What Exactly Is Crypto Arbitrage and How Does It Work? (2021)

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With tens of billions of dollars worth of cryptocurrencies crossing hands across exchanges, some traders benefit by pitting them against one another.

Tens of billions of dollars in cryptocurrencies move hands in millions of deals every day. Unlike traditional stock exchanges, however, there are hundreds of cryptocurrency exchanges, each with a different pricing for the same coins.

For clever traders—and those who aren’t afraid of a little risk—this presents a chance to get an advantage over their competitors: play these trades against one other. Hello and welcome to the world of cryptocurrency arbitrage.

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

Crypto arbitrage is self-explanatory; it is arbitrage using cryptocurrency as the asset in issue. This method takes use of the fact that cryptocurrency prices vary among exchanges. Bitcoin may be valued at $10,000 on Coinbase, but it may be valued at $9,800 on Binance. The key to arbitrage is to take advantage of this pricing discrepancy. A trader may purchase Bitcoin on Binance, transfer it to Coinbase, and then sell it for a profit of roughly $200.

The name of the game is speed, and these gaps generally don’t stay long. However, if the arbitrageur accurately timed the market, the rewards can be enormous. When Filecoin hit exchanges in October 2020, some exchanges listed the price for $30 in the first few hours. Others? $200.

How do crypto prices work?

So, where does the value of cryptocurrencies come from? Some detractors argue that because Bitcoin isn’t backed by anything, any value attributed to it is merely speculative. The counterargument is that if people are prepared to pay for a cryptocurrency, it must have value. As with most unsolved debates, there is truth on both sides.

The game is played out in order books on exchanges. These order books include purchase and sell orders at various prices. A trader, for example, may place a “buy” order for one Bitcoin at a price of $30,000. This order would be added to the order book. If another trader wishes to sell one Bitcoin for $30,000, they may put a “sell” order to the book, which will complete the transaction. The buy order is then taken off the order book as it has been filled. This process is called a trade.

The most recent trade is used to price a coin on cryptocurrency exchanges. This might be the result of a purchase or sell order. Using the initial example, if the most recent completed deal was the selling of the lone Bitcoin for $30,000, the exchange would fix the price at $30,000. If a trader then sells two Bitcoin for $30,100, the price will rise to $30,100, and so on. The amount of cryptocurrency exchanged is unimportant; what matters is the most recent price.

Except for certain crypto exchanges that base their pricing on other cryptocurrency exchanges, every crypto exchange rates cryptocurrencies in this manner.

Different types of arbitrage

Between exchanges

Buying a cryptocurrency on one exchange and then transferring it to another exchange where the currency is traded at a greater price is one technique of crypto arbitrage. However, there are a few issues with this strategy. Spreads are often only present for a few seconds, but shifting across exchanges might take minutes. Another issue is transfer costs, which apply when moving cryptocurrency from one exchange to another, whether through withdrawal, deposit, or network costs.

Crypto exchanges list
The price of Bitcoin can differ between exchanges. Image: Coinranking.com

Arbitrageurs can avoid transaction fees by holding money on two separate exchanges. Using this strategy, a trader may purchase and sell a coin at the same time.

Here’s how it could go down: A trader may have $30,000 in a stablecoin tied to the US dollar on Binance and one Bitcoin on Coinbase. When Bitcoin is worth $30,200 on Coinbase but only $30,000 on Binance, the trader will purchase Bitcoin on Binance (using the stablecoin) and sell Bitcoin on Coinbase. They would neither gain or lose a Bitcoin, but they would profit by $200 because of the disparity between the two exchanges.

Did you know that?

USDT (Tether) is a cryptocurrency that is linked to the value of a single US dollar. Because of its relative stability, cryptocurrency traders frequently utilise it. It makes it easy to store cryptocurrencies without fear of their price plummeting dramatically. The benefit of retaining stablecoins like Tether rather than converting crypto to cash is that crypto-to-fiat transfers sometimes suffer exorbitant fees.

Triangular arbitrage

This strategy entails trading the difference between three distinct cryptocurrencies on a single platform. (Because it all happens on one exchange, transfer costs aren’t an issue.)

As a result, a trader may identify an opportunity in Bitcoin, Ethereum, and XRP arbitrage. On the exchange, one or more of these cryptocurrencies may be undervalued. So a trader may profit from arbitrage chances by selling Bitcoin for Ethereum, then using the Ethereum to buy XRP, and then purchasing Bitcoin again with the XRP. If their approach worked, the trader will end up with more Bitcoin than they started with.

Statistical Arbitrage

Statistical arbitrage is the use of quantitative data models to trade cryptocurrency. A statistical arbitration bot may trade hundreds of different cryptocurrencies at the same time, meticulously calculating the likelihood that a bot would benefit from a transaction using a mathematical model and going “long” or “short” on a transaction.

In general, a bot will give a cryptocurrency that did exceptionally well a low score and a cryptocurrency that did exceptionally poorly a high score; those who did very well will reap greater rewards. A good trading algorithm will excel at developing mathematical models that can anticipate the price of cryptocurrencies and expertly trade them against each other.

Arbitrage in Decentralized Finance (DeFi)

Decentralized finance, or DeFi, refers to non-custodial financial protocols that operate as lending protocols, stablecoins, and exchanges without human interference. Their code-heavy nature makes them ideal for arbitrage; “DeFi degens” interested in attempting arbitrage can apply a variety of tactics.

One such technique seeks to profit from the different returns provided by DeFi lending methods. If one platform gives a 10% return on a stablecoin while another provides an 11% yield on a different stablecoin, a trader might exchange their low-yield stablecoin into a high-yield stablecoin to make that extra 1%. This is done automatically by a number of systems. Yearn.finance, Andre Cronje’s DeFi project, automatically allocates funds between several decentralised finance protocols to maximise returns.

Another technique is to profit from prices on different exchanges. This functions just like the “between exchanges” type of arbitrage, only this time it relies on decentralized exchanges like Uniswap. Some decentralized exchanges offer different prices for coins and it’s possible to earn money by profiting from the difference.

 

It is also feasible to benefit by trading ahead of other deals. If a DeFi trader recognises a wonderful opportunity, they may want to place the deal as soon as possible in order to profit. A bot, on the other hand, may spend a little extra money to ensure that its deal is processed first. A trading bot may earn some more cash by moving to the head of the queue and paying higher gas fees.

Arbitrage trading risks

Arbitrage trading comes with a number of dangers. Slippage is one of these. Slippage happens when a trader places an order to acquire a cryptocurrency that is greater in size than the cheapest offer in the order book, causing the transaction to ‘slip’ and cost more than the trader anticipated. This is an issue for traders, particularly when the margins are so thin that slippage might wipe out prospective winnings.

Another risk linked with arbitrage is price change. Traders must be fast to capitalise on spreads when they occur, as the spread may vanish in a matter of seconds. Some traders use bots to do arbitrage trading, which has increased competition.

Finally, dealers must consider transfer costs. Spreads for the major cryptocurrencies are rarely extremely wide, and with such thin margins, a transfer or transaction charge might wipe out any possible profit. Because of the narrow margins, any trader who wants to make a considerable profit must execute a huge number of deals.

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