What is Crypto Arbitrage and how does it work? (2021)

In short

  • Crypto arbitrage takes advantage of the fact that cryptocurrencies can be priced differently on different exchanges.
  • Arbitrators can trade between exchanges or perform triangular arbitrage on a single exchange.
  • Risks associated with arbitrage trading include slippage, price movement, and transfer fees.

Every day, tens of billions of dollars of cryptocurrency changes hands in millions of transactions. But unlike traditional exchanges, there are dozens of cryptocurrencies Tradeseach displaying different prices for the same cryptocurrencies.

For savvy traders – and those not averse to a little risk – this opens up an opportunity to gain an edge over their compatriots: play these trades against each other. Welcome to the world of crypto arbitrage.

What is Crypto Arbitrage?

Arbitrage is a trading strategy in which an asset is bought in one market and immediately sold in another market at a higher price, exploiting the price difference to make a profit.

Crypto arbitrage is pretty self-explanatory; it is arbitrage using crypto as the asset in question. This strategy takes advantage of how cryptocurrencies are priced differently on different exchanges. At Coinbase, Bitcoin could be priced at $10,000, while on Binance it could be priced at $9,800. Exploiting this price difference is the key to arbitrage. A trader could buy Bitcoin on Binance, transfer it to Coinbase, and sell the Bitcoin, profiting around $200.

Speed ​​is the name of the game – these gaps usually don’t last very long. But the profits can be immense if the arbitrageur times the market correctly. When filecoin hit exchanges in October 2020, some exchanges listed the price as $30 in the early hours. Others? $200.

How do crypto prices work?

So how does cryptocurrency get its value? Some critics point out that the cryptocurrency is not backed by anything, so any value attributed to it is purely speculative. The counter-argument is pretty much that if people are willing to pay for a cryptocurrency, then that coin has value. Like most unresolved arguments, there is truth to both sides.

On the stock exchanges, the game is played in the order books. These order books contain buy and sell orders at different prices. For example, a trader could place a “buy” order to buy a Bitcoin for $30,000. This order will go into the order book. If another trader wants to sell Bitcoin for $30,000, they can add a “sell” order to the book, completing the trade. The purchase order is then withdrawn from the order book as it has been executed. This process is called a trade.

Cryptocurrency exchanges rate a cryptocurrency on the most recent trade. This can come from a buy order or a sell order. Using the original example, if selling Bitcoin alone for $30,000 was the most recent transaction, the exchange would set the price at $30,000. A trader who then sells two Bitcoins for $30,100 would move the price to $30,100, and so on. The amount of crypto traded does not matter, all that matters is the most recent price.

Every cryptocurrency exchange rates cryptocurrencies this way, except for some crypto exchanges that base their prices on other cryptocurrency exchanges.

Different Types of Arbitration

Between exchanges

One method of crypto arbitrage is to buy cryptocurrency on one exchange and then transfer it to another exchange where the currency is sold for a higher price. There are a few issues with this method, however. Spreads usually only exist for a few seconds, but transferring between exchanges can take a few minutes. Transfer fees are another issue, as transferring crypto from one exchange to another incurs fees, whether through withdrawals, deposits, or network fees.

Bitcoin price may differ from exchange to exchange. Picture: Coinranking.com

One way arbitrageurs get around transaction fees is to hold currencies on two different exchanges. A trader employing this method can then buy and sell cryptocurrency simultaneously.

Here’s how it might play out: A trader might have $30,000 in a US dollar-pegged stablecoin on Binance and one Bitcoin on Coinbase. When Bitcoin is valued at $30,200 on Coinbase but only $30,000 on Binance, the trader would buy the Bitcoin (using the stablecoin) on Binance and sell the Bitcoin on Coinbase. They would neither gain nor lose a bitcoin, but they would earn $200 due to the spread between the two exchanges.

Did you know?

USDT (Tether) is a cryptocurrency pegged to the price of one US dollar. Cryptocurrency traders often use it due to its relative stability. It makes it easy to hold cryptocurrencies without risking its price dropping massively. The advantage of holding stablecoins such as Tether, instead of converting crypto to cash, is that crypto-to-fiat transfers often incur huge fees.

Triangular arbitration

This method involves taking three different cryptocurrencies and trading the difference between them on an exchange. (Since everything happens on an exchange, transfer fees are not an issue).

Thus, a trader might see an opportunity in arbitrage involving Bitcoin, Ethereum, and XRP. One or more of these cryptocurrencies may be undervalued on the exchange. Thus, a trader could take advantage of arbitrage opportunities by selling their Bitcoin for Ethereum, then using that Ethereum to buy XRP, before ending up buying back Bitcoin with XRP. If their strategy made sense, then the trader will have more Bitcoin at the end than at the beginning.

Statistical arbitrage

Statistical arbitrage involves using quantitative data models to trade cryptos. A statistical arbitrage bot can trade hundreds of different cryptocurrencies at once, carefully evaluating the possibility that a bot could profit from a trade based on a mathematical model, and go “long” or “short” on a transaction.

Typically, a bot will give a cryptocurrency that performs very well a low score and once it performs particularly badly, a high score; there are greater profits to be had from those who have performed well. A decent trading algorithm will be excellent at creating mathematical models that can predict the price of cryptocurrencies and expertly trade them against each other.

Decentralized finance (DeFi) arbitrage

Decentralized finance, or Challengerefers to noncustodial financial protocols that operate, without human intervention, such as lending protocols, stablecoins and as exchanges. Their code-heavy architecture makes them perfect for arbitration; there are several different strategies that “DeFi degens” looking to try out arbitrage can use.

One of these strategies aims to take advantage of the different yields offered by DeFi lending protocols. If one platform offers a 10% return from one stablecoin and another offers an 11% return from another stablecoin, then a trader could convert their low-yielding stablecoin to a high-yielding one. yield to earn that extra 1%. Many platforms do this automatically. Yearn.finance, André Cronje’s DeFi project, automatically moves funds across different decentralized finance protocols to get the best return.

Another technique is to take advantage of prices on different exchanges. This works exactly like the “between exchanges” type of arbitrage, except this time around it relies on decentralized exchanges like Uniswap. Some decentralized exchanges offer different prices for coins and it is possible to earn money by profiting from the difference.

It is also possible to take advantage of other top trades. If a DeFi trader sees a big opportunity, they might want to place that trade as soon as possible to earn their money. But a bot might pay a little more money to ensure their trade gets processed first. By jumping to the front of the queue by paying higher gas fees, a trading bot could earn a bit more moolah.

Arbitration Risks

There are several risks associated with arbitrage trading. One of them is slippage. Slippage occurs when a trader places an order to buy a cryptocurrency, but their order is larger than the cheapest bid in the order book, causing the order to “slip” and cost more provided that. This is a problem for traders, especially since margins are so low that a slippage could wipe out potential profits.

Price movement is another risk associated with arbitrage. Traders need to be quick to take advantage of spreads when they form, as the spread can disappear in seconds. Some traders are programming bots to perform arbitrage trades, which has only added to the competition.

Finally, merchants should consider transfer fees. Spreads are rarely very large for major cryptocurrencies, and with tight margins, transfer or transaction fees could wipe out any potential profit. These tight margins also mean that any trader who wants to make big gains has to make a lot of trades.

Warning

The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment or other advice.

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