Arbitrage opportunities are becoming increasingly prevalent in the crypto sector and offer traders an attractive way to maximize their gains. However, just like any other trading strategy, crypto arbitrage has its upsides and pitfalls. In this guide, we will discuss the smartest ways to engage in crypto arbitrage. But first, let’s briefly delve into the concept of arbitrage in general.
What Is Arbitrage?
Traders have engaged in arbitrage long before the emergence of the crypto market. At its most basic, arbitrage means that a trader capitalizes on the non-uniformity of the price of an asset across multiple markets. In essence, if the price of asset x is different on two different exchanges, a trader can buy the asset on one exchange at a cheaper rate and sell it on the other platform at a slightly higher price.
A low correlation in the pricing of an asset across multiple exchanges is indicative of market inefficiencies, which traders – in this case, specifically arbitrageurs – can potentially profit from.
Whilst the occurrence of market inefficiencies is far more infrequent in traditional financial markets, the opposite seems to be the case in the crypto market. This is due to the way in which the cryptocurrency exchange sector functions. These platforms tend to run siloed systems, resulting in uncorrelated pricing. Therefore, over the years, arbitraging has become one of the go-to strategies for crypto traders.
What Is Crypto Arbitrage?
Just like traditional arbitrage, crypto arbitrage is the process of capitalizing on the low correlation in the prices of crypto assets across two or more exchanges. For example, if Binance is selling Bitcoin for $53,000 and Coinbase is selling Bitcoin at $53,400, an arbitrageur can buy Bitcoin on Binance, transfer the purchased BTC to Coinbase, and sell it a higher rate.
Since there are over 300 spot market exchanges selling crypto assets like Bitcoin at slightly different prices, crypto arbitrage opportunities are boundless. This explains why traders are increasingly looking for ways to efficiently identify these opportunities and capitalize on split-second price differentials across multiple exchanges.
Note that the profits generated from such trading activities largely depend upon the speed at which an arbitrageur can capitalize on the uncorrelated pricing of assets. In most cases, the price difference across multiple exchanges exists only for a fleeting moment. The more arbitrageurs capitalize on the spread across two exchanges, the higher the probability of price convergence. In other words, you have to take advantage of crypto arbitrage opportunities ahead of other traders or else you court the risk of potentially significant losses.
Why Are Prices Not Fixed Across Crypto Exchanges?
As noted earlier, market inefficiencies occur as a result of siloed crypto exchange operations. Except for smaller, low-volume exchanges, which tend to trail the prices of more established crypto trading platforms, most exchanges have an in-house price discovery system.
Crypto exchanges continually update the official price of a given crypto asset according to the most recent price at which the asset has been bought or sold on their platforms. Therefore, depending on the supply and demand of a given digital asset at a specific moment, the prices of cryptocurrencies across multiple markets may differ.
Is Crypto Arbitrage Legal?
The process of capitalizing on market inefficiencies is entirely legal. In fact, crypto arbitrage is central to the overall uniformity of the crypto market. Whenever there are price differentials across multiple exchanges, the trading activities of crypto arbitrageurs will eventually cause the prices of the digital asset across exchanges to converge.
What Are the Different Types of Crypto Arbitrage?
There are several types of arbitrage activity. Here, we will highlight those most popular amongst crypto traders:
- Deterministic Arbitrage. This is the simplest form of arbitrage. It involves traders simultaneously buying and selling a digital asset on two exchanges in such a way as to potentially profit from market inefficiencies. Here, the trader identifies arbitraging opportunities on two specific exchanges, buys the asset on the platform with the lower price, and sells the asset a higher price on the second exchange.
- Triangular Arbitrage. There is also an opportunity to profit from the uncorrelated pricing of three cryptocurrency pairs on an exchange, especially when one of the cryptocurrencies is momentarily underpriced on the platform. For example, a trader could trade BTC for ETH, convert the ETH to XRP and then trade the XRP back to BTC. In sum, this process involves moving funds via BTC/ETH, ETH/XRP and XRP/BTC pairs with the aim of ending up with more BTC.
- Decentralized Arbitrage. With this strategy, traders are looking to execute arbitrage trades on decentralized exchanges (DEXs) such as Uniswap, Balancer or Curve. Arbitrageurs can buy or sell pooled digital assets that may be under- or overvalued on these different platforms. Just as with centralized crypto exchanges, these activities eventually result in price uniformity across DEXs.
- Statistical Arbitrage. This involves the use of quantitative data models and bots to profit from arbitrage opportunities at scale. Since the process is automated, an arbitrageur can execute hundreds of trades in a matter of minutes to boost their profitability potential.
How to Optimize Your Crypto Arbitrage Strategy
When engaging in crypto arbitrage, the first thing you should keep in mind is that you are trading in a very volatile market. Therefore, you should do whatever it takes to optimize the speed of your trades before your window of opportunity to make a profit closes. You can optimize speed by sticking to high liquidity exchanges that can match and execute your orders instantly. By contrast, trades on low-volume exchanges may take several minutes before they are matched. By then, the arbitrage opportunity may have expired.
There is also the option of using bots designed to automate and optimize crypto arbitrage trading. These tools, combined with market inefficiencies trackers, are recommended for crypto arbitrageurs. Moreover, if you are looking to transfer funds between two exchanges, ensure that you stick to cryptocurrencies with high transaction speeds. Therefore, an arbitrageur would not be advised to transfer Bitcoin from one exchange to another, especially during times of high network congestion.
Another factor you should keep in mind is potential transaction fees. You don’t want the overhead costs for executing trades and transfers to eat too much into your profits. To mitigate the impact of high transaction fees, you can deposit sufficient holdings of crypto assets on multiple exchanges at once. Then, whenever you want to seize on an arbitrage opportunity, you can reshuffle your portfolio in such a way that allows you to capitalize on the opportunity.
For example, an arbitrageur can hold 1 BTC on Coinbase and $53,000 worth of USDT on Binance. When the price of Bitcoin is $53,000 on Binance and $53,200 on Coinbase, the logical trader could sell their Bitcoin on Coinbase for USDT and buy 1 BTC on Binance with their USDT holdings. This would allow the trader to pocket the $200 difference as a profit.
In this way, the trader has bypassed any deposit and withdrawal fees, as well as saving the time it takes to process inter-exchange transactions. The only thing such a trader needs to worry about are maker and taker fees, which are however rather low for high-volume traders. Note that crypto arbitrageurs almost always have to execute large trades in order to be able to generate significant profits from a single arbitrage opportunity.
A last note on crypto arbitrage: keep in mind the risks associated with hot wallets. Crypto arbitrageurs are very much exposed to these risks because they are required to hold crypto assets in wallets provided by cryptocurrency exchanges. For this reason, it’s advisable, as far as possible, to restrict your activities to reputable and highly secure exchanges.
Keeping to the above basic crypto arbitrage best practices and measures should help you to make the most of the multiple arbitrage opportunities out there in the crypto market today.
Remember to always do your own research before investing in cryptocurrencies.