Cryptocurrency arbitrage has become more popular in recent years as cryptocurrency markets have grown and the risks involved with individual cryptocurrencies have decreased.
Cryptocurrency arbitrage is the process of taking advantage of price differences between cryptocurrency exchanges to make profit.
Although there are still some hurdles and pitfalls to contend with, arbitrage opportunities are common and profitable when you know how to find them.
This article will give you an overview of the cryptocurrency arbitrage business so that you can determine if it’s right for you.
What is Arbitrage Trading?
Opportunities for arbitrage, whether in traditional financial markets or in the crypto markets, exist, but it seems as though there’s more hype surrounding the idea of it in the crypto world.
Volatility in the crypto market means that the asset’s value may substantially change over a short period of time.
For crypto asset traders, there are many more opportunities to find In arbitrage when trading due to how the prices are different on different exchanges around the world.
A cryptocurrency trader will need to be observant of where the pricing discrepancies are and be able to execute transactions to take advantage of the price differential.
A cryptocurrency arbitrage is when someone might spot a price difference on the different cryptocurrency exchanges, and make money by buying bitcoin on one site and selling it on another to make a profit.
How Profitable Is Crypto Arbitrage?
In 2018, arbitrage has been one of the most lucrative ways for traders to earn money from cryptocurrencies.
It’s easy to see why: if you can identify price differences between two exchanges and execute trades on both sides simultaneously, you can make risk-free profits.
Why are Crypto Exchange Prices Different?
Crypto markets tend to have high volatility, which means it’s common for prices on different exchanges to be at different levels.
If you have coins sitting on one exchange that are worth more than they are on another, it can make sense—economically—to arbitrage by buying where your coins are cheaper and selling where they’re worth more.
The below are reasons why crypto exchange price are different
- Centralized exchanges
First of all, you need to know that the price of digital assets on centralized exchanges are driven by the most recent matched bid-ask order.
For example, the most recent order matched on an exchange to buy bitcoin for $60,000 becomes the latest price of bitcoin quoted on the platform. It’s a continual process of ascertaining the value of a digital asset.
It’s best to be aware that the price will vary depending on investor demand as there are multiple exchange rates to look out for.
- Decentralized exchanges
Contrary to a centralized crypto exchange, decentralized crypto exchanges are driven by an automated market maker system, which utilizes traders to exchange coins so prices are similar across the board.
Here, instead of the order book system where buyers and sellers are matched to trade crypto assets at a certain price and amount, decentralized exchanges use liquidity pools. Each crypto trading pair must have its own pool.
For example, if someone wished to trade ETH for LINK, they would need to find an ETH/LINK liquidity pool on the exchange.
Anyone with funds of their own can provide a share of their own funds to other users by means of funding pools in return for shares of the trade fee revenue.
One major benefit of this system is that there is no need to find an opponent who will match their buy and sell prices at the same time. You can trade at any time.
For the most part, a mathematical formula regulates the price of each asset in the pool (A and B) on most decentralized exchanges.
What this means is that when a trader wishes to purchase ETH tokens on the ETH/LINK platform, he will have to deposit LINK tokens into the ETH/LINK pool in order to receive ETH tokens.
When this happens, the protocol causes the ratio of assets to change (more LINK tokens in the pool and less ETH tokens). In order to return balance, the protocol automatically lowers the price of LINK tokens and increases the price of ETH tokens. It forces the trader to convert some of the cheaper LINK tokens into ETH.
In circumstances where a trader changes the ratio significantly in a pool (executes a large trade), it can lead to dramatic changes in the price of the assets in the pool, which can create very different values when compared to their average value across other exchanges.
Types of Crypto Arbitrage Strategies
Cross-exchange arbitrage: This is the simplest form of arbitrage trading. An arbitrage trader profits by buying on one exchange and selling on another.
Spatial arbitrage: The key difference is that the exchanges are located in different countries. For example, capitalizing on the difference in the demand and supply of bitcoin in America and South Korea through spatial arbitrage would work.
Triangular arbitrage: This is the process of transferring funds from one or more digital currencies to the account of another for the purpose of purchasing, the second crypto at a discounted price, e.g. a trader could create a circular trading loop with the first and final destination being the same cryptocurrency.
You could swap bitcoin for ether, then exchange the ether for Cardano’s ADA token and finally convert the ADA back to bitcoin. In this example, the trader moves his funds among three crypto trading pairs – BTC/ETH → ETH/ADA → ADA/BTC.
If there are different prices between the three bitcoin trading pairs, then the trader will end up with more bitcoin than they started with. In this scenario, all the transactions are done on one exchange. As a result, the trader does not need to withdraw or deposit funds at multiple exchanges.
Decentralized arbitrage: If the prices of crypto trading pairs on centralized exchanges are significantly different from their spot prices on decentralized exchanges, traders will use arbitrage to get profits by executing cross-exchange trades involving the decentralized exchange and a centralized exchange.
Statistical arbitrage: is a strategy that uses econometric, statistical, and computational methods to identify trading opportunities and act on them in a scalable way. People who use this method rely on math-based strategies and computer programs to execute high-frequency arbitrage trades as well as make more profit. Computerized trading mechanisms called trading bots execute high volumes of trades in rapid succession according to predefined trading strategies.
Why is Crypto Arbitrage Considered a Low-risk Strategy?
Unlike day traders, crypto arbitrage traders don’t have to predict the future prices of bitcoin nor enter trades that can take hours or days before they start generating profits.
With the intent of making fixed profit, traders exploit what is called arbitrage opportunities and time their investments with specific precision.
Traders, though, can only analyze their investment when their predictive strategy, which does not depend on other analytical pricing, does not predict the direction of the trade.
The conclusion to be drawn is that a short period of time may pass before an opportunity can be detected. Taking these factors into account, it’s therefore possible to conclude the following
One benefit of cryptocurrency arbitrage trading is that the risk is less than other strategies, but the most important requirement is an in-depth knowledge of the trends.
As an arbitrage trader, it’s their job to trade stocks only for a short amount of time and so the chance of experiencing trading losses is lower.
On the other hand, that doesn’t mean that crypto arbitrageurs are completely safe from risk.
Crypto Arbitrage Trading Risks
Certain factors will lower an arbitrageur’s chance of generating profit.
Factors like the low-risk nature of arbitrage opportunities make them less profitable.
Fewer risks equals lower profits, and that’s why crypto arbitrageurs must execute high volumes of trades to earn sizable profits. Moreover, arbitrage trades are not cost-free.
All things considered, bear in mind that arbitrage trading across two exchanges will come with trading, withdrawal, and deposit fees. Looking at our original example, let’s assume the withdrawal fees of Coinbase, deposit fees of Kraken, and trading fees of Kraken would come to an extra 2%. This means the total cost of executing this trade would be $45,000 + (2% * $45,000) = $45,900. Consequently, it is impossible for the crypto arbitrage trader to have earned any money because their potential profit is only $200.
In order to decrease the risks of financial losses due to high fees, arbitrageurs could limit their trades to exchanges with a competitive fee structure.
They could also invest in various markets and periodically trade their funds between various exchanges in order to profit from market inefficiencies.
For example, Bob looks at the price disparities between bitcoin on Coinbase and Kraken and decides to get involved. Instead of exchanging funds between the two exchanges, Bob has funds denominated in tether (USDT) on Coinbase and 1 BTC on Kraken.
Therefore, in order to take advantage of this trading opportunity, all he has to do is sell 1 BTC on Kraken for $45,200, transfer this money to Coinbase and buy 1 BTC for $45,000 USDT. Once this is done, he generates the $200 profit and saves himself from having to pay withdrawal and deposit fees.
Here, Bob has to worry about only one fee, which is the trading fee. It’s worth mentioning that the trading fee is not too expensive for traders who execute a lot of trades.
Crypto arbitrage trading has a limited window of opportunity; because more traders jump on the bandwagon to take advantage of the discrepancy in prices between exchanges, the price disparity typically dissipates quickly.
Suppose that Bob happened to spot and exploit the opportunity in the situation from our original example first. In retaliation, Sarah then attempted the same thing.
In this situation, when Bob purchases bitcoin on Coinbase at $45,000 and sells on Kraken at $45,020, Sarah might no longer be able to execute this trade at this exact price due to the market’s competitive nature.
She may have to buy bitcoin on Coinbase for $45,005 and sell on Kraken for $45,015. As bitcoin prices across Coinbase and Kraken converge, you will have a diminished opportunity to profit from trading.
The below mentioned factors may affect the time it takes to execute crypto arbitrage trades
- The transaction speed of the blockchain: To execute an arbitrage strategy that includes cross-exchange transactions, the time it takes to validate transitions on the blockchain could hinder your ability to execute transactions quickly. For example, transactions on the Bitcoin blockchain may take anywhere from 10 minutes to one hour to be confirmed. With time, the markets may have moved in the wrong direction for arbitrageurs. To minimize their losses, arbitrageurs should go for fast blockchain. for those that do not experience congestion on the network.
- The AML checks of exchange: Exchanges usually carry out anti-money laundering checks on traders before large sums are moved. The checks can sometimes take weeks. All of this means that you ought to keep in mind the extra security measures taken by crypto exchanges and other operations as you execute cross-exchange arbitrage trades.
- Offline exchange servers: Sometimes crypto exchanges have disruptions. Sometimes exchanges limit deposits and withdrawals for one reason or another. When this happens, you have to rely on other kinds of investment to get higher returns.
While arbitrage traders deposit money on exchange wallets, they are vulnerable to exchange hacks and exit scams. Exit scams occur when a company abruptly ceases operations and robs customers of their money. Based on this information, we advise diligence and compliance with leading crypto exchanges.
How to start arbitrage trading
Even if you’re new to crypto arbitrage trading or have years of experience in it, the best thing about crypto arbitrage trading is that you have plenty of choices.
Whether you want to set up your bot, or don’t want to worry about it, these sites offer a great passive income opportunity. And these sites include
How To Successfully Run a Crypto Arbitrage Business
For arbitrage to be successful, you need to think about the following
- Look Out For Opportunities:
For one to succeed in the crypto arbitrage business, they need to learn how to calculate profit and have the knack to be on the lookout for opportunities.
This is the one skill a crypto arbitrage trader needs to have in order to do well. In the cryptocurrency arbitrage game, the person who discovers an opportunity and exploits it will likely take more profits than someone who discovers it too late.
- Scrutinize The Opportunity:
It is one thing to identify potential crypto arbitrage opportunities and it is another thing to determine whether or not they are worth pursuing.
Without vetting the situation and considering all of the factors, the endeavor is just likely to result in more losses than profits. To accurately understand the price you’ll be paying, you need to figure out what you’ll be paying in transaction fees, network fees, and in wallet costs.
Only once you do these calculations can you make an informed decision on whether or not you want to continue to trade or if you want to look for an opportunity elsewhere.
- Be Time Sensitive:
To be a good crypto arbitrage trader, you must know that time is the most important thing in this line of work and act accordingly.
The price of cryptocurrencies changes quickly, even when trading at exchanges. When you use your time wisely, you will make a profit or save some losses.
Trades in the crypto market need to be done with caution and proper risk management. Crypto arbitrage, in particular, is one of the least exploited crypto opportunities and this is because many people lack knowledge of how to successfully execute a crypto arbitrage operation.
It’s important to understand what this business is based on and the strategies you will need in order to create a significant profit.