What is Crypto Arbitrage

Here's Everything You Need to Know

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What is Crypto Arbitrage – Here’s Everything You Need to Know

Cryptocurrency, Concept, Blockchain, Money, Litecoin

Cryptocurrency

Cryptocurrency is still in its infancy, and as such, there are many market inefficiencies when dealing with crypto trades. Within these inefficiencies, there are opportunities for savvy crypto traders to make a quick profit. One such opportunity lies in cryptocurrency arbitrage.

Every single day, billions of dollars in cryptocurrencies trade hands between investors within the many different crypto exchanges. Unlike the traditional stock market, there are quite a few cryptocurrency exchanges in this space, and they don’t always synchronize their prices.

It’s very common to find that the price of a single Bitcoin is slightly higher or lower in one exchange to the next on the very same day at the very same time.

Savvy traders with an appetite for some risk can take advantage of this price difference. By simply buying Bitcoins in one exchange at a lower price and quickly selling them in another at a higher listed price, this trader can make a profit. This process effectively allows them to play one cryptocurrency exchange against the other to make money. That is the world in which cryptocurrency arbitrageurs live in. While it might sound simple enough, there are some risks involved.

Let’s take a quick look at what crypto arbitrage is, the kind of methods and risks involved as well as how you can start making money as a crypto arbitrageur today.

What Is Crypto Arbitrage?

Crypto arbitrage uses the principles of arbitrage trading where an asset such as a crypto asset is bought in one market and immediately sold in another market such as a crypto exchange for a higher price. This exploitation of the price difference often helps the trader turn a profit.

The entire process of crypto arbitrage hinges on the fact that the different cryptocurrency exchanges that exist don’t necessarily synchronize the prices of the different virtual currencies they hold.

For example, on any given day, a single Bitcoin would be trading at say $10,000 on Coinbase, yet on the very same day and time, a single Bitcoin could be trading for $9,900 on Binance.

That means that if a savvy crypto trader were to buy a Bitcoin at Binance and then quickly sell it on Coinbase, they would effectively make $100 on the same asset. They can then simply rinse and repeat this process with any of the many different digital currencies on any of the many different exchanges. The exploitation of this price difference of the same asset in the different exchanges is what provides the arbitrage opportunity.

While this might seem like an excellent strategy to make lots of money quickly, the truth is that these trades need to be made extremely quickly because these gaps don’t last for too long. Sometimes they are gone in a matter of minutes.

How Are Cryptocurrency Prices Determined?

One of the biggest selling points of cryptocurrencies is that they are independent of government interference (largely but not completely). They aren’t backed by any centralized authority such as central banks.

It’s also this lack of a central authority that makes crypto trades so interesting. Most people say that since these monies aren’t backed by any authority, their prices are purely speculative.

On the other hand, one of the characteristics of money is “acceptability.” As long as people are willing to pay for Bitcoins and other cryptocurrencies, these monies have value. This value is often determined by how much most of these people are willing to pay for a single coin.

This is the principle that crypto exchanges use. Only in those streets, this process is recorded in “order books.” These order books have “buy order” and “sell order” columns.

When a trader wants to buy a single Bitcoin from an exchange of their choice, they place a “buy order” with the amount they want to spend. Say $31,000. This order is then entered into the order books.

Simultaneously, when a seller wants to sell a single Bitcoin, they also place a “sell order” with the price they are willing to accept for their Bitcoin. Should this “sell price” match the $31,000 value already on the “buy order” column, that trade is fulfilled, and both orders are taken off the books.

Blockchain, Cryptocurrency, Bitcoin, Exchange, Network

Bitcoin

Like every other exchange online, this exchange will then price their Bitcoins at $31,000 because that was the value of the most recent trade. Keeping with this example, should another trade immediately happen after this one and the pricing changes to say $31,110, then the exchange would price their Bitcoins at $31,110 with just as a swift action.

Every crypto exchange prices its virtual currencies in this manner. There are, however, a few that price theirs based on the prices that other exchanges hold.

Either way, you look at it, the fact is that the number of Bitcoins traded here doesn’t matter – only the most recent trade value. And that speed is key to this kind of arbitrage trading.

The Different Types of Arbitrage

As you would imagine, traders employ different strategies to try and make the most of Bitcoin arbitrage or any other type of crypto arbitrage. Here are some of the most common types of arbitrage used today:

Spatial Arbitrage

This is the simple arbitrage method where a trader sees a crypto arbitrage opportunity on different exchanges meaning a lower price on one and a higher price on another. In this case, they can simply buy the cryptocurrency in question on the lower exchange and transfer it to the higher one to sell. If successful, they immediately make a profit.

The problem with this type of arbitrage is that these differences only last for seconds, seeing as people are buying and selling on these different exchanges all the time. Unfortunately, most transfers between exchanges take minutes. By the time the entire process is complete, the advantage may be lost.

There’s also the matter of transfer fees as moving virtual currency from one exchange to another incurs a slight charge. This is true whether you are buying, selling, depositing, withdrawing, or just transferring.

One way to avoid paying these fees is to hold cryptocurrency in both exchanges. Here’s how that works:

  • An arbitrage trader holds a certain amount of dollars’ worth of a cryptocurrency like Stablecoin (say $30,000 worth) on a crypto exchange like Binance
  • Simultaneously, this trader holds a single Bitcoin on another exchange like Coinbase
  • Should Bitcoin happen to be valued at say $30,100 on Coinbase but only $30,000 on Binance, the trader can then buy the Bitcoin on Binance using their Stablecoin, which is worth $30,000, and simultaneously sell the Bitcoin on Coinbase for $30,100
  • This means that they now have a Bitcoin on Binance, so they haven’t lost their Bitcoin but also have $30,100 on Coinbase, effectively earning them $100 on that exchange

In this case, they will have lost their Stablecoin but retained their Bitcoin and gained $100.

Triangular Arbitrage

This kind of cryptocurrency arbitrage takes place on one exchange, and since it’s all done on the same platform, there are no transfer fees or excessive time delays involved. In this scenario, the crypto arbitrage trader holds three different coins on the same crypto exchange simultaneously. Say:

  • Bitcoin
  • XRP
  • Ethereum

Should one or even more of these coins be momentarily be undervalued on their exchange, the trader could bring all his or her coins into play.

In this case, they would sell one of their coins (Bitcoin) for Ethereum and then use the newly earned Ethereum to buy XRP before finally buying back Bitcoins with their newly earn XRP.

If their math made sense, the trader should be left with much more money than they had going into the arbitrage trade.

Statistical Arbitrage

This arbitrage strategy is slightly complicated since it involves using quantitative data models to make profitable crypto arbitrage trading. There are statistical crypto arbitrage bots that make thousands of arbitrage trades at any given moment.

The trick is to carefully analyses the chances that these trading bots will make a profit from any given trade and then decide whether to go “long” or “short” on that particular trade.

In general, a trading bot will give cryptocurrencies that perform well low scores and cryptocurrencies that perform poorly high scores. Traders have a much better chance to reap lucrative profits from cryptocurrencies that perform well.

There are trading platforms with excellent mathematical models that can predict the price of virtual currencies and then trade them against one another.

Cross-Border Arbitrage

Because cryptocurrency trading is fairly new, there are different rules, economic factors, and regulations that wreak havoc on the prices of these virtual coins when put side by side with typical fiat currencies.

For example, there is a very good chance that when you take a trading pair like BTC/USD or BTC/GBP, there will be some discrepancies. And when that happens, there’s money to be made.

Also, some countries only have access to exchanges that favor specific currencies, which means that there are some restrictions applied towards foreigners trading on those particular exchanges.

In this case, these pairs might experience inflated prices simply because investors have a difficult time access the exchange platforms or fair market rates.

Risks Associated with Cryptocurrency Arbitrage Trading

As you can imagine, whenever there’s money to make and in such quick fashion, some significant risks come with the territory. That being said, cryptocurrency arbitrage trading has some inherent risks such as:

Price Fluctuations

As already mentioned, these arbitrage opportunities last mere seconds. Imagine finding out that your BTC/ETH pair is much cheaper on one exchange than on another. By the time you make the transfer, that price has changed or, worse yet, flipped on its head.

Not only will you be stuck paying the trading fees or transaction fees, but you might be stuck with coins that are worth far less on the current exchange, which means you made a loss.

Time

While sending virtual money is a fairly fast process, each exchange determines how long they take to approve your transaction. Some exchanges are much faster than others. Depending on which exchange you deal with, the time it takes to approve your transaction could cost you the arbitrage trading advantage.

Exchange Trust

Arbitrage opportunities often present themselves on the much smaller exchanges that are still unknown, and their prices aren’t exactly in sync with the prices on the much bigger exchanges. However, before you can deal with these exchanges, you need to go through their “Know Your Customer” processes which take time. Time that could lose you the arbitrage advantage.

Associated Fees

There are going to be some associated fees that you need to take into account. These often include transaction fees, trading fees, transfer fees, withdrawal, and even deposit fees. In many cases, the profits made aren’t significant enough to cover these fees, let alone warrant the risk.

Bitcoin, Cryptocurrency, Blockchain, Money, Finance

Bitcoin

Is Cryptocurrency Arbitrage Legal?

Yes. Cryptocurrency arbitrage is completely legal. The cryptocurrency market is in constant flux, with prices climbing and dropping almost by the second. Taking advantage of these price differences is quite legal and can be rather lucrative when done properly with the right trading strategy.

If you have a fair appetite for risk, are quick on the trigger (mouse), or are good with quantitative data analysis, you could make good money as a cryptocurrency arbitrageur. While this method of making money is fairly straightforward and exciting, it’s not without its associated or inherent risks.

Not only does it call for excellent arbitrage strategizing, but it also calls for someone who is extremely up to date on their cryptocurrency news.

Yes, the prices of the virtual currencies will be determined by the most recent trade on the exchanges; it’s still up to the investor to find exchanges that might be slightly off the pace.

 

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