With the cryptocurrency trading still being in its early stages and the markets being dispersed globally, there can sometimes be substantial price variations between exchanges. Cryptocurrency arbitrage provides an opportunity for you to capitalize on these price discrepancies by purchasing a cryptocurrency on an exchange where it is being offered at a low price, and then promptly selling it on another exchange where the price is higher.
However, it’s crucial to be cognizant of the significant risks and pitfalls before you commence your trading activities.
What is cryptocurrency arbitrage?
Arbitrage involves the concurrent purchasing and selling of an asset across various markets to benefit from the price discrepancy between those markets. As a straightforward illustration of how cryptocurrency arbitrage operates, one would search for a particular cryptocurrency that is priced lower on Exchange A than on Exchange B. Afterward, the cryptocurrency is bought on Exchange A and sold for a higher price on Exchange B, and the profit is pocketed from the price difference.
The idea of arbitrage trading is not novel and has been present in stock, bond, and foreign exchange markets for a prolonged period. However, with the advancement of quantitative systems specifically created to identify price disparities and execute trades across multiple markets, the practice of arbitrage trading is now inaccessible to most retail traders.
However, opportunities for arbitrage persist in the cryptocurrency sphere due to the sharp increase in trading volume and disparities between exchanges that result in price variations. Larger exchanges with more substantial liquidity dictate the prices of the rest of the market, with smaller exchanges following suit. Yet, smaller exchanges do not promptly align with the prices established by their larger counterparts, presenting opportunities for arbitrage.
How does cryptocurrency arbitrage work?
Arbitrage is a result of imbalanced trading volumes between two different markets. In a market with a high trading volume and a plentiful supply of a particular coin, prices tend to be lower. Conversely, in a market with limited supply, prices are typically higher. By buying in the market with lower prices and instantly selling in the market with higher prices, traders can potentially profit from the price difference.
However, there are also opportunities for arbitrage in the opposite direction, where one would buy on a smaller exchange and sell on a larger exchange. The rise in popularity of cryptocurrency has led to a significant boost in trading volumes on numerous exchanges globally. These exchanges are not interconnected, and a low trading volume on some exchanges could result in prices not adjusting to the exchange average promptly. Consequently, this has created price disparities that arbitragers may have the chance to benefit from.
The most well-known illustration of the variation in cryptocurrency exchange pricing is the so-called “kimchi premium.” In January 2018, the price of bitcoin in South Korea was more than 50% higher compared to the global market, making it a prime example of such a discrepancy.
How to do it
The simplest way to engage in cryptocurrency arbitrage is by manually monitoring the markets for any price disparities, and executing trades and transferring funds accordingly. However, for those seeking ease, there are a variety of cryptocurrency arbitrage bots available that make it easier to track price movements and differences. Additionally, utilizing online or mobile trading apps like Blockfolio can streamline the market monitoring process.
It’s noteworthy to mention that hedge funds are gradually venturing into the cryptocurrency industry. A good example is the Singapore-based hedge fund, Kit Trading, which is collecting $10 million for its cryptocurrency arbitrage fund and is one of the over 80 crypto hedge funds that established in the year 2017.
There are multiple strategies arbitrage traders can use to make a profit, including the following:
- Simple arbitrage. Buying and selling the same coin immediately on separate exchanges.
- Triangular arbitrage. This process involves taking advantage of the price differences between three currencies. For example, buy BTC in USD, sell it to make EUR, and then exchange those EUR back to USD.
- Convergence arbitrage. This approach involves buying a coin on one exchange where it is undervalued and short-selling the same coin on another exchange where it is overvalued. When the two separate prices meet at a middle point, you can profit from the amount of convergence.
A simple example of crypto arbitrage
To explain how arbitrage works, let’s look at a hypothetical case study. Let’s assume that we have two exchanges that both list bitcoin:
- Exchange A is a major exchange with a high trading volume. The price of BTC on this exchange is $8,800.
- Exchange B is a smaller exchange with less trading volume. The price of BTC on this exchange is $8,805.
Now let’s assume that there’s an important announcement that’s likely to encourage people to buy BTC, such as the US Internal Revenue Service announcing that all BTC deposits will never be subject to tax. This prompts widespread demand for BTC, and most buyers head to the biggest exchanges because they offer the easiest way to buy cryptocurrency.
This surge of buyers causes an increase in BTC prices on large exchanges like Exchange A, while Exchange B sees less trading volume, and its price is slower to react to the change in the market. BTC reaches $9,240 on Exchange A, but only rises to $9,070 on Exchange B, which is where arbitrage comes in. You could do the following:
- Buy BTC on Exchange B for $9,070.
- Transfer your BTC to Exchange A.
- Sell your BTC on Exchange A for $9,240, securing a profit of $140 per BTC.
Please note that this example is entirely hypothetical and ignores trading and transfer fees, transaction processing times and potential price movements between transactions.
The potential benefits of arbitrage
Why should one consider cryptocurrency arbitrage? There are multiple reasons for doing so:
- Consider cryptocurrency arbitrage as a potential fast path to profits. In just the amount of time it takes to execute all the necessary trades, you can finish an arbitrage transaction, offering the possibility of quick gains compared to the conventional method of purchasing and holding cryptocurrency before selling it at a later time.
- Expansive Availability of Exchanges. At the time of writing, according to CoinMarketCap, there are over 180 exchanges worldwide where you can buy and sell cryptocurrencies. With so many options, the possibilities for a price differential are numerous.
- Limited regulation and lower competition in cryptocurrency markets provide opportunities for arbitrage trading. The slow transfer of information between exchanges and a lesser number of traders, compared to other established investment markets, could result in potential price differences to be exploited through arbitrage.
- Cryptocurrency prices are highly unstable. Take a look at a graph showing the price of bitcoin or any other widely traded cryptocurrency over the past 12 years. This gives a clear picture of the fluctuations in crypto prices and highlights the potential for price disparities between exchanges where high volatility exists.
The risks of cryptocurrency arbitrage
While crypto arbitrage may seem like an easy opportunity in theory, there are several obstacles and potential risks to keep in mind before diving in:
KYC regulations.KYC regulations can hinder entry to various exchanges by requiring certain criteria to be met. For instance, one may have to have a bank account in the same country where an exchange operates, or they may have to get their account verified, which could take more than a day, to be able to trade.
Storing coins on exchanges.Storing coins on exchanges for arbitrage trades carries the risk of exchange hacks and theft of customer funds, so it is important to be aware of these potential threats before starting.
Exchange fees.Before engaging in cryptocurrency arbitrage, it’s important to take into account the fees charged by exchanges for trades, deposits, and withdrawals, as these can affect the overall profitability of a trade.
Large trades often required.Once fees and processing delays are considered, the profits from successful arbitrage trades may be minimal. Therefore, a larger volume of crypto must typically be bought and sold to increase returns.
Withdrawal limits.Be mindful of withdrawal limits when looking to make large trades, as many exchanges have a daily cap on the amount you can remove from your wallet, which could limit your ability to execute a profitable arbitrage transaction.
Failing to execute in time. Another potential issue with cryptocurrency arbitrage is that the market conditions could change or a trade could be executed before you have a chance to sell your holdings. Due to the high volatility of cryptocurrencies, the price can rapidly shift in the time it takes to transfer funds from one exchange to another, causing potential losses.
Slow transactions. The recent increase in global cryptocurrency trading has put pressure on many exchanges, causing them to struggle to meet demand. This has led to frequent instances of delayed withdrawals, which can be a major issue if you need to move funds quickly. Additionally, the speed at which transactions are processed can vary depending on the cryptocurrency being transferred. For instance, Ether (ETH) transactions are processed much faster compared to Bitcoin (BTC) transfers.
Competition risk. As the benefits of cryptocurrency arbitrage become more widely recognized, it’s possible that the competition for trades will increase.
Things to consider before attempting cryptocurrency arbitrage
It’s important to understand that trading in cryptocurrencies involves complexity and high speculation, and that engaging in arbitrage carries its own risks. Before attempting to carry out an arbitrage trade, you should thoroughly familiarize yourself with these potential risks.
Before embarking on a journey in cryptocurrency arbitrage, make sure to keep the following points in mind after thoroughly researching and understanding the associated risks:
Look for new listings.Monitor cryptocurrency discussion boards and news portals for updates on a recently listed coin on an exchange. This can present an opportunity for a wider price gap if the coin has limited demand on that particular platform.
Don’t transfer in BTC.When engaging in arbitrage trading, speed is critical. A slow transaction time of Bitcoin (BTC) may hinder your chances of realizing a profit. An alternative option could be using Ethereum (ETH), which offers quicker transactions.
Have a plan.Before starting cryptocurrency arbitrage, there are important considerations to take into account, such as: how much capital to invest, whether the price difference will yield a sufficient return, and whether to maintain balances on multiple exchanges or transfer funds, which can result in delays.
Only use trusted exchanges.Before engaging in cryptocurrency trading, it is important to thoroughly research and only deal with credible and trustworthy exchanges to minimize risk.
Monitor the market.During unstable market conditions, the possibility of encountering price disparities increases. Keep an eye on cryptocurrency news and events that could cause swift price fluctuations.
Hedge.It may be beneficial to educate yourself on hedging strategies to guard against unfavorable market shifts.
Diversify. Channeling your money into only one exchange or one particular cryptocurrency is risky. Spreading your money around can help to minimize risk.
Limit your exposure. Never arbitrage an amount that’s more than you can afford to lose. With so many potential risks that could lead to a loss, it’s always a good idea to play it safe.
Disclaimer: Cryptocurrencies are speculative, complex and involve significant risks – they are highly volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of future performance. Consider your own circumstances, and obtain your own advice, before relying on this information. You should also verify the nature of any product or service (including its legal status and relevant regulatory requirements) and consult the relevant Regulators’ websites before making any decision. Finder, or the author, may have holdings in the cryptocurrencies discussed.