Arbitrage is a trading strategy in which an asset like a cryptocurrency is bought in one market and sold immediately in another market at a higher price.
Every day, tens of billions of dollars worth of cryptocurrency changes hands in numerous trades. But unlike traditional stock exchanges, there are dozens of cryptocurrency exchanges, each displaying different prices for the same cryptos.
For savvy traders—and those who aren’t averse to a little risk—that opens up a good chance to get the edge over their compatriots: play these exchanges against each other. Welcome to the world of crypto arbitrage.
What is cryptocurrency arbitrage?
Cryptocurrency arbitrage is fairly self-explanatory; it’s arbitrage using cryptocurrency as the asset in question. This strategy takes advantage of how cryptocurrencies are priced differently on various exchanges. On Coinbase, Bitcoin might be priced at $48,200, while on Binance it could be priced at $49,800. Exploiting this difference in price is the key to arbitrage. A trader could purchase Bitcoin on Binance, move it to Coinbase, and sell the Bitcoin—profiting by around $200.
Speed is the name of the game—these gaps often don’t last long. But the profits can be immense if the arbitrageur times the market properly. When Filecoin hit exchanges in October 2020, some exchanges listed the price for $30 in the first hours. While others listed it for $200.
How do crypto prices work?
So how does cryptocurrency get its value? Some critics point out that crypto is not backed by anything, so any value assigned to it is purely speculative. The counterargument is roughly that if people want to pay for a cryptocurrency, then that coin has value. Like most unresolved arguments, there’s truth to both sides.
On exchanges, there are order books. These order books contain buy and sell orders at different prices. For instance, a trader could make a “buy” order to buy one Bitcoin for $45,000. This order would go on the order book. If another trader aims to sell one Bitcoin for $45,000, they could add a “sell” order to the book, thus fulfilling the trade. The buy order is then taken off the order book as it has been filled. This process is trading.
Crypto exchanges price a cryptocurrency on the most recent trade. This could come from a buy order or a sell order. Taking the original example, if the sale of the lone Bitcoin for $45,000 was the most recently completed trade, the exchange would set the price at $45,000. A trader who then sells two Bitcoin for $45,100 would move the price to $45,100, and so on. The quantity of crypto traded doesn’t matter, all that matters is the most recent price.
Every crypto exchange prices cryptocurrencies this way, save for some crypto exchanges that base their prices on other cryptocurrency exchanges.
Different types of arbitrage
One way of cryptocurrency arbitrage is to purchase a cryptocurrency on one exchange, then transfer it to another exchange where the currency is sold at a higher price. There are some problems with this way, however. Spreads usually only exist for a matter of seconds, but transferring between exchanges can take some minutes. Transfer fees are another problem, as moving asset from one exchange to another incurs a charge, whether through withdrawal, deposit or network fees.
One way that arbitrageurs get around transaction fees is to hold currency on two different exchanges. A trader employing this method can then buy and sell a cryptocurrency at the same time.
Here’s how that might play out: A trader might have $45,000 in a US dollar-pegged stablecoin on Binance and one Bitcoin on Coinbase. When Bitcoin is valued at $45,200 on Coinbase but only $45,000 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 BTC, but they would be making $200 due to the spread between the two exchanges.
This strategy involves taking three various cryptocurrencies and trading the difference between them on one exchange. (Since it all happens on one exchange, transfer fees aren’t an issue).
So, a trader might face an opportunity in arbitrage involving Bitcoin, Ethereum and XRP. One or more of these cryptocurrencies may be undervalued on the exchange. So a trader might take advantage of arbitrage opportunities by selling their BTC for ETH, then using that ETH to buy XRP, before finishing by buying BTC back with the XRP. If their strategy made sense, then the trader will have more BTC at the end than when they started.
Statistical arbitrage involves using quantitative data methods to trade crypto. A statistical arbitration bot might trade many different cryptocurrencies at once, carefully working out the chance that a bot might profit from a trade based on a mathematical model, and going “long” or “short” on a trade.
Normally, a bot will give a crypto that’s performed really well a low score and once that’s performed particularly badly a high score; there are bigger profits to be reaped from those that performed well. A trading algorithm worth its salt will be great at making mathematical models that can estimate the price of cryptocurrencies and can expertly trade them against each other.
Decentralized Finance (DeFi) Arbitrage
Decentralized finance, or DeFi, are non-custodial financial protocols that operate, without third party, as lending protocols, stablecoins and as exchanges. Their code-heavy architecture makes them perfect for arbitrage; there are many different strategies that “DeFi degens” looking to try arbitrage can employ.
One such strategy aims to turn a profit from the various yields provided by DeFi lending protocols. If one platform provides a 10% yield from a stablecoin, and another offers an 11% yield from a different stablecoin, then a trader could convert their low-yield stablecoin into a high-yield one to earn that extra 1%. Different platforms do this automatically. Yearn.finance, the DeFi project of Andre Cronje, automatically moves funds across different decentralized finance protocols to gain the best yield.
Another method is to profit from prices on different exchanges. This functions just like the “between exchanges” type of arbitrage, only in this case it relies on decentralized exchanges such as Uniswap. Some decentralized exchanges give different prices for coins and it’s possible to earn money by profiting from the difference. You can also profit from front-running other trades. If a DeFi trader sees a great opportunity, they might want to place that trade as quickly as possible to make their money. But a bot could pay a little bit more money to ensure that its trade is processed first. By jumping to the front of the queue by paying heightened gas fees, a trading bot could make a little extra moolah.
Arbitrage trading risks
There are lots of risks associated with arbitrage trading. One of these is slippage. Slippage happens when a trader makes an order to purchase a cryptocurrency, but their order is larger in size than the cheapest offer on the order book, making the order to ‘slip’ and cost more than they expected to pay. This is a problem for traders, especially since the margins are so small that slippage could wipe out potential profits.
Price momentums is another risk associated with arbitrage. Traders need to be quick to take advantage of spreads when they form, as the spread could disappear within some seconds. Some traders program bots to perform arbitrage trading, which has only added to the competition.
Finally, traders need to take into account transfer fees. Spreads are rarely very large for the leading cryptocurrencies, and with tight margins a transferral or transaction fee could wipe out any potential profit. These tight margins also mean that any trader who aims to make massive gains must carry out a large number of trades.