Arbitrage means taking advantage of a price difference in 2 markets. When you apply this concept to the crypto world, it is called crypto arbitrage. Buyers and sellers consider it as an opportunity to make some quick profits but it is not very easy.
If you do not possess the requisite knowledge, it can backfire on you. This article covers everything you need to know about Crypto Arbitrage.
Crypto Arbitrage – The Concept
Arbitrage is the process of using prices in your favor. There are thousands of Cryptocurrency exchanges presently. Not every exchange has the same price for particular crypto.
For example, a Bitcoin may trade on one exchange at $50,000 whereas another exchange may be trading it at $50,050. When the trader has the opportunity to take advantage of this price difference between 2 exchanges, it is called crypto arbitrage.
There are several reasons for the different prices on different exchanges. The essential characteristic of arbitrage is that the entire process takes place very quickly as the crypto market is volatile and price changes every minute.
Suppose you bought a Bitcoin at $50,000 and you were planning on selling it at $50,050 on another exchange but the price fell to $49,980 just when you were about to sell. Yes, it happens. In the crypto market, the ups and downs are fast and unpredictable. One needs to be equipped with a lot of knowledge to take advantage of situations like these.
How Does it Work?
When the currency is the same, why does it trade at different rates? This question must be bugging you. Here is the answer. There are several reasons which result in the fluctuation in the price.
One is the trading volume. Larger exchanges deal in a large volume of cryptocurrencies. Thus, the market is quite competitive there, as there are thousands of buyers and sellers and one is not in a hurry to sell off currencies.
Similarly, the buyers have options to buy from the seller who is offering minimal prices. Thus, the prices are generally low. While on smaller exchanges, the trading volume is low and prices are quite high.
Another reason for this price fluctuation is geography. If you have figured out the best time to buy and sell your currency, you win. Say, you bought a currency on an exchange when the prices were low and you waited for another platform on the other side of the globe to sell off your currency. It is not as easy as it sounds.
As said earlier, the changes in prices are so fast in the crypto market that an opportunity may result in a risk. A general transaction takes 15-20 minutes and where prices are changing every second, this is a great amount of time to put you into trouble. Sometimes, you may even need to hold on to your currency to make a profit.
The Process Of Crypto Arbitrage
To take advantage of the crypto arbitrage, you must have 2 accounts on 2 different exchanges. Both of these exchanges must have the underlying currency in common. E.g. If you want to take advantage by buying and selling Ethereum, both of the exchanges should be trading in it.
Each exchange has a different buying and selling rate. There is a low ask price at which the trader will sell coins and there will be a bid price at which the buyer will buy the crypto coins. One more thing to take into consideration here is that both the exchange ask and bid prices must differ. If they are different, then there is an arbitrage opportunity.
Now, imagine you bought Ethereum on one exchange at a lower price. Now, you must ensure that the price of Ethereum on the second exchange is higher than the rate at which you bought the coin on the first exchange.
Now, transfer the coins to the second exchange and sell them at the highest bid price. The difference is the profit after deducting the withdrawal and exchange fees.
Types of Arbitrage
One can take advantage of the arbitrage opportunity in 2 ways:
- Arbitrage between exchanges, and
- Arbitrage within the exchange.
Arbitrage between exchanges
It is the kind of arbitrage we discussed above when the arbitrage opportunity exists due to price fluctuations between 2 crypto exchanges. This is the most common type of arbitrage. The only problem is the withdrawal and trading fee which may extend up to 15% depending upon the exchanges you use.
Arbitrage within exchange
This is also known as triangular arbitrage, cross-border arbitrage, or intra-exchange arbitrage. One can take advantage of arbitrage opportunities by using 2 or more crypto coins or cryptocurrencies and fiat currency.
It starts with depositing fiat on an exchange. If you already have a certain crypto coin you can also use it. Suppose you are arbitrating with 3 crypto coins, namely Binance Coin, Ethereum, and Ripple. You have Ether in your wallet. You exchange it with a Binance coin which is priced low. Then you buy Ripple with it.
You repeat this process only to end up buying Ethereum at the last stop and now, you have more Ether coins than you had at the start of the process. Wondering how it happens? The difference between the prices of the 3 coins is the reason as is the different USD price ratios between the currencies.
Other Arbitrage Types
This is not for small investors or newbie investors as it requires in-depth knowledge of trading as well as the market and a good understanding of the long and short positions.
Statistical arbitrage involves a pair of two stocks or cryptocurrencies and applying the fundamentals of hedging to minimize the risk by going long on one stock while going short on another closely related stock so that the risk is minimal even though the market crashes.
This type of arbitrage works due to the liquidity, risk, volatility, and other factors of the market.
Decentralized Finance (DeFi) Arbitrage
Decentralized Finance, as the name suggests, was invented to create a system that could manage the projects without human intervention in a transparent and permissionless manner. Since its invention, the DeFi market has grown manifolds but it is still inefficient and fragmented, which serves as a great opportunity for the arbitrators.
One can benefit from the DeFi Arbitrage in 2 ways. One way to make a profit is to trade as per the yield offered. Say if one DeFi exchange is offering 5% yield while another one is offering 8% for the same currency, then the trader can convert her low-yielding currency into the high-yielding one on another exchange and make a profit by earning a higher yield.
Another way to make a profit is to trade coins between exchanges. It is the same as arbitrage between exchanges and the only difference is that here, the trading takes place on DeFi exchanges.
Things to Consider Before Making a Crypto Arbitrage
You cannot just go out there, choose one or two random exchanges and earn profits. There are certain things you need to consider before you get into the game. These are:
Exchanges with Low Fees
This is very important. Say you earned a profit of 50 dollars but you paid 40 dollars as transaction and withdrawal fee. So, did you go through all the pain for mere 10 dollars?
It is disheartening and if you hardly trade a spread or two, you are left with 20 dollars out of the 100 dollars you earned. So, choose an exchange that has the lowest fees but is also a trustworthy one.
This is important as it is always said that time is everything in arbitrage. You miss the time, you lose the money. Transact in faster currencies like Ether or Bitcoin or others which does not make you lose your money.
The time it takes for the approval of the withdrawal, authentication and everything sometimes takes around 15-20 minutes, which can be a game-changer. You may earn as the prices rise during this time manifold or you may lose as the prices fall with speed greater than they had risen.
Advantages of Crypto Arbitrage
The following are major reasons traders love Crypto Arbitrage:
There are thousands of cryptocurrencies in the market and the larger the number of currencies, the better there is the chance to undertake crypto arbitrage.
The Volatility of Crypto Coins
The cryptocurrency market is still volatile and the prices differ on different exchanges due to liquidity, supply and demand imbalances, trading volumes, etc. These factors present arbitrage opportunities for traders.
You don’t have to hold your currency and wait for the prices to rise. Instead, you can make profits by selling your coins immediately to another exchange providing a greater amount for the coins.
The Developing Market
The market is developing and the number of investors is rising every day, providing opportunities to sell the crypto coins easily on exchanges. The market has demand and supply and this is the gap where the opportunity lies to make money.
Disadvantages of Crypto Arbitrage
Every coin has two sides and, as such, crypto arbitrage also has some downsides to it:
The exchanges have a withdrawal limit and you cannot simply withdraw all of your coins on the same day.
Nothing comes for free especially when you are making profits out of something. The exchange is going to charge you for buying, selling, converting, etc. If your transaction fee exceeds your earning, you lose money instead of earning it.
Every country and exchange has its own KYC regulations in place. You need to adhere to them otherwise, you won’t be able to withdraw your profits unless you have a bank account in a particular bank, for example, or your identity verification is not complete.
The Risk of Theft
You need to deal in multiple exchanges in order to cash out on your arbitrage opportunity. Thus, you need to store cons in different wallets on different exchanges. These exchanges and wallets are always susceptible to theft or hacking.
The Transaction Time
Crypto transactions take lots of time to process as the trading volumes across exchanges are huge. It is possible that you may miss the opportunity due to the slow transaction time.
Are you doing all this hard work to earn a meager 10 or 20 dollars? If you want to increase your earnings, you need to trade multiple threads. With the increased number of threads, the risk also increases as it is a possibility that you lose due to any of the above-mentioned factors.
Is Crypto Arbitrage Always Profitable?
Crypto arbitrage is profitable only when you have the requisite level of knowledge of the market, the right set of tools, and the patience to lose if things don’t turn out the way you had planned.
As of now, there is a 10 dollar difference in Bitcoin prices on two popular exchanges Cex.io and Binance. It is an opportunity and the prices changed as I wrote it. This is the volatility of the market and you can take advantage only if you can complete the transaction faster.
One way to make profits is to increase the trading volume. Say if you deal in 10-12 spreads a day and make a 10 dollar profit in each of the spreads, you have 100 dollars a day and 3,000 dollars a month.
Does it sound enticing? It is but it is possible only if the market does not crash. If the market takes a downturn when your transaction is processing, you may lose 20 instead of earning 10.
With advanced technology, the chances of arbitrage opportunities have come down. So, the prices on the exchanges change in seconds and also affect prices on both the exchanges, making things difficult for you.
Is it Legal?
You are buying a currency and selling it. It is the same as intra-day trading and thus, it is perfectly legal. You are only taking advantage of the inefficiency and volatility of the market as the prices fluctuate due to market conditions. It is perfectly legal as well as taxable.
The Chances of Making Mistakes
You don’t always need to make mistakes in order to learn from them. You can also learn from other’s mistakes. So, here are certain areas where people normally make mistakes:
Lack of Volume
It is possible that there is a price difference of a currency on two exchanges but there is no demand for it. So, you may end up buying the coins at low prices but there is no buyer on the second exchange. Then you end up with coins in your wallet. Your money is stuck and you never know when you will find the same opportunity.
The Currency Confusion
You don’t remember the symbols of more than 10 Cryptocurrency tokens, right? It’s alright. No one does. But this is the reason why many people end up buying a different coin than they intended. In this case, it was totally up to you to buy a certain crypto coin and you pick the wrong one and now, the exchange will not refund your money.
High Transaction Fee
As long as you talk about cryptos, the transaction fee will rear its ugly head as it is an integral part of trading. It is important to study the deposit and withdrawal fee on both exchanges because engaging in arbitrage only to pay all your earnings in the form of a transaction fee is worthless.
You are ready to trade and you have deposited money and now you are stuck. Why? Because the exchange will approve your request, then only you can move forward with your transaction. It results in losing productive time. The worst thing, in this case, is, you can do nothing but wait.
If you have time, knowledge and you are not someone to back out from making efforts, crypto arbitrage is a good opportunity for making money.
You must be experienced in trading and must understand the nuisances of the crypto world to make something out of it. You must also be aware of the financial risks involved, the tax implications, and the legal aspects of trading.
The best way to make the most out of it is to tailor your own strategy or to take the help of crypto arbitrage bots that help you to minimize risks, grow profits, and limit losses. So, keep learning and keep earning with crypto arbitrage opportunities.