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What Is Cryptocurrency Arbitrage?

Last updated 26th Sep 2022
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Cryptocurrency arbitrage is a trading strategy where investors capitalize on slight price differences across multiple exchanges or brokers. To put it simply, crypto arbitrage trading is the process of buying a cryptocurrency on one exchange and selling it on another for a higher price.

This allows investors to make small profits on every trade that involves little to no risk. Another benefit of this strategy is that you don’t need in-depth knowledge about trading to start making money with crypto arbitrage.

This guide covers everything you need to know about cryptocurrency arbitrage. We’ll go over the different trading strategies and the top crypto exchanges in 2022.

What Exactly is Arbitrage Trading?

Arbitrage trading has been a top-performing strategy long before the emergence of the crypto market. However, there seems to be more hype surrounding the potential of this trading strategy in the crypto scene. Perhaps this could be due to the crypto markets' high volatility, providing more money-making opportunities for investors.

Compared to traditional financial markets, cryptocurrencies tend to sway in price significantly. This opens up more opportunities and price discrepancies between exchanges. All a trader would need to do is spot a difference in value across two or more exchanges and execute a series of trades. Furthermore, developers have created trading bots that do this process for investors resulting in faster transactions and higher profits.

For example, let’s assume Bitcoin is valued at $70,000 on Binance and $72,000 on Coinbase. In this situation, you can purchase the coin on Binance and sell it on Coinbase for a profit of $2,000.

Best Cryptocurrency Arbitrage Platforms

Selecting the perfect cryptocurrency exchanges for arbitrage trading is vital in your investment journey. This is because you want to create a streamlined system that synergizes well across all platforms. The crypto exchanges should provide fast withdrawal times, transparent fee structures, and multiple trading pairs. Therefore, we’ve researched the marketplace and found some amazing options for arbitrage trading.

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Why Are Crypto Exchange Prices Different?

Centralized Exchanges

Pricing on centralized exchanges depends on the most recent bid in the order book. So the most recent price at which a trader buys or sells a cryptocurrency is considered the real-time value.

For instance, if the most recent order for Bitcoin is $70,000, then that becomes its value for the time being. However, if an investor places a trade for $72,000, the value of Bitcoin increases by $2,000. Centralized exchanges rarely have exact prices on their coins, so you’ll always find a small or large discrepancy between cryptocurrency platforms.

Decentralized Exchanges

Decentralized exchanges use a different method for pricing cryptocurrencies compared to centralized platforms. The system is called “Automated Market Maker”, which directly relies on crypto arbitrage traders to keep prices exactly like those shown across exchanges.

Instead of an order book system, DEXs use liquidity pools to place value on tokens. Every cryptocurrency trading pair must have a unique pool created. For example, if an investor wants to trade Tether for Bitcoin, a USDT/BTC liquidity pool must be created or linked to the decentralized exchange.

The benefit of this system is traders won’t need to wait for a counterparty (a seller or buyer) to complete the transaction. So if an investor wanted to buy BTC from the USDT/BTC pool, they would need to add USDT to remove BTC. Afterward, the ratio of tokens has changed, and the protocol automatically lowers the price of Bitcoin. This is where investors can participate in arbitrage trading when the price falls on one exchange but stays the same on another.

Types of Cryptocurrency Arbitrage Strategies

Investors have three trading strategies they can implement when using arbitrage. Let’s analyze how they work in more detail.

  • Triangular Arbitrage: This is when you trade funds in a loop to capitalize on a price discrepancy of one or two coins. For example, you can start with Bitcoin and trade a few coins to end up with Bitcoin again to finish the loop. The strategy would look like this: BTC/ADA -> ADA/ETH -> ETH/BTC.

  • Cross-Exchange Arbitrage: This is the most basic form of arbitrage trading. It requires you to buy a coin on one exchange and sell it on another to generate profit.

  • Spatial Arbitrage: This is another cross-exchange strategy. The difference is the exchanges are located in different regions, allowing you to capitalize on the supply and demand of certain coins. For example, America may be wealthy with Bitcoin, but South Africa may be in high demand for the coin. Therefore, you can transfer the BTC to the South African exchange and sell it at a higher price.

Why is Cryptocurrency Arbitrage a Low-Risk Strategy?

Unlike day traders, arbitrage investors do not have to rely on predicting the future to make a profit. Instead, they focus on spotting arbitrage opportunities in the market and capitalizing on them. Arbitrage allows investors to calculate their profits beforehand, reducing risk before executing a trade.

Moreover, arbitrage traders can complete transactions in seconds or minutes, limiting the time their position is live. This continuous flow of trades using arbitrage minimizes potential losses while acquiring the best cryptocurrency prices. However, flash drops can negatively impact profits and leave investors with bags to hold until the value climbs back up.

Risks Associated With Crypto Arbitrage Trading

Several factors can diminish an arbitrageur’s chances of making money. Although the trading strategy is low risk, it tends to have subpar profits compared to other methods. Therefore, arbitrageurs must generate high volumes of trades to receive substantial profits. Let’s go over what can impact profitability with this trading strategy.

Timing

Cryptocurrency arbitrage trading is highly dependent on timing. As more traders spot an opportunity on a particular asset, the price difference disappears quickly between the exchanges.

Most traders have alerts set up to have a first movers advantage. However, this isn’t enough time to execute the trade and gain the most profit. This is because bots are becoming more advanced, and they can execute thousands of trades per second, making it difficult to be profitable with a hands-on approach.

Fees

Depending on your arbitrage strategy, you’ll encounter various fees. For example, you’ll have to pay a withdrawal and trading fee with cross-exchange arbitrage. Depending on the exchanges’ fee structures, these costs can accumulate and eat into profits.

Security Risk

Since you must open multiple exchange accounts and deposit funds, you leave yourself vulnerable to exit scams and hacks. Exit scams are when a company suddenly closes its operation and steals clients’ money. Therefore, it’s advised to thoroughly research the platforms you intend to use before signing up.

Sudden Drops

The cryptocurrency market is highly volatile, so sudden dips in price are common events. Unfortunately, the market suddenly dropping can be due to several factors like terrible world news, new crypto laws, or investors selling their profits. Therefore, you can buy a coin and experience a sudden drop leaving you holding a “heavy bag”. Selling means you’d lose significant gains, so your only option is to hold until the price rises.

Final Thoughts

That concludes our guide on cryptocurrency arbitrage. To put it simply, arbitrage is buying a cryptocurrency cheaper on one exchange and selling it at a higher price on another. It’s a safe investment strategy because you don’t rely on how the market will perform. Instead, you focus on finding discrepancies between crypto platforms and capitalizing on the difference.

Furthermore, there are multiple arbitrage investment strategies that you can implement, like Spatial, Triangular, and Cross-Exchange. They are straightforward to learn, and in many situations, you can enable a bot to do the trading for you.

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Staff Writer

Staff Writer