What is arbitrage trading?
Arbitrage is a trading practice that exploits price discrepancies in one asset across multiple exchanges. Although there are many styles of arbitrage trading, they all involve quickly buying and selling an asset to take advantage of a deviation in the quoted price.
Despite the popularity of crypto arbitrage trading, this strategy existed long before Bitcoin (BTC). Investors can find arbitrage opportunities in any tradable asset, including stocks, bonds, and fiat currencies.
In fact, arbitrage traders serve an essential function in financial markets. Arbitrage naturally adjusts an asset’s supply on various exchanges, thus helping even out the bid/ask prices. Extensive arbitrage trading will draw attention to pricing errors on an exchange, which may cause market makers to add or reduce liquidity to adjust prices.
For example, a stock trader may notice shares for the Chinese company Alibaba (BABA) are trading for $85 on the NASDAQ and $87 on the Hong Kong Stock Exchange (HKEX). For every BABA share a trader buys on the NASDAQ, they would make a $2 profit by selling on the HKEX.
If an arbitrage trader bought 1,000 shares of BABA for $85,000 and sold for $87,000 on the HKEX, they would earn a profit of $2,000. In this case, arbitrage traders would also consider the current conversion rates between the USD and the Hong Kong dollar, which may increase or decrease the success of this trade.
How does crypto arbitrage work?
Arbitrage trading in crypto works the same as it does in traditional markets. Traders must quickly buy and sell an asset across platforms whenever they notice a price inefficiency. The only difference is that cryptocurrency arbitrage traders focus on crypto assets like Bitcoin or Ethereum (ETH).
Another distinction between traditional and crypto exchange arbitrage is that the latter can target centralized exchanges (CEXs) and decentralized exchanges (DEXs). In conventional markets, arbitrage traders only have access to CEXs with institutional market makers.
DEXs are a new innovation in the field of DeFi (decentralized finance). Instead of relying on centralized market makers, these blockchain-based exchanges use a technology called "liquidity pools." Anyone with a crypto wallet can supply tokens to these pools for peer-to-peer trading. Since liquidity pools run on smart contract codes, there are no centralized authorities facilitating trades.
DEXs aren't as regulated or liquid as CEXs, which means they usually present more arbitrage opportunities for crypto traders. Also, DEXs rely on arbitrage trades to balance the token pairs in their liquidity pools. As arbitrage traders adjust the supply of tokens in a trading pair, they naturally help balance the quoted price.
Why is crypto arbitrage so common?
Many features make digital currency a lucrative asset class for arbitrage traders. Cryptocurrencies aren't tied to real-world items, governments, or corporations, which means there are no central authorities that can provide clarity on what a digital token should be trading at. The decentralized nature of cryptocurrencies makes them more prone to price discrepancies across multiple markets.
Also, since crypto is decentralized, it's more volatile than other asset classes. The price volatility in crypto is usually higher than in traditional markets like equities. Also, since the crypto market cap is lower than markets like bonds or precious metals, it doesn't take as much money to move these tokens up or down.
Lastly, crypto arbitrage allows traders to explore the emerging DeFi ecosystem. DEXs and liquidity pools give traders more potential targets for price fluctuations.
FTX's CEO Sam Bankman-Fried is the best-known example of crypto arbitrage trading. Bankman-Fried noticed that Bitcoin traded for a significant premium in South Korea and Japan versus the U.S. market. To exploit these differences, Bankman-Fried organized large purchases and transfers of Bitcoin to overseas markets and quickly converted the local fiat currencies back to USD. Using these strategies, Bankman-Fried realized about $9 billion in profits in about three years.
Types of arbitrage trading strategies
Arbitrage trading can be as simple as swapping a token between two exchanges. However, there are a few more complicated ways arbitrage traders attempt to make profits. Here are three:
- Cross-exchange arbitrage: This first technique is the "standard" arbitrage trade. With this strategy, someone buys a token on one exchange at a lower price and sells it on a second exchange for a profit. In crypto, cross-exchange arbitrage can occur on both CEXs and DEXs.
- Spatial arbitrage: Spatial arbitrage attempts to profit off price differences on the same asset in different regions. The most famous example of spatial arbitrage in crypto is South Korea's "Kimchi premium." Crypto markets in South Korea are famous for selling Bitcoin at a premium relative to exchanges in most other countries.
While it may seem simple to sell Bitcoin onto Korean crypto markets for a profit, arbitrage traders have to account for foreign transaction fees and conversion rates between their fiat currency and the Korean won. Also, now that more people know about this premium, regulators are keeping a closer eye on suspiciously large transactions.
- Triangular arbitrage: Triangular arbitrage is commonly used to profit off price differences in fiat currencies in the foreign exchange (FOREX) market. However, some crypto traders use this setup to exploit price abnormalities on a single trading platform.
This trade is called "triangular" because it involves three parts, and it ends where it began. Traders first trade one crypto for another that's undervalued on the trading platform. Next, the trader will sell this undervalued token for an overvalued crypto. Lastly, the trader will sell this third token back into the initial cryptocurrency position.
What are crypto arbitrage trading bots?
Crypto arbitrage bots are computer programs that automatically buy and sell crypto according to a pre-set algorithm. Trading bots link with users' exchange accounts via APIs and make automatic trades when they detect price fluctuations.
While people can use trading bots for many trading setups, they’re common with arbitrage traders. Since arbitrage demands that traders make swift moves between multiple platforms, an automated trading bot may give traders the speed they need to succeed.
However, crypto trading bots can never guarantee a profit. These software programs are only as good as the algorithm a trader uses. Also, since trading bots require a higher initial investment, they’ll eat into whatever profits an arbitrage trader makes. Despite the increased prominence of arbitrage bots in cryptocurrency, traders must weigh this technology's pros and cons before trying it.
Are there drawbacks to arbitrage trading?
Arbitrage trading may seem to be a "safe" trading strategy, especially when compared with risky practices like leverage trading or naked shorts. However, that doesn't mean arbitrage trading is risk-free. Here are five disadvantages of crypto arbitrage trading:
- Arbitrage opportunities are time-sensitive: The key feature of a successful arbitrage trade is speed. Countless arbitrage traders globally have advanced software programs ready to make a profit. If an arbitrage trader isn't fast enough, there's a good chance many others already took advantage of the price discrepancy. New traders should expect to face fierce competition for arbitrage opportunities.
- Risk of slippage: "Slippage" refers to a significant deviation in the quoted price you wanted to buy or sell an asset. This phenomenon tends to occur on small and illiquid exchanges or with small-cap tokens. If an arbitrage trader can't close their trades quickly on a chosen exchange, there's a risk the final sale price will nullify their trade setup.
- Foreign exchange rates: Spatial arbitrage traders must factor fiat exchange rates into their expected profit. While crypto prices may seem elevated in other regions, consider how much it’ll cost to transfer the host country’s fiat into your desired currency.
- Trading fees: Every exchange charges different rates for buying, selling, and transferring crypto and fiat currency. Arbitrage traders must carefully study their preferred platforms' fee schedules before implementing a strategy.
- Tax implications: In most countries, arbitrage trading is subject to short-term capital gains taxes. Even if an arbitrage trader is successful, they’ll have to report their profits to tax authorities. Remember to double-check your region’s tax rate for crypto investing before getting involved in arbitrage trading.
Crypto arbitrage is a legal trading practice and serves a vital function in financial markets. Indeed, it's doubtful that DEXs like Uniswap would function as smoothly as they do without arbitrage trading.
However, just because crypto arbitrage is a viable option doesn't mean it's safe. Having little experience trading cryptocurrencies can make it easy to quickly lose your funds in poorly executed arbitrage trades. If you’re interested in crypto arbitrage, you need high risk tolerance and a well-prepared strategy.
At Worldcoin, we believe everyone must have access to crypto, which is why we aim to put a share of our crypto in everyone’s hands for free. Subscribe to our blog to learn more about the cryptocurrency market.