What is Crypto Arbitrage and How Does It Work?

Fibo Quantum

In brief

  • 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.
  • Risks associated with arbitrage trading include slippage, price movement and transfer fees.

Every day, tens of billions of dollars worth of cryptocurrency changes hands in millions of trades. But unlike traditional stock exchanges, there are dozens of cryptocurrency exchanges, each displaying different prices for the same cryptocurrencies.

For savvy traders—and ones who aren’t averse to a little risk—that opens up an opportunity to get the edge over their compatriots: play these exchanges against each other. Welcome to the world of crypto arbitrage.

What is crypto arbitrage?

Crypto arbitrage is a trading strategy that takes advantage of how cryptocurrencies are priced differently on different exchanges. On Coinbase, Bitcoin might be priced at $10,000, while on Binance it could be priced at $9,800. Exploiting this difference in price is the key to arbitrage. A trader could buy Bitcoin on Binance, transfer it to Coinbase, and sell the Bitcoin—profiting by 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 arbitrageur times the market correctly. When Filecoin hit exchanges in October 2020, some exchanges listed the price for $30 in the first few hours. Others? $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 assigned to it is purely speculative. The counterargument is roughly that if people are willing to pay for a cryptocurrency, then that coin has value. Like most unresolved arguments, there’s truth to both sides.

On exchanges, the game plays out in order books. These order books contain buy and sell orders at different prices. For example, a trader could make a “buy” order to buy one Bitcoin for $10,000. This order would go on the order book. If another trader wants to sell one Bitcoin for $10,000, they could add a “sell” order to the book, thus fulfilling the trade. The buy order is then taken off the order book as it has been filled. This process is called a trade.

Cryptocurrency exchanges price a cryptocurrency on the most recent trade. This could come from a buy order or a sell order. Taking the original example, if the sale of the lone Bitcoin for $10,000 was the most recently completed trade, the exchange would set the price at $10,000. A trader who then sells two Bitcoin for $10,100 would move the price to $10,100, and so on. The quantity of crypto traded doesn’t matter, all that matters is the most recent price.

Each crypto exchange prices cryptocurrencies this way, save for some crypto exchanges that base their prices on other cryptocurrency exchanges.

Different types of arbitrage

Between exchanges

One method of crypto arbitrage is to buy a cryptocurrency on one exchange, then transfer it to another exchange where the currency is sold at a higher price. There are a few problems with this method, however. Spreads usually only exist for a matter of seconds, but transferring between exchanges can take minutes. Transfer fees are another issue, as moving crypto from one exchange to another incurs a charge, whether through withdrawal, deposit or network fees.

The price of Bitcoin can differ between exchanges. Image: Coinranking.com

One way that arbitrageurs get around transaction fees is to hold currency on two different exchanges. A trader employing this method can then buy and sell a cryptocurrency simultaneously. Here’s how that might play out: A trader might have $10,000 in a US dollar-pegged stablecoin on Binance and one Bitcoin on Coinbase. When Bitcoin is valued at $10,200 on Coinbase but only $10,000 on Binance, the trader would buy the Bitcoin (using the stablecoin) on Binance and sell the Bitcoin on Coinbase. They would neither gain nor lose a Bitcoin, but they would be making $200 due to the spread 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 because of its relative stability. It makes it easier to hold cryptocurrencies without the risk that its price will massively decrease. The advantage to holding stablecoins such as Tether, instead of converting crypto to cash is that crypto-to-fiat transfers often incur huge charges.

Triangular arbitrage

This method involves taking three different cryptocurrencies and trading the difference between them on one exchange. (Since it all takes place on one exchange, transfer fees aren’t an issue).

So, a trader might see an opportunity in arbitrage involving Bitcoin, Ethereum and XRP. One or more of these cryptocurrencies may be undervalued on the exchange. So a trader might take advantage of arbitrage opportunities by selling their Bitcoin for Ethereum, then using that Ethereum to buy XRP, before finishing by buying Bitcoin back with the XRP. If their strategy made sense, then the trader will have more Bitcoin at the end than when they started.

Trading risks

There are several risks associated with arbitrage trading. One of these is slippage. Slippage occurs when a trader makes an order to buy a cryptocurrency, but their order is larger in size than the cheapest offer on the order book, causing the order to ‘slip’ and cost more than they expected to pay. This is a problem for traders, especially since the margins are so small that slippage could wipe out potential profits.

Price movement is another risk associated with arbitrage. Traders have to be quick to take advantage of spreads when they form, as the spread could disappear within a few seconds. Some traders program bots to perform arbitrage trading, which has only added to the competition.

Finally, traders must take into account transfer fees. Spreads are rarely very large for the major cryptocurrencies, and with tight margins a transferral or transaction fee could wipe out any potential profit. These tight margins also mean that any trader who wants to make significant gains must carry out a large number of trades.

Disclaimer

The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment, or other advice.