit or network fees, which can eat into the potential profit.

To avoid transaction fees, arbitrageurs can hold a cryptocurrency on multiple exchanges. This way, they can buy and sell the cryptocurrency simultaneously. An example of this strategy is having $30,000 in a US dollar-pegged stablecoin on Binance and one Bitcoin on Coinbase. If Bitcoin is valued at $30,200 on Coinbase and $30,000 on Binance, the trader would buy the Bitcoin using the stablecoin on Binance, and then sell it on Coinbase. The trader wouldn’t gain or lose any Bitcoin, but they would earn $200 due to the price difference between the two exchanges.

Did you know?

USDT (Tether) is a cryptocurrency tied to the price of one US Dollar. Cryptocurrency traders often use it because of its relative stability. It makes it easier to hold cryptocurrencies without the risk that its price will massively decrease. The advantage to holding stablecoins such as Tether, instead of converting crypto to cash is that crypto-to-fiat transfers often incur huge charges.

Triangular arbitrage

This strategy involves utilizing three different cryptocurrencies and exploiting price differences between them on a single exchange. This method eliminates transfer fee issues as it all takes place on one exchange. An example of this method would be a trader identifying an arbitrage opportunity with Bitcoin, Ethereum and XRP on an exchange. If one or more of these currencies is undervalued, the trader can take advantage by selling their Bitcoin for Ethereum, then using that Ethereum to purchase XRP, and finally buying back Bitcoin with the XRP. If executed correctly, the trader will end up with more Bitcoin than they started with.

Statistical Arbitrage

Statistical arbitrage in DeFi uses quantitative data models to trade cryptocurrencies. It involves using a trading bot that analyzes hundreds of different cryptocurrencies at once, determining the potential profitability of a trade through mathematical models, and making decisions to either go “long” or “short” on the trade. The bot will typically assign a low score to a cryptocurrency that has performed well and a high score to one that has performed poorly, as there are greater potential profits from the former. A skilled trading algorithm is able to create accurate mathematical models that predict the price of cryptocurrencies and effectively trade them against each other.

Decentralized Finance (DeFi) Arbitrage

DeFi, short for decentralized finance, refers to financial protocols that operate without human intervention and include lending protocols, stablecoins, and exchanges. These protocols are code-based, making them ideal for arbitrage. There are various strategies that DeFi enthusiasts can use when attempting to perform arbitrage.

A popular strategy in DeFi is to take advantage of the different yields offered by lending protocols. By converting their assets from a lower yielding stablecoin to a higher yielding one, traders can earn a profit. For example, if one platform offers a 10% yield and another offers 11%, a trader could convert their funds to the higher yielding stablecoin to earn that extra 1%. Some platforms, such as Yearn.finance, created by Andre Cronje, have automated this process by moving funds across different protocols to gain the highest yield.

Another approach to DeFi arbitrage is to take advantage of price discrepancies on different exchanges. This is similar to traditional “between exchanges” arbitrage, but utilizing decentralized exchanges like Uniswap. As prices for coins may vary on different decentralized exchanges, traders can earn a profit by buying a coin at a lower price on one exchange and selling it at a higher price on another exchange.

Another way to profit from crypto arbitrage is through front-running trades. This involves placing a trade ahead of others by paying higher gas fees. For example, a DeFi trader might spot a profitable opportunity and want to execute the trade quickly. A trading bot, however, could pay a bit more to ensure that its trade is processed first. By being at the front of the queue, the bot could earn a small extra profit.

Arbitrage trading risks

Arbitrage trading comes with certain risks, one of which is slippage. This occurs when a trader places an order to buy a cryptocurrency, but the order size exceeds the available quantity at the best price, resulting in the order being executed at a higher price than intended. This can be detrimental to traders, as the small margins in arbitrage trading make it vulnerable to slippage that could erase potential profits.

Another risk factor in arbitrage trading is market volatility. Arbitrage opportunities can appear and disappear quickly, and traders must be able to act quickly to capitalize on them. This is further complicated by the use of bots by some traders, which can result in increased competition for these opportunities.

An additional factor that traders must consider is transfer fees. The narrow margins in the major cryptocurrencies often make it difficult for traders to make a profit, as transfer fees can easily erase the potential gains. This is why traders who are looking to make substantial profits need to carry out a large number of trades to compensate for this.

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