In the letter
- Crypto arbitrage takes advantage of the fact that cryptocurrencies can be priced differently on different exchanges.
- Arbitrageurs can trade between exchanges or perform triangular arbitrage on a single exchange.
- The risks associated with arbitrage trading include slippage, price movements and transfer fees.
Every day tens of billions of dollars of cryptocurrency change hands in millions of transactions. But unlike traditional exchanges, there are dozens of cryptocurrency exchanges, each with different prices for the same cryptocurrencies.
For savvy traders – and those who aren’t averse to a bit of risk – this opens up an opportunity to gain an advantage over their compatriots: play these trades against each other. Welcome to the world of crypto arbitrage.
What is crypto arbitrage?
Crypto arbitrage is a trading strategy that takes advantage of the way cryptocurrencies are priced differently on different exchanges. On Coinbase, Bitcoin could be priced at $ 10,000, while on Binance, it could be priced at $ 9,800. Exploiting this price difference is the key to arbitrage. A trader could buy Bitcoin on Binance, transfer it to Coinbase, and sell Bitcoin – with a profit of around $ 200.
Speed is the name of the game – these gaps usually don’t last very long. But the profits can be immense if the arbitrager correctly times the market. When Filecoin hit the exchanges in October 2020, some exchanges quoted the price of $ 30 in the early hours. Other? $ 200.
How do crypto prices work?
So how does cryptocurrency get its value? Some critics point out that cryptocurrency is not backed by anything, so any value attributed to it is purely speculative. The counter-argument is basically that if people are willing to pay for a cryptocurrency, then that coin has value. Like most unresolved arguments, there is truth on both sides.
During exchanges, the game takes place in order books. These order books contain buy and sell orders at different prices. For example, a trader could place a “buy” order to buy Bitcoin for $ 10,000. This order would be entered in the order book. If another trader wants to sell a Bitcoin for $ 10,000, they could add a “sell” order to the book, thus completing the trade. The purchase order is then removed from the order book as and when it is executed. This process is called an exchange.
Cryptocurrency exchanges price cryptocurrency on the most recent trade. This can come from a buy order or a sell order. Using the original example, if selling Bitcoin alone for $ 10,000 was the most recent transaction, the exchange would price at $ 10,000. A trader who then sells two Bitcoins for $ 10,100 would move the price to $ 10,100, and so on. It doesn’t matter how much crypto traded, all that matters is the most recent price.
Every crypto exchange prices cryptocurrency this way, with the exception of some crypto exchanges which base their prices on other cryptocurrency exchanges.
Different types of arbitration
One method of crypto arbitrage is to buy cryptocurrency on one exchange and then transfer it to another exchange where the currency is sold at a higher price. There are some issues with this method, however. Spreads typically only exist for a few seconds, but the transfer between trades can take a few minutes. Another issue is transfer fees, as moving crypto from one exchange to another comes with fees, whether through withdrawal, deposit, or network fees.
One way for arbitrageurs to get around transaction fees is to hold currencies on two different exchanges. A trader using this method can then buy and sell cryptocurrency simultaneously. Here’s how it could play out: A trader can have $ 10,000 in a US dollar-indexed stablecoin on Binance and a Bitcoin on Coinbase. When Bitcoin is valued at $ 10,200 on Coinbase but only $ 10,000 on Binance, the trader would buy Bitcoin (using stablecoin) on Binance and sell Bitcoin on Coinbase. They wouldn’t win or lose a Bitcoin, but they would earn $ 200 due to the gap between the two exchanges.
Did you know?
USDT (Tether) is a cryptocurrency tied to the price of one US dollar. Cryptocurrency traders often use it due to its relative stability. This makes it easier to hold cryptocurrency without the risk of its price dropping massively. The advantage of holding stablecoins like Tether, instead of converting cryptocurrencies into cash, is that crypto-fiat transfers often come with huge fees.
This method involves taking three different cryptocurrencies and trading the difference between them on a single exchange. (Since everything takes place on a single exchange, transfer fees are not an issue).
So, a trader might see an arbitrage opportunity involving Bitcoin, Ethereum, and XRP. One or more of these cryptocurrencies may be undervalued on the exchange. Thus, a trader could take advantage of arbitrage opportunities by selling his Bitcoin for Ethereum, then using that Ethereum to buy XRP, before ending by buying back Bitcoin with XRP. If their strategy made sense, then the trader will have more Bitcoin at the end than at the beginning.
There are several risks associated with arbitrage trading. One of them is slip. A slippage occurs when a trader places an order to buy a cryptocurrency, but their order is larger than the cheapest bid in the order book, causing the order to “slip” and cost more than planned. This is a problem for traders, especially since the margins are so low that a slide could wipe out potential profits.
Another risk associated with arbitrage is price movement. Traders need to be quick to take advantage of spreads when they form, as the spread can disappear in seconds. Some traders program robots to perform arbitrage, which has only added to the competition.
Finally, traders should take into account the transfer fees. Spreads are rarely very large for major cryptocurrencies, and with tight margins, a transfer or transaction fee could wipe out any potential profit. These tight margins also mean that any trader who wants to make significant gains has to transact a lot.
The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment or other advice.