Crypto trading is slowly becoming an amazing game for traders as the strategies which were now implemented only in sophisticated markets are now available in crypto markets. In fact, in some cases, its much better bet to play those strategies in cryptos than anywhere else. One such roll of the dice is Arbitrage which slowly is becoming the best strategy for crypto traders to make profits.
To define, Arbitrage is the concurrent and synchronized purchase and sale of an asset to profit from a disparity in the price in two different markets.
It is a strategy which the trader implements to make profits by exploiting the difference in the price of exactly the same instrument or asset in different markets. The strategy was born and continues to exist due to the inefficiencies of markets and would not have existed if markets were perfect.
Explaining: What is Bitcoin Arbitrage
Arbitrage takes place when a trader purchases a security from one market identically sells it in another market for a higher price thus making a profit due to the imparity of the markets. Arbitrage tries to find gaps in the market prices and delivers profit before that price differential is filled or recovered. Arbitrage also tries to provide a full-proof mechanism to the markets which ensure that the price does not deviate much from the face value for a significant period of time.
In matured markets like the equities, technological superiority of the systems has nearly squeezed the chance of getting an arbitrage opportunity. Exchanges, today, have deployed specialized computer systems that monitor and detect price differentiation so that no trader can make money out of market inefficiencies due to an undue advantage.
Arbitrages are of a variety of types and continue to happen as far all markets selling the same coin (say Bitcoin), asset or securities quote the same price for it. A trader would continue to buy and sell the same asset at different markets as much as wanted and as much as he can make a profit.
Example: Simple Bitcoin Arbitrage
To understand the Bitcoin arbitrage with a simple example, let us look at the following scenario.
- Let us consider that Bitcoin is trading at $10000 on the while on exchange A, at the same moment; it is trading for $10200 on Exchange B.
- For a successful arbitrage to happen, a trader will buy bitcoin on Exchange A and immediately sell the same on Exchange B, earning a profit of $200 per bitcoin.
- A trader, who is a true arbitrageur, will continue to exploit this market difference until some exchange specialists or market forces adjust the prices between the two exchanges to wipe out the opportunity.
Example: Triangular Arbitrage
Triangular Arbitrage is considered slightly complex because there are 3 different assets trading pairs are involved where a trader buys and sells his assets to take advantage of the price difference. What is crucial here is the speed at which the transaction happens which is near-instant in all three markets before the market forces bring parity in the prices in all three markets
Exchange 1: XRP/USDT = 0.894
Exchange 2: XRP/British pound = 1.276
Exchange 3: USDT/British pound = 1.432
Now what happens here is, consider that
- The trader has 2 million worth of XRP, he would convert the 2 million XRP to USDT at the 0.894 rates, giving the trader 1,788,000 USDT.
- Next, he moves to the second pair, where he would transact the 1,788,000 USDT to convert them to GBP or the British Pounds at the rate of 1.276, giving the trader GBP or British Pound 1,401,254.
- Next, he moves to the third pair to complete his triangle where the trader takes the GBP or British pounds of the second trade and transacts them back to USDT at the 1.432 rates, giving the trader USDT 2,006,596.
- By this series of trades, the total risk-free arbitrage profit of the trader would be $6,596.
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Why Do Crypto Arbitrage Opportunities Arise?
Anyone who has seen crypto trading knows that there are a variety of exchanges across the globe which trade almost the same coins, at least the major ones. Say for example at this point (while going to press) the prices quoted for Bitcoin around exchanges is –
Also the prices on top exchanges which were as follows:
- Kraken – $9,618.80
- Coinbase Pro- $9,617.00
- Gemini – $9,621.78
- Bitfinex – $9,637.48
- Bitstamp – $9,610.32
Why does this happen? A few reasons which could be responsible for this are
- Liquidity: Bitcoin has been scoring massive volumes on prominent crypto exchanges since the interest in crypto trading has picked up such as Binance, Kraken, Coinbase Pro, etc. but has remained much lower on several smaller exchanges. These differences in supply across exchanges affect the price of Bitcoin.
- No common way to find fair value Bitcoin: While there have been many theories about how one values the bitcoin, there has been no common centralized formula that could do so. Because of this, no one actually knows the fair price and the trades take place depending on what the trader feels the fair price could be. Hence all trades in exchanges happen on the pure sense of judgment, and their price discovery happens on what the buy and seller feel about it.
- Infrastructure Issues: This problem is because of the nascency of the industry which obstructs buyers from quickly purchasing cryptos across multiple exchanges at once; hence the price differences persist. This will surely go off once the technology in crypto exchanges increases but there is still a lot of time.
Barriers to Arbitrage
While arbitrage looks fabulous and an exciting money-making opportunity, traders should realize that there are certain key barriers that obstruct arbitrage opportunities.
- Verification Time: Again due to the structure of cryptocurrencies and the way the trading takes place, it may take some time for transactions verification (between two exchanges), and due to volatility in the markets, there are chances that, during this time, the price of Bitcoin may change.
- Regulatory Verifications: A lot of exchanges due to regulatory pressures and security reasons do make traders go through a considerable amount of verification steps. These steps further increase where there is a larger amount of coins that need to move in and out of the exchange.
- Fees: If you go through the above examples a major component that is missing here is that of Exchange fees will eat away at your profits. This includes Fiat deposit fees, fiat withdrawal fees, bitcoin deposit fees, bitcoin withdrawal fees, and transaction fees.
- Liquidity: Arbitrage only would be good and profitable if the volumes are high enough on both exchanges as arbitrage is done with high volumes of cryptos and the transactions need to go through.
- Exchange Reputation: One big caution that a trader needs to keep in mind which transacting on the exchange is the reputation of the exchange. The price difference in the exchange may also be due to technical issues. An amazing example for this is the exchanges that have been hacked and where the price of Bitcoin suddenly goes extremely low because traders don’t trust the exchange and often is the scenario that there are no buyers or takers.
Is Arbitrage Legal?
Arbitrage is completely legal and is practiced all across the globe and across assets and commodities where there is a price difference between two exchanges or market places.
Overall, Bitcoin arbitrage is an amazing opportunity for traders to generate some good income, but as a caution, it comes with huge risks. The act of arbitraging Bitcoin is not as simple as it may seem at the first look even though Arbitrage is actually a process which is far more positive than speculation and margin trading which is often termed as price manipulation.