What is arbitrage trading with reference to cryptocurrency?

 Cryptocurrency arbitrage is about leveraging prices to your advantage. Crypto trading has been around for quite a few years now; however, the prices of cryptocurrencies vary from one exchange to another. Each crypto exchange has its value for specific cryptocurrencies, and this may be due to multiple reasons. Crypto arbitrage helps traders take advantage of the price difference by buying cryptocurrency from one exchange and selling it on another immediately.


Crypto arbitrage is one trading technique that helps traders earn profits from the crypto market inefficiency. However, these trades have to be performed instantaneously to earn any amount of profit, else the market may fluctuate, and you may end up with a loss.


Arbitrage is a familiar concept that has been around since stock, bond, and foreign markets emerged. It simply refers to buying and selling the same asset on different markets to make a profit from the difference between the listing price on both these exchanges.


For example, if Bitcoin is available at a higher price on exchange A than on exchange B you can buy BTC on exchange B and sell it on exchange A to pocket the difference.


Opportunities may arise due to price differences caused by a rapid surge in trading volumes or inefficiencies within the exchange. Smaller platforms tend to follow the prices set by larger exchanges, but this doesn’t happen instantly. This is where arbitrage happens.


Bigger exchanges can offer better prices, whereas smaller exchanges have to try and compete with them to offer something similar. But these prices depend on supply and demand so that smaller exchanges may actually be more stable.


Leveraging is possible as long as the crypto markets are not perfect. There are mainly two types of crypto arbitrage:


Arbitrage between exchanges (also known as Triangular arbitrage)

Arbitrage within the exchange

We are already quite familiar with arbitrage between the two exchanges. For an opportunity to happen within the exchange, you need to purchase two different cryptocurrencies from the same exchange and sell it when there’s a price difference. If any trader is looking for crypto arbitrage, then they must take into account the risks and rewards associated with it.


The normal arbitrage in finance is spatial arbitrage (or triangular arbitrage for three exchanges), where it is about taking advantage of differences in the listing prices on different exchanges. There are two other methods – cross-border arbitrage and statistical arbitrage.


Cross-border arbitrage is arbitrage in two exchanges that are situated in different countries. You can also have cross-border arbitrage in the form of triangular arbitrage which consists of three exchanges offering differences in pricing.


Statistical arbitrage is quite difficult to pull off as it involves mathematical modelling. It is quite risky as in a crypto market; things can change within a short period.


How Does Cryptocurrency Arbitrage Work?


Arbitrage can be caused by various market factors. But, one of the major factors is the difference in trading volumes between the exchanges.


In larger exchanges, the trading volumes of cryptocurrencies may be quite high, which leads to lower prices. Whereas in other exchanges where the trading volume is minimal, the price of the crypto coins might be quite high.


There have been instances where people bought cryptocurrencies from smaller exchanges and sold it on larger ones for arbitrage. One such case was observed in 2017, where Bitcoin on a local exchange was much higher than quoted on international exchanges.


Crypto arbitrage also occurs when a crypto coin is listed on popular exchange. Even geography plays an important role in arbitrage as it may be easier or harder to sell during different times of the day. To be successful at this, you need to look out for an opportunity. Once you notice an opportunity, you need to execute it quickly. You can document in your order book how much you will make by buying and selling on different platforms, and then make a decision accordingly.


It takes around 15-20 minutes for major coins to confirm the transaction. If the market price drops within this time frame, then you may run a risk of generating less arbitrage.


Simultaneous arbitrage is rare in the crypto world as the market is quite volatile. You may even have to wait for a couple of days to execute the perfect arbitrage. This is the case of single-side trade, where you buy the cryptocurrency, and you cannot sell it for arbitrage.


Finally, when you execute the crypto arbitrage, ensure that you don’t mess things up. Make sure to double-check your analysis of the buy and sell listings on the exchanges. Also, have a closer look at the trading volumes.


You may be able to find programs that do the arbitrage work for you, but they might not be quite effective as there are plenty of risks to consider, for instance, security. To be able to perform crypto arbitrage, you also need to open up accounts in various exchanges. Doing so might make yourself vulnerable to a security risk.


Bitcoin Arbitrage Example 

The best way to explain bitcoin arbitrage is to look at an example. Let us consider two exchanges that both list Bitcoin. Let’s call them Exchange Y and Exchange Z.


Exchange Y is a major exchange with a high trading volume where the price of BTC is $10,000. Exchange Z is a smaller exchange with a low trading volume where the price of BTC is $10,015.


Suppose if the US Internal Revenue Service announces that BTS deposits will not be subjected to any tax. This would cause an influx of trades everywhere particularly in the US. Now here, the price difference due to the difference in trade volumes is around $15.


More users will purchase BTC from exchange Y, due to which the price will increase to $11,140, whereas the price of BTC on exchange Z will only be $11,000. This is where arbitrage comes in. You have the option of purchasing BTC from Exchange Z at $11,000 and then selling it on Exchange Y for $11,140, acquiring a profit of $140 per BTC.


In this example, we do not consider the transaction and fees, transaction procession times, and potential price changes between the transactions.


Pros Of Crypto Arbitrage


Fast Profit


You can perform crypto arbitrage as early as the transactions are completed, which may be within an hour or lesser. This is much quicker than traditional trading where you buy and hold cryptocurrency to sell at a later date.


Wide Range of Opportunities


There are numerous crypto exchanges in the market these days. With so many, there’s a wide range of arbitrage opportunities. According to Coindesk, there are more than 391 cryptocurrency exchanges in the world today.


The Crypto Market is Still Developing


Cryptocurrency is yet to be widely accepted by the public, and hence the crypto market is still in the early stages of development. Due to this, there is quite a bit of irregularity, disjointing, and lack of information transfer between exchanges. There are also a fewer number of crypto traders and less competition in the market, which leads to potential price differentials.


Cryptocurrencies are Still Volatile


Although the first cryptocurrency, Bitcoin, was launched way back in 2009 by Satoshi Nakamoto, it is still one of the most volatile cryptocurrencies in the market. This is due to the changes in supply and demand and highly because the coin is decentralised. With cryptocurrencies being so volatile, there can be huge price changes between exchanges. This gives us an opportunity for arbitrage.


Cons Of Crypto Arbitrage


KYC Restrictions


To trade on any cryptocurrency exchange, you need to adhere to the KYC regulations that are in place. Sometimes, you need to hold a bank account in the same country where the exchange is based, or you may need to link your bank account and verify your identity. It may also take up to 24 hours to verify your account via KYC before you can trade.

Storing Coins


Since you need to access multiple exchanges for arbitrage, you may need to store your coins across them all. Since these crypto coins are stored in an online account, they are susceptible to hacks. Some of these smaller less known businesses also tend to steal the coins from their customers. So you need to be aware of this risk before you start signing up for crypto trading on less established platforms.


Fees


Crypto exchanges do not let you deposit, withdraw, or trade for free. They charge a definite percentage of the money as fees. So you need to include the fees while calculating the profit made from arbitrage.


Large Trades Provide Better Profit


Profits from arbitrage might be quite small after all the processing delays and fees that apply. To be able to make huge profits from arbitrage, you need to increase the trade volume.


Withdrawal Limits


When you place large trades, you need to keep in mind that exchanges have specific withdrawal limits. So you may not be able to withdraw the crypto balance from your wallet on the same day.


Timing


Each cryptocurrency transaction may take at least 10 minutes to be completed and verified by the miners. Within this period, the market may move against you, and you may lose your potential arbitrage profit. There are many cases where the trader has not received any profit as the market collapsed, and the profit turned into a loss.


In some cases, you might have bought coins from one exchange, but the market moved against you, and you were not able to sell the coin on another exchange.


Slower Transactions


With a surge in the trading volume on the global cryptocurrency markets, transactions take a longer time to be processed and verified. This could be a major issue when you are looking to transfer funds quickly. Bitcoin transactions take much longer to be processed when compared to Ethereum (ETH) transactions.

Competition


There may be more traders looking for arbitrage, and this may lead to changes in the trading volumes on different exchanges. This may also reduce arbitrage opportunities for others.




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