What is crypto arbitrage?
Crypto arbitrage means "buy low, sell high", but not as you know it.
What is crypto arbitrage?
Arbitrage is simply the fancy term given to the process of buying a specific asset at a lower price and then immediately selling it somewhere else where the price is higher.
For instance, say there's an Exchange A that's selling Bitcoin for $100,000 per coin, while Exchange B is selling it for $110,000.
You could quickly purchase Bitcoin on Exchange A and sell it at the higher price on Exchange B, making a profit from the price difference.
The concept of arbitrage trading is not a new one and has existed in stock, bond and foreign exchange markets for many years.
However, as trading has become more sophisticated and automated, it's now harder for regular traders to take advantage of arbitrage opportunities without the assistance of trading bots.
The number of fees involved in buying and selling crypto can also limit the profitability of arbitrage trades, especially if your trade involves multiple exchanges or currencies.
The most famous example of crypto exchange pricing differences was a phenomenon known as the "kimchi premium", which in 2018 saw the price of Bitcoin (BTC) in South Korea rise to around 50% higher than global prices.1
What makes crypto arbitrage possible?
Arbitrage is made possible by a difference in pricing between 2 or more markets.
There's a couple of reasons this discrepancy may occur, including:
Liquidity and trading volume
As a general rule, the more liquidity and volume an exchange has, the more stable its prices will be. For example, if an investor market sells $1 million of Bitcoin on an exchange with high liquidity, it may only cause the price to drop 1%.
However, if they were to sell the same amount of Bitcoin on an exchange with low liquidity. This could see the price drop 5% as there's not enough buyers available to purchase the Bitcoin at that price.
This would temporarily cause a price difference between the two exchanges and create an arbitrage opportunity.
Regional demand
Let's say a news story breaks that the US is about to introduce tighter laws around crypto trading. This causes investors in the US to sell some of their Bitcoin, which leads to the price dropping on US-based exchanges.
Of course, this news has no direct impact on Chinese Bitcoin investors, so the price of Bitcoin doesn't drop on Chinese-based crypto exchanges.
Again, this would potentially create an arbitrage trade for investors who could buy Bitcoin slightly cheaper on a US exchange and then immediately sell it on a Chinese exchange.
Information asymmetry and market timing
The crypto markets trade 24 hours a day, which means while investors are busy trading in one country, they're busy sleeping in another.
If we take the US-China example above, this could mean the news about US tightening its laws occurs in the middle of the night in China.
Naturally, Chinese traders are going to be slower to react to the news, which again could see the price of Bitcoin drop in the US but stay the same in China, creating the same arbitrage situation.
How does crypto arbitrage work?
To explain how arbitrage works, let's look at a hypothetical example.
Let's assume we have 2 crypto exchanges that both list Bitcoin:
- Exchange A is a major exchange with a high trading volume. The price of BTC on this exchange is US$60,000.
- Exchange B is a smaller exchange with less trading volume. The price of BTC on this exchange is US$62,000.
Now let's assume that there's an important announcement that is likely to encourage people to buy BTC, such as the US government announcing that all BTC deposits will never be subject to tax.
This prompts widespread demand for BTC, and most buyers head to the biggest exchanges because they offer the easiest way to buy cryptocurrency.
This surge of buyers causes an increase in BTC prices on large exchanges like Exchange A, while Exchange B sees less trading volume and its price is slower to react to the change in the market.
BTC reaches US$65,000 on Exchange A, but only rises to US$63,500 on Exchange B, which is where arbitrage comes in.
You could then do the following:
- Buy BTC on Exchange B at US$63,500.
- Transfer your BTC to Exchange A.
- Sell your BTC on Exchange A for US$65,000, securing a profit of US$1,500 per BTC.
Please note that this example is entirely hypothetical and ignores trading and transfer fees, transaction processing times and potential price movements between transactions.
* This is a fictional, but realistic, example.
Expert insight: Is arbitrage a good strategy for investors?
"Crypto arbitrage trading is generally more suited for experienced traders due to its complexity and the need for quick decision-making. As for short-selling Bitcoin, it's a high-risk strategy that should only be attempted by experienced traders with a deep understanding of market dynamics and risk management."
Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific
provider, service or offering. It is not a recommendation to trade.
How to arbitrage crypto
Here are 5 key tips to keep in mind if you're looking to try crypto arbitrage:
- Set up accounts on multiple crypto exchanges
To arbitrage trade crypto, you will need several cryptocurrency exchange accounts created before hand. This will allow you to quickly switch between exchanges and seize any arbitrage opportunities. Check here for an extensive list of crypto exchanges in Australia. - Set up your trade environment.
Arbitrage opportunities can be identified manually, with the aide of software or a bot, or a combination of the two. You will need to decide which option works best for you and set up your workspace accordingly. This could involve using multiple monitors to track prices and news, while another is dedicated to your exchange trading window. - Monitor prices and news.
To give yourself the best change of identifying an arbitrage opportunity you will need to constantly track price fluctuations on a wide number of exchanges. You may be able to get an edge by closely monitoring news for events that could move the market. - Trade execution and risk management.
Arbitrage trading benefits from speed, but you still need to exercise caution. Before entering your trade, you should have mapped out your entry price and reason for entering, your potential profit target and a stop-loss in case the market moves against you. You will also need to calculate the cost of any withdrawal or gas fees involved in transferring your crypto from one exchange to another, which will impact the profitability of your trade. - Move your profits to a secure wallet.
As with all trading, it's generally a good idea to take profits frequently so that you're gains are locked in and you're not tempted to add them to your trading capital. For the best security, consider moving your funds off an exchange and into a personal crypto wallet to mitigate any exchange risks, like hacks or fiscal mismanagement. Alternatively, you could withdraw them as AUD to your bank account.
Arbitrage trading strategies
The most basic approach to cryptocurrency arbitrage is to do everything manually – monitor the markets for price differences and then place your trades and transfer funds accordingly.
However, there are several cryptocurrency arbitrage bots available online, designed to make it as easy as possible to track price movements and differences.
There are multiple strategies arbitrage traders can use to make a profit, including the following:
Simple arbitrage
Buying and selling the same coin immediately on separate exchanges.
Triangular arbitrage
This process involves taking advantage of the price differences between 3 currencies. For example, buy BTC in USD, sell it to make EUR, and then exchange those EUR back to USD.
Convergence arbitrage
This approach involves buying a coin on an exchange where it is undervalued, and short-selling the same coin on another exchange where it is overvalued. When the 2 separate prices meet at a middle point, you can profit from the amount of convergence.
Arbitrage trading bots
Arbitrage trading bots are similar to what professional quant trading firms use. They are automated programs that scan the market to spot opportunities and execute trades on behalf of the user. Beware that some bots may require access to your funds, and may be prone to error or front-running if you're trading on-chain.
What are the benefits of crypto arbitrage?
- Fast way to (potentially) turn a profit. You can complete an arbitrage deal in as little time as it takes you to complete all the relevant trades. This offers the potential to realise gains much faster than if you're taking the traditional approach to buying and holding cryptocurrency before selling at a later date.
- Huge range of exchanges. According to CoinGecko there are now more than 200 centralised and 800 decentralised crypto exchanges around the world. With so many exchanges available, in so many different markets, there's plenty of potential to spot arbitrage opportunities.
- Cryptocurrencies are volatile. Choose Bitcoin or any other top-traded cryptocurrency and take a look at a graph charting its price for the past 12 years (or whichever time frame is appropriate for the cryptocurrency you are researching). This is a great way to understand just how volatile crypto prices can be – and wherever there's volatility, there's potential for arbitrage.
What are the risks of crypto arbitrage?
Cryptocurrency arbitrage sounds like a piece of cake in theory, so why isn't everybody and their dog doing it?
Well, there are several barriers you'll need to overcome and risks you'll need to be willing to accept in order to trade profitably:
- KYC regulations. Know Your Customer (KYC) regulations can place barriers on entry to many exchanges. For example, you may need to hold a bank account in the same country where an exchange is based in order to be allowed to place trades, or you may need to have your account verified (which could take 24 hours or more) before you can trade. To avoid this, consider opening an account with major exchanges beforehand.
- Storing coins on exchanges. To place arbitrage trades, you'll need to store coins on crypto exchanges so they're ready for use whenever you need. There have been plenty of examples of exchanges getting hacked, not to mention some stealing money from customers, so you'll need to be aware of this risk before getting started.
- Fees. Most crypto exchanges charge fees on trades, while deposit and/or withdrawal fees sometimes also apply. The biggest fee of all can be gas fees, which are fees paid to the blockchain network to move assets between wallets. If network congestion is high, you may end up paying a three-figure sum just to move your funds around. You'll need to factor these fees into your calculations when determining the profitability of a trade.
- Large trades often required. Once you take into account processing delays and all the fees that apply, profits from successful arbitrage trades may be small. As a result, you'll often need to buy and sell large volumes of crypto in order to magnify your returns.
- Withdrawal limits. If you're looking to place large trades, be aware that many exchanges limit the amount you can withdraw from your wallet per day, so it may not be possible to withdraw the coins you want to execute a profitable arbitrage deal.
- Failing to execute in time. Another risk with arbitrage is if the market moves against you or a trade is already taken before you can execute your sell trade. Cryptocurrencies are highly volatile, so the price could rapidly move against you in the time it takes to move funds from one exchange to another.
- Slow transactions. With the recent surge in trading volume on global cryptocurrency markets, many exchanges have struggled to keep up with demand. There have been numerous instances of delayed withdrawals, which could be highly problematic if you're looking to move funds as quickly as possible. Transaction times can also vary depending on the coin you're transferring – for example, Ethereum (ETH) transactions are processed much more quickly than BTC transfers.
- Competition risk. As more traders become aware of the potential advantages of arbitrage, there may be increased competition for trades. This is especially true for large firms which use software to constantly monitor the market and identify opportunities faster than most retail investors can.
How to find crypto arbitrage opportunities
Cryptocurrencies are complicated and highly speculative and, as we've outlined above, arbitrage comes with its own risks attached. You'll need to make sure you're fully aware of those risks before you even attempt to execute an arbitrage deal.
If you've thoroughly researched how arbitrage works and you understand the risks involved, keep the following tips in mind before getting started:
- Monitor the news. News events can have a major impact on price. In some cases they will only impact prices in one market (like say Japan or the US) but not in others which provides an arbitrage opportunity.
- Monitor exchange prices. The most obvious step in arb trading is to monitor prices of your favourite assets on major crypto exchanges. But don't forget about the smaller exchanges, or decentralised exchanges which run on blockchains like Ethereum. Decentralised exchanges use an Automated Market Maker (AMM) system which is essentially designed to provide arbitrage opportunities to traders.
- Monitor Automated Market Maker (AMM) exchanges. AMM's are explicitly designed to provide arbitrage opportunities to traders in order to keep asset pools evenly balanced. They do this by pooling two assets (eg, ETH/USDT) and let traders buy or sell either asset from the pool. Over time, if one asset is more popular than the other then the pool becomes imbalanced and arbitrage traders step in to restore balance and potentially secure a profit.
- Monitor multiple blockchains. Sometimes the value of an asset on one blockchain (eg, USDC on Ethereum) will deviate from the price of the same asset on another blockchain (eg, USDC on Solana). Keep in mind you will need to bridge assets between both chains which can become costly.
- Look for new listings. Keep track of crypto forums and news sites for announcements of a new coin being added to an exchange. If a coin has only been recently added to an exchange and there is only limited demand for the coin on that site, you may be able to find a larger price differential.
- Don't transfer funds using BTC. Speed is of the essence when doing this type of trading, so BTC's slow transaction time could hurt your chances of making a profitable trade. You may want to consider transferring funds between exchanges using a stablecoin on a network like Ethereum, which offers faster transactions, instead. Better yet, use a layer-2 like Arbitrum or Optimism for cheaper gas fees.
- Have a plan. There are several key questions and factors you'll need to consider before starting. For example, how much money should you put in? What percentage difference between prices will represent a sufficiently profitable opportunity? Will you keep a balance of coins on multiple exchanges or transfer your funds around as needed, thereby increasing delays?
- Only use trusted exchanges. While there's always a certain level of risk when dealing with any crypto exchange, do plenty of research beforehand to make sure you only deal with reputable platforms.
- Monitor the market. There is a greater chance of price differences during periods of market volatility, so monitor crypto markets for any news and developments that could cause rapid price changes.
- Hedge. To protect against sudden market moves that aren't in your favour, it's worth reading up on hedging strategies and how to use them.
- Diversify. Only channelling your money into a single exchange, or a single type of cryptocurrency, is risky. Spreading your money around can help to minimise risk.
- Limit your exposure. Never arbitrage an amount that is more than you can afford to lose. With so many potential risks that could lead to a loss, it's always a good idea to play it safe.
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Key takeaways
- Crypto arbitrage means taking advantage of price discrepancies on certain assets.
- The crypto markets have historically been good for arbitrage, but this has changed as the industry has matured.
- Because crypto trades 24/7 across dozens of exchanges, arbitrage opportunities do still exist.
Bottom line
The volatile nature of cryptocurrency means that arbitrage opportunities are abundant, especially thanks to the introduction of DeFi.
However, making a tidy profit from arbitrage is not as easy as it once was. Automated software and bots now hunt for arbitrage opportunities constantly, making it harder for entry level traders who are only equipped with a keyboard and mouse.
To get an edge you will need to create a plan, research the field in depth, monitor the market closely and consider using specialised software or tools.
FAQs
Disclaimer: Cryptocurrencies are speculative, complex and involve significant risks – they are highly
volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of
future performance. Consider your own circumstances, and obtain your own advice, before relying on this information.
You should also verify the nature of any product or service (including its legal status and relevant regulatory
requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may
have holdings in the cryptocurrencies discussed.
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