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Crypto Arbitrage: What is Crypto Arbitrage and How Does It Work?

What-is-crypto-arbitrage-and-How-does-it-work

In this article, we will explore everything you need to know about crypto arbitrage. We will also mention arbitrageurs’ ability to perform triangular arbitrage on a single crypto exchange. Apart from that, we will analyze risks linked with crypto arbitrage trading. Also, we will learn everything about crypto arbitrage and its work specifics in this overview.

As the crypto market is an excellent place for arbitrage, price variations usually occur. This is a result of market-related inefficiencies. The more inefficient the market, the more room for price freaks and arbitrage chances.

Also, it makes the crypto market an engaging place for crypto arbitrage traders. It is decentralized, with various exchanges offering the same cryptos. Many exchanges increase the possibility that the same crypto will occasionally trade at different prices on multiple exchanges. When the difference is sizable enough, there is a chance to make money.

There are several kinds of crypto arbitrage. One is trading involving two or more cryptos on the same exchange. For example, you can deposit USD on the exchange, use it to buy ETH, sell the ETH to buy EOS coins, and sell the EOS coins in exchange for USD.

What Is Crypto Arbitrage?

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

For example, if Bitcoin is available at a higher price on Coinbase than on Binance, you can buy BTC on Binance and sell it on Coinbase to earn a profit. Chances may appear due to price variations made by a rapid surge in trading volumes or inefficiencies within the exchange. Smaller platforms tend to copy the rates set by larger exchanges, but this doesn’t happen instantly. This is where crypto arbitrage happens.

However, bigger exchanges can offer better prices, whereas smaller exchanges have to compete to provide something similar. But these prices depend on supply and demand so that smaller exchanges may be more stable.

Arbitrage has been exercised for centuries, and it is starting to gain friction in the world of cryptocurrencies. The reason why arbitrage trading is popular in cryptos is the variations in supply and demand, significantly impacting the prices.

With over 200 exchanges being carried out, where you can buy and sell cryptos, there are bound price changes. Hence, you can make a neat amount of profits in a short period. Moreover, carrying out arbitrage is getting easier due to introducing various trading platforms that connect buyers to sellers.

Through the platforms, customers can buy cryptos from markets wherein the demand is low and supply high and sell the coin in a marketplace where the need and the cost are high. However, crypto arbitrage is a great tool when prices aren’t moving much in a day and other crypto-day trading tactics. Such as swing trading, aren’t entirely viable.

How Do Crypto Prices Work?

Some experts point out that nothing backs crypto, so any value allotted to it is speculative. The counter argument is that if people are likely to pay for crypto, then that coin has value. Like most unfinished arguments, there’s truth to both parties.

The game plays out in order books on exchanges. These order books introduce buy and sell orders at different prices. For example, a trader could execute a “buy” order to buy one crypto for $20,000. Besides, this order would go on the order book. If another trader wants to sell one crypto for $20,000, they could add a “sell” order to the book, thus fulfilling the trade. The buy order is then driven off the order book as it has been filled. This process is called a trade.

Crypto exchanges value a crypto on the most recent trade. This could appear from a buy order or a sell order. Taking the original example, if the sale of the lone Bitcoin for $20,000 were the most recently completed trade, the exchange would set the price at $20,000. A trader who then sells two Bitcoin for $20,100 would move the price to $20,100, and so on. The quantity of crypto traded doesn’t matter. All that matters is the most recent price.

Each crypto exchange values this way, except for some crypto exchanges that base their prices on other crypto exchanges.

Different Types of Crypto Arbitrage

When it comes to trading in cryptocurrencies, there are different methods of carrying out crypto arbitrage. Mentioned below is a brief of each method.

Spatial Arbitrage

A common mistake with arbitrage is that you must buy crypto on one exchange, transfer it to another, then sell. While this is one approach, it’s not your only option. Other ways of crypto arbitrage trading don’t rely on waiting for a potentially slow and expensive transfer.

Transferring Between Exchanges

Transferring between exchanges involves buying crypto on one exchange, transferring it to another exchange. It is traded for a higher price and then sold. But, it is not a realistic way to profit because price differences may only exist for a couple of seconds. Therefore, by transferring the crypto to another exchange, the price will probably change again. In addition to trading fees, transfer fees also incur.

Without Transferring Between Exchanges

This arbitrage approach passes the step of transferring crypto between exchanges. You can immediately act on a spare without having to wait on a slow transfer or pay a transfer fee. Besides, it makes a better option for crypto day trading compared to the transfer method. To do this, you hold a balance on two exchanges and submit a buy and sell order at the same time on both exchanges.

For example, some spreads on the BTC-USD market when buying on Coinbase and selling on Binance. You would move your USD to Coinbase and your BTC to Binance, then wait for a spread. When the price difference appears, let say 1.2% more on Binance, you would buy BTC with your USD on Coinbase Pro. At the same time, sell BTC for USD on Binance.

Triangular Arbitrage

This tactic utilizes a single or more exchange while exploiting the differences between the trading pairs. As several exchanges have a wide variety of markets with many currency options, you can utilize many opportunities for triangular arbitrage.

You can trade Bitcoin for Ethereum, Ethereum to LiteCoin, and LiteCoin back to Bitcoin. If the variations were valuable, we would have made a profit.

In addition, to make this example clearer, let us go over the method step by step.

  • Firstly, you need to choose one asset. Here we can take BTC. This asset will be the starting point and the endpoint of our arbitrage loop.
  • Secondly, trade the first asset (BTC) for a second one. Second one is ETH. Take note, ensure that the second asset, the first asset, and the third asset are connected.
  • Thirdly, trade your second asset (ETH) for a third one, here being LTC. Make sure that the third asset, the second asset, and the first asset are connected.

And at the end, all you need to do is convert this third asset (LTC) back to the starting one (BTC).

Statistical Arbitrage

Statistical arbitrage strategies are market neutral because they involve opening both a long position and a short position. Simultaneously, to take advantage of careless pricing in correlated securities. For example, if a BTC is overvalued and ETH is overvalued, they would open a long position in BTC. At the same time, it will open a short position in ETH. Investors often refer to statistical arbitrage as pair trading.

Statistical arbitrage is not strictly limited to two securities. Investors can apply the concept to a group of correlates. Also, just because two stocks operate in different industries does not mean they cannot be correlated.

Generally, a bot will give crypto that’s performed well a low score. Once that’s performed particularly severely, a high score can reap bigger profits from those that served well. A trading algorithm worth its salt will be great at creating mathematical models that can predict the price of cryptos and expertly trade them against each other.

Decentralized Finance (DeFi) Arbitrage

An example of DeFi arbitrage strategy would be to buy ETH in exchange for USDT on a decentralized basis. Afterward, sell it quickly on another decentralized exchange at a higher price. Thus make a profit in USDT and end up with more USDT in your wallet than before the arbitrage. The challenge in arbitrage lies in determining a spread for the same trading pair across two different exchanges.

Another advantage of doing arbitrage on DeFi is that there is no risk of losing money. The transactions can return due to a lack of funds because the smart contract cannot repay a flash loan. On the other hand, centralized exchanges arbitrage traders could lose money during an arbitrage. Since they cannot execute multiple trades in a single transaction, i.e., unlike smart contracts, centralized exchanges’ won’t revert trades.

Thus traders will both have to sell at a loss or keep the unsold token. For example, by the time a trader gets some ETH in exchange for DAI on a centralized exchange. The USD (DAI) value of ETH on the other exchange may have dropped under the expected sell price. Because someone else filled the order from the order book first, leaving the trader with a bag of unsold ETH. This is called price slippage.

Conclusion

The act of arbitraging crypto is not as simple as it may seem at first glance. Overall, crypto arbitrage may be a chance to make some passive income. At the same time, it involves huge risks. Crypto arbitrage is a positive process, unlike speculation, margin trading, and other activities such as market manipulation. But in some cases may even be genuinely harmful to the market as a whole.

Moreover, crypto should have the same price across all exchanges. Crypto arbitrage helps bring the exchanges together onto the same page. As the crypto market grows, the gap between exchanges will narrow as more and more people will conduct crypto arbitrage. Nowadays, almost all exchanges have an API, which can become a helpful crypto arbitrage tool.

Furthermore, utilizing these APIs will allow you to create a custom crypto arbitrage bot. So, you don’t have to sit in front of the computer all day. Still, it is very beneficial to do arbitrage by yourself. As long as you watch closely and make sure you are placing simultaneous trades. However, all trading comes with high risks, so proceed with caution.

FAQ

What is crypto arbitrage?

Crypto arbitrage is a trading strategy that exploits the price differences of an asset. Different types of arbitrage allow trading across different platforms or trading pairs.

How does arbitrage work on the cryptocurrency market?

Arbitrage is a combination of trades that profit by exploiting the price difference of the identical trading pair between two or more crypto exchanges.

Is crypto arbitrage profitable?

When most people think of buying on one exchange, transferring to another exchange, then selling there, that takes too long and doesn’t guarantee a profit, so it’s really not feasible.

What is a triangular arbitrage crypto strategy?

Triangular arbitrage is a trading strategy that exploits the price differences between three different cryptocurrencies on the same exchange to generate profit.

Is Cryptocurrency Arbitrage Legal?

Yes, cryptocurrency arbitrage is legal. Each exchange offers its own rate for a specific cryptocurrency. This price is approximately the same across all exchanges, but sometimes there is a deviation of about 5-10% or rarely as high as 20%.

Disclaimer: The views and opinions expressed in this article are solely the author’s and do not necessarily reflect the views of CoinQuora. No information in this article should be interpreted as investment advice. CoinQuora encourages all users to do their own research before investing in cryptocurrencies.

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A Computer Engineering graduate who writes news focuses on cryptocurrency-related and blockchain technology. He is enjoying using his skills to contribute to informing people of the exciting technological advances that happen every day.