Cryptocurrency arbitrage is an interesting concept with favourable outcomes but there is more that a trader must know about arbitrage opportunities in the crypto market. Find it all out in this blog.
We cover:
- What is Arbitrage?
- How are cryptocurrencies traded?
- What is cryptocurrency arbitrage?
- Why do cryptocurrency arbitrage opportunities occur in the market?
- How to identify cryptocurrency arbitrage opportunities
- Types of arbitrage opportunities in the cryptocurrency market
- How to begin cryptocurrency arbitrage trading?
- Advantages of cryptocurrency arbitrage
- Drawbacks of cryptocurrency arbitrage
What is arbitrage?
Arbitrage means capturing the profit opportunities stemming from the price differences between different markets for an asset.
Assume an asset X is traded in two markets, market A and market B. If it is traded at 100 in marketplace A and 105 in marketplace B, one can enjoy a riskless 5% profit opportunity excluding transaction cost.
Before diving into cryptocurrency arbitrage, let’s first understand how cryptocurrencies are traded.
How are cryptocurrencies traded?
Cryptocurrencies are mostly traded in centralized exchanges. Users can bid or ask for the cryptocurrency that they want to trade and once a particular buy and sell order matches, the exchange of the assets are realised between buyer and seller.
Based on this logic, cryptocurrencies are traded 24/7 around the world. The same cryptocurrencies are traded on thousands of different exchanges.
For example, you can see some of the markets in which BTC is traded below:
What is cryptocurrency arbitrage?
Cryptocurrency arbitrage is profiting from simultaneously buying a cryptocurrency from an exchange and selling it on a different one with a slightly higher price.
If you check the price column in the above Bitcoin Markets list, there are slight differences between the prices on different exchanges. Although these slight differences cannot absorb the transaction costs, you can experience net arbitrage opportunities during highly volatile times.
Why do cryptocurrency arbitrage opportunities occur in the market?
As mentioned, cryptocurrencies are traded across thousands of exchanges in the world. They are traded in different fiat currencies and they are also traded in major cryptocurrencies.
There are several reasons causing arbitrage opportunities between different markets.
Local Restrictions Imposed to Fiat Currency Transfers
Some countries restrict the flow of capital out of the country, leading to local cryptocurrency investors being barred from accessing the cryptocurrency markets outside the country. That causes imbalances between supply and demand in the local cryptocurrency exchanges.
The most famous example of this situation is Kimchi Premium. In South Korea, there is tight capital control for cryptocurrency investors and foreign cryptocurrency investors are not allowed to trade in local cryptocurrency exchanges. Therefore, cryptocurrency prices in the country deviate from other cryptocurrency markets.
The below chart shows this deviation. As you can see, most of the time, the price of Bitcoin is more expensive in South Korea compared to other markets and this situation is called ‘Kimchi Premium’ among cryptocurrency investors.
Sudden Changes in the Prices
Cryptocurrencies are prone to high price movements as history has shown. The prices can go down 20% and up 20% within the same day. Sometimes it may be impossible for traders placing orders manually to cancel their orders.
Also, some crypto exchanges may show slightly slower or quicker reactions to these price movements because of the liquidity differences between cryptocurrency exchanges.
For example, when cryptocurrency prices start to decrease, market orders in an illiquid exchange would cause prices to drop more severely, which may give rise to arbitrage opportunities.
Transaction and Transfer Costs
Sometimes although there are no restrictions and no high volatility environment, the difference between prices can be seen because of the transaction costs.
You may think that although there are differences between the prices it may not mean that there is an arbitrage opportunity. However, not everyone in a cryptocurrency exchange has the same transaction cost.
Transaction costs in cryptocurrency exchanges are typically much lower for the investors producing high trade volumes. Therefore, these price differences would be slight arbitrage opportunities for them.
How to identify cryptocurrency arbitrage opportunities
In a broad sense, you can identify arbitrage opportunities in two ways, manual calculations and automated screening.
Considering the number of exchanges and cryptocurrency pairs, the manual calculation does not seem like an option here.
The best way to identify cryptocurrency arbitrage opportunities is to create a cryptocurrency arbitrage bot, as these arbitrage opportunities appear for a very short time.
However, this is not enough to capture arbitrage opportunities. You need to have both fiat currency and cryptocurrency on the exchanges you are operating as you cannot know on which exchange you will be the buyer or seller in case an arbitrage opportunity arises.
One of the best things about the cryptocurrency market is that the market data is free and everyone can access an exchange’s real-time data by APIs. You don’t even need to create algorithms from scratch to connect with an exchange’s server and fetch real-time data.
Most cryptocurrency exchanges have their ready to use client packages that enable you to fetch real-time data, send orders and check account balance by only calling functions from the package.
For example, you can find Binance’s package for python here. To be able to use this package, first, you need to install it by writing the below command to the terminal or command line of your computer:
``pip install binance-connector``
Now you can reach real-time and historical data, and place orders by using python. An example would be fetching the candlestick pattern by using 'klines' function:
By following this process, you can fetch tick data from multiple exchanges and compare the prices to see if there is an arbitrage opportunity.
Types of arbitrage opportunities in the cryptocurrency market
Because of all the features, flexibilities and innovations that came with cryptocurrencies, there are a lot of opportunities in this market. Under this section, you will find different ways of capturing riskless profits in the cryptocurrency market.
Pure Spot Arbitrage
In this type, you buy a cryptocurrency from one exchange and then sell it in another one at a higher price.
You can see the real-time price difference of Bitcoin between two different exchanges below.
As you see, one can benefit from the arbitrage opportunity by buying BTC on the left exchanges and selling it on the right exchange.
However, to be able to capture this arbitrage opportunity, you must have fiat currency (USDT) at the exchange on the left and BTC at the exchange on the right so that you can capture the opportunity by simultaneously selling and buying.
Since these arbitrage opportunities appear for a very short time, buying the cryptocurrency and transferring it to another exchange to sell it at a higher price would not be a riskless trade as the price of the cryptocurrency would change even if there is still an arbitrage opportunity when the cryptocurrency transfer is completed.
Actually, by simultaneous buying and selling, one may not need to transfer cryptocurrency at all as an arbitrage opportunity with the opposite position may also appear.
For example, assume you capture the above arbitrage opportunity, after a short period of time, below arbitrage opportunity also occurred.
So this time, you can make a profit by selling at the exchange on the left and buying at the exchange on the right.
Although this is such a small arbitrage opportunity that not everyone can benefit because of the variable transaction costs, only those who have been charged very low transaction costs due to the high volume on the exchanges would benefit from this opportunity.
Also, note that these opportunities have appeared when the market volatility is low. It can be said that during highly volatile times, there may be such arbitrage opportunities from which everyone can benefit.
Positional Arbitrage
This type of arbitrage has the same logic as pure spot arbitrage but this time there is no exchange of ownership of the fiat currency and cryptocurrency on the exchanges.
Instead, you capture the arbitrage opportunities by opening positions on the exchanges and then realise the profit by closing the positions once the prices converge to the same price level.
Assume the first arbitrage opportunity, where we buy on the left side, appeared in the futures market of Bitcoin. In this case, instead of buying at the exchange on the left, you open a position by going long and instead of selling at the other exchange, you open another position at that exchange by going short.
Once the prices converge to the same price level, you can close both positions and the profit you will make at one exchange will be higher than the loss you will incur at another (as you took opposite positions, converging to the same price level can be at a higher or a lower price).
Since this kind of arbitrage does not require holding cryptocurrency funds on the exchanges, you don’t take the price risk of holding a cryptocurrency. You just need to hold fiat currencies at both exchanges.
Interest Rate Arbitrage
Most cryptocurrency exchanges provide borrowing and lending services to all users. The rates charged to borrowers or received by the lenders are based on the supply and demand of the users.
Therefore, one can enjoy a riskless profit by borrowing at a lower rate from a cryptocurrency exchange and lending at a higher rate on another cryptocurrency exchange.
How to begin cryptocurrency arbitrage trading?
To be able to profit from arbitrage trading in the cryptocurrency market, you should be able to buy and sell cryptocurrencies on multiple exchanges. Also, you should be able to detect and catch the opportunities that appear for a very short period of time.
Therefore, the best way of starting arbitrage trading is learning python for algorithmic trading. With python, you will be able to monitor cryptocurrency prices, backtest and automate your trading strategies and capture arbitrage opportunities very quickly.
We offer a variety of python courses at every level for algorithmic trading. You can develop python programming language skills after taking these courses and then use your skills to develop an arbitrage trading bot.
Advantages of cryptocurrency arbitrage
There are many advantages of cryptocurrency arbitrage trading compared to other trading strategies.
First, the risk related to arbitrage trading is very low. Since you aim to capture price differences between cryptocurrency exchanges simultaneously, you don’t have an open position and hence, the risk is very low.
Secondly, no matter what the direction of the prices is, you can make a profit as the price difference can occur while the prices are both decreasing and increasing.
Also, you do not need to wait for too long to realise the profit you capture. Even if you capture a positional arbitrage opportunity, closing your long and short positions won’t take much time as price convergence happens in a very short period.
Drawbacks of cryptocurrency arbitrage
Cryptocurrency arbitrage trading also has some important drawbacks that you should consider before starting to trade.
Funds
First of all, it requires holding some of your funds in cryptocurrency. To take advantage of simultaneous arbitrage, you need to sell the cryptocurrency at the same time as you buy it. For interest-rate arbitrage, you must have cryptocurrencies to be able to borrow fiat currency.
Trading bot
Secondly, to catch spot or positional arbitrage opportunities, you must have a well-functioning trading bot that monitors the prices of all cryptocurrencies across cryptocurrency exchanges, it should also monitor the funds in the wallets and the offered interest rates for borrowing and lending on these exchanges.
Fiat currency
Also, because of the restrictions imposed by the local authorities, sending fiat currency to multiple cryptocurrency exchanges can sometimes be impossible.
Crash
Furthermore, although there are more opportunities during highly volatile times, some exchanges tend to crash because of the overload as history has shown us.
Therefore, your trading bot can buy at one exchange and cannot sell on another due to a possible exchange crash or vice versa. This may result in severe losses as you would have open positions and the market could show a sharp increase or decrease.
Conclusion
In this blog, you have learned what arbitrage is and also about cryptocurrency arbitrage in every aspect. Cryptocurrency arbitrage is making a profit by buying crypto from one exchange and simultaneously selling it on another exchange at a higher price.
Since there is a variety of cryptocurrencies and exchanges, and these opportunities last for a very short period, cryptocurrency arbitrage opportunities require an automated bot to monitor and catch these opportunities.
Also, you have seen that spot trading is not the only way for arbitrage trading. You can make a riskless profit by opening positions and also by borrowing fiat currency or cryptocurrency at a lower rate from an exchange and lending it at a higher rate on another exchange.
Cryptocurrency arbitrage is one type of trading strategy you can apply to crypto-assets. To learn more about crypto trading strategies, be sure to check out the course Crypto Trading Strategies: Advanced by Quantra. Enroll now!
Disclaimer: Any information regarding cryptocurrency in this article is intended to convey general information only. This article does not provide investment, legal, tax, etc. advice. You should not treat any information in this article as a call to make any particular decision regarding cryptocurrency usage, legal matters, investments, taxes, cryptocurrency mining, exchange usage, wallet usage, etc. We strongly suggest seeking advice from your own financial, investment, tax, or legal adviser. Neither QuantInsti
