With cryptocurrency trading still in its infancy and markets spread all around the world, there can sometimes be significant price differences between exchanges. Cryptocurrency arbitrage allows you to take advantage of those price differences, buying a cryptocurrency on one exchange where the price is low and then immediately selling it on another exchange where the price is high.
However, there are several important risks and pitfalls you need to be aware of before you start trading.
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What is cryptocurrency arbitrage?
Arbitrage is the simultaneous buying and selling of an asset on different markets to profit from the price difference between those markets. In a highly simplified example of how cryptocurrency arbitrage works, you would search for a specific coin that’s cheaper on Exchange A than on Exchange B. You then buy the coin on Exchange A, sell it for a higher price on Exchange B and pocket the 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, the development of quantitative systems designed to spot price differences and execute trades across separate markets has put arbitrage trading out of reach of most retail traders.
But arbitrage opportunities still exist in the world of cryptocurrency, where a rapid surge in trading volume and inefficiencies between exchanges cause price differences to arise. Bigger exchanges with higher liquidity effectively drive the price of the rest of the market, with smaller exchanges following the prices set by their larger counterparts. However, smaller exchanges don’t immediately follow the prices set on larger exchanges, which is where opportunities for arbitrage arise.
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How does cryptocurrency arbitrage work?
Arbitrage is typically made possible by a difference in trading volumes between 2 separate markets. The reason behind this is simple: In a market with high trading volumes where there’s reasonable liquidity of a particular coin, prices are generally cheaper. Meanwhile, in a market where there’s limited supply of a particular coin, it will be more expensive. By purchasing from the former and instantaneously selling on the latter, traders can theoretically profit from the difference.
However, arbitrage opportunities also exist in the opposite direction, where you would buy on a smaller exchange and sell on a larger exchange. The recent surge in the popularity of cryptocurrency has led to a dramatic increase in trading volumes on many exchanges around the world. Those exchanges are not linked, and a low trading volume on some exchanges can mean that the price listed doesn’t adjust to the exchange average immediately. As a result, this has seen the creation of price differences arbitragers could potentially exploit.
The most famous example of cryptocurrency exchange pricing differences was a phenomenon known as the “kimchi premium” which, in January 2018, saw the price of Bitcoin (BTC) in South Korea rise to more than 50% higher than global prices.
How to do it
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. Online or mobile trading apps, such as Blockfolio, can also simplify the market monitoring process.
It’s also worth pointing out that hedge funds are increasingly moving into the cryptocurrency sphere. For example, Singapore hedge fund Kit Trading is raising US$10 million for a crypto arbitrage fund and is set to join the more than 80 crypto hedge funds that launched in 2017.
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 one 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.
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A simple example of crypto arbitrage
To explain how arbitrage works, let’s look at a hypothetical example. Let’s assume we have 2 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$8,800.
- Exchange B is a smaller exchange with less trading volume. The price of BTC on this exchange is US$8,805.
Now let’s assume that there’s an important announcement that is likely to encourage people to buy BTC, such as the US Internal Revenue Service 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$9,240 on Exchange A, but only rises to US$9,070 on Exchange B, which is where arbitrage comes in. You could do the following:
- Buy BTC on Exchange B at US$9,070.
- Transfer your BTC to Exchange A.
- Sell your BTC on Exchange A for US$9,240, securing a profit of US$140 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.
The potential benefits of arbitrage
Why would you consider cryptocurrency arbitrage? There are several reasons:
- 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 CoinMarketCap, at the time of writing (12 February 2018), you could buy and sell cryptocurrencies on more than 180 exchanges around the world. With so many exchanges available, there’s plenty of potential for a price differential.
- Crypto markets are in their infancy. Cryptocurrency trading is largely unregulated and disjointed, and the information transfer between exchanges is slow. There are also fewer traders and less competition compared to many popular investment markets, all of which can lead to potential 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. This is a great way to understand just how volatile cryptocurrency prices can be, and wherever there’s volatility, there’s the potential for price differences between exchanges.
The risks of cryptocurrency arbitrage
Cryptocurrency arbitrage sounds like a piece of cake in theory, so why isn’t everybody 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.
- Storing coins on exchanges. To place arbitrage trades, you’ll need to store coins on cryptocurrency 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.
- Exchange fees. Most cryptocurrency exchanges charge fees on trades, while deposit and/or withdrawal fees sometimes also apply. 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 a cryptocurrency 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, Ether (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.
Things to consider before attempting cryptocurrency arbitrage
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:
- 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 in 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 ETH, which offers faster transactions, instead.
- 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 cryptocurrency exchange, do plenty of research beforehand to make sure you only deal with reputable sites.
- 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 1 exchange, or 1 particular 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.