Crypto arbitrage is a trading strategy in which investors profit from minor price differences in a digital asset across multiple markets or exchanges. In its most basic form, crypto arbitrage trading is the process of purchasing a digital asset on one exchange and selling it (almost) simultaneously on another with a higher price.
This entails, much like an affiliate program, profiting through a process that involves little or no risk. Another advantage of this strategy is that you don’t have to be a professional investor with an expensive setup to start arbitrage trading.
What is Arbitrage Trading?
Arbitrage has been a mainstay of traditional financial markets long before the emergence of the crypto market. And yet, there seems to be more hype surrounding the potential of arbitrage opportunities in the crypto scene.
This is most likely because the crypto market is renowned for being highly volatile compared to other financial markets. This means crypto asset prices tend to deviate significantly over a certain time period. Because crypto assets are traded globally across hundreds of exchanges 24/7, there are far more opportunities for arbitrage traders to find profitable price discrepancies.
All a trader would need to do is spot a difference in the pricing of a digital asset across two or more exchanges and execute a series of transactions to take advantage of the difference.
Assume the price of bitcoin on the Coinbase cryptocurrency exchange is $60,000 and the price on Kraken is $60,200. In this case, crypto arbitrageurs may notice the price difference and buy bitcoin on Coinbase and sell it on Kraken to pocket the $200 difference. This is an example of a typical crypto arbitrage trade.
Why Are The Prices Of Cryptocurrency Exchanges So Different?
The first thing you should know is that asset pricing on centralized exchanges is determined by the most recent bid-ask matched order on the exchange order book. In other words, the most recent price at which a trader buys or sells a digital asset on an exchange is considered the exchange’s real-time price.
For example, if the order to buy bitcoin for $60,000 is the most recently matched order on an exchange, this price becomes the platform’s latest price of bitcoin. The price of the digital asset will be determined by the next matched order after this. As a result, price discovery on exchanges is a continuous process of determining a digital asset’s market price based on its most recent selling price.
It is also worth noting that prices tend to fluctuate because investor demand for an asset varies slightly across exchanges.
Decentralized crypto exchanges, on the other hand, price crypto assets in a different way. This system, known as a “automated market maker,” directly relies on crypto arbitrage traders to keep prices in line with those displayed on other exchanges.
Decentralized exchanges rely on liquidity pools rather than an order book system in which buyers and sellers are matched together to trade crypto assets at a specific price and amount. A separate pool must be created for each crypto trading pair. If someone wanted to trade ether (ETH) for link (LINK), they would need to find an ETH/LINK liquidity pool on the exchange.
Each pool is funded by volunteers who deposit their own crypto assets to provide liquidity against which others can trade in exchange for a proportionate share of the pool’s transaction fees.
A mathematical formula maintains the prices of both assets in the pool (A and B) across the majority of popular decentralized exchanges. This formula maintains the pool’s asset ratio in balance. This means that if a trader wants to buy ether from the ETH/LINK pool, he must first add LINK tokens to the pool before removing ETH tokens. When this occurs, the asset-to-asset ratio changes (more LINK tokens in the pool and less ETH.) To restore balance, the protocol lowers the price of LINK while increasing the price of ETH. This encourages traders to remove the less expensive LINK and replace it with ETH until the prices rebalance with the rest of the market.
When a trader significantly changes the ratio in a pool (makes a large trade), the prices of the assets in the pool can diverge significantly from their market value (the average price reflected across all other exchanges).
Types of Crypto Arbitrage Strategies
Crypto arbitrage strategies are classified into several types.
Crypto arbitrageurs can profit from market inefficiencies in a variety of ways. Among them are:
Cross-exchange arbitrage: This is the most basic form of arbitrage trading in which a trader attempts to profit by purchasing cryptocurrency on one exchange and selling it on another.
Spatial arbitrage: This is a type of cross-exchange arbitrage trading. The only difference is that the exchanges are in different parts of the country. Using the spatial arbitrage method, for example, you could profit from the difference in bitcoin demand and supply in the United States and South Korea.
Triangular arbitrage: This is the process of moving funds between three or more digital assets on a single exchange in order to profit from a price difference between one or two cryptocurrencies. A trader, for example, can set up a trading loop that begins and ends with bitcoin.
A trader could first exchange bitcoin for ether, then for Cardano’s ADA token, and finally for bitcoin again. The trader in this example moved their funds between three crypto trading pairs: BTC/ETH, ETH/ADA, and ADA/BTC. If any of the three crypto trading pairs’ prices diverge, the trader will end up with more bitcoin than they did at the start of the trade. All transactions are completed on a single exchange in this case. As a result, the trader is not required to withdraw or deposit funds at multiple exchanges.
Decentralized arbitrage: This arbitrage opportunity is common on decentralized exchanges or automated market makers (AMMs), which use automated and decentralized programs called smart contracts to determine the price of crypto trading pairs.
Arbitrage traders can swoop in and execute cross-exchange trades involving the decentralized exchange and a centralized exchange if the prices of crypto trading pairs differ significantly from their spot prices on centralized exchanges.
Statistical arbitrage: This technique combines econometric, statistical, and computational techniques to execute arbitrage trades on a large scale. This method is frequently used by traders who rely on mathematical models and trading bots to execute high-frequency arbitrage trades and maximize profit. Trading bots are automated trading mechanisms that execute a large number of trades in a short period of time using predefined trading strategies.
Why is Cryptocurrency Arbitrage Regarded As A Low-Risk Strategy?
You may have noticed that, unlike day traders, crypto arbitrage traders do not have to predict future bitcoin prices or enter trades that can take hours or days to generate profits.
Traders base their decisions on the expectation of generating a fixed profit by spotting and capitalizing on arbitrage opportunities, rather than analyzing market sentiments or relying on other predictive pricing strategies. Furthermore, depending on the resources available to traders, arbitrage trades can be entered and exited in seconds or minutes. Keeping these factors in mind, we can reach the following conclusion:
Because it does not require predictive analysis, the risk in crypto arbitrage trading is lower than in other trading strategies.
Arbitrage traders only have to execute trades that last a few minutes at most, which reduces their exposure to trading risk significantly.