Before we begin, it’s important to understand how an exchange order book works. We can see in the above illustration that Bid orders are placed on the left side. On the right side, we must place Ask orders. If you want to execute an instant trade, which results in being the taker in the exchange, you can either place a limit order on the other side of the bid-ask spread (from your current position), or execute a market order.
Arbitrage is the process of taking advantage of inefficiencies in markets. In the case of cryptocurrencies, this can occur as the price of assets fluctuates over time. If there is a difference between the price of an asset across exchanges (or even potentially within the same exchange), it may be possible to buy and sell the same asset in a way which will result in a net profit.
This process will be dissected in more detail throughout the remainder of this article. We will discuss how to calculate arbitrage opportunities, how to take advantage of these situations, and even how to build your own trading system designed for arbitraging the market.
Crypto arbitrage allows traders to exploit inefficiencies in the market. It is a surprisingly simple concept with opportunities cropping up many times a day. Read on to find out the meaning of cryptocurrency arbitrage, its benefits, risks and the useful tools available to help generate profits.
The arbitrage opportunity for any market is calculated by identifying the overlap between the highest bid prices and the lowest ask prices. When the bid price on one exchange is higher than the ask price on another exchange for a cryptocurrency, this is an arbitrage opportunity.
Now, before we start throwing trades at this situation hoping for a quick buck, let’s take a measured approach by calculating the size of the opportunity. One thing we need to remember when calculating the value of the arbitrage opportunity: Executing the arbitrage will result in consuming the order book. For example, let’s look at “Step 2” in the illustration to the left. In this step, we have highlighted the amount of the order book which overlaps. That means the bid price on one exchange is higher or equal to the ask price on another exchange for the highlighted area
However, once we begin executing on the arbitrage opportunity, what we notice in steps 4 and 5 is that consuming the order book results in the arbitrage opportunity shrinking after each price value is taken. Therefore, we aren’t able to capitalize on all of the value which is highlighted in yellow in step 2 (the area of the depth), but only a fraction of the value.
When calculating the size of the opportunity, we must therefore take this behavior into account. We can do this by systematically simulating the execution of the actual buys and sells we would actually make on the exchange during the arbitrage.
According to most financial textbooks, it is believed that markets are efficient and thus that an arbitrage opportunity simply can’t occur. (Un)Fortunately, the reality is far from theory and traders have found a way to exploit it.
There are many reasons behind the occurrence of a crypto arbitrage and I’ve extracted the most notable ones:
Liquidity variance across several exchanges
Most of the exchanges have their own order books that tend to be different with varying liquidity for a particular asset. For those new to trading, an order book is an automated list of current sell and buy positions for a specified asset.
For example, if we are buying Bitcoin, it might be easier to convert it into cash on a particular exchange without causing a loss. This can easily have something to do with the order book of an exchange.
If one exchange has a wide order book and the other a more filled one, it would be wise for us to buy our asset on the latter, as the former would end up in us paying a higher price.
But why does this happen if both order books show the same price for our asset?
Well, one exchange (with the wide order book) can be made up of small orders of BTC at the very top of its book price.
After we buy these orders, we’re automatically moving into the lower levels of the order book to make the rest of our order, and thus paying a higher price.
Now that we understand conceptually how arbitrage happens, let’s discuss the most popular types of arbitrage opportunities: Simple and Triangular Arbitrage.
Simple arbitrage is the buying and selling action we described in our previous examples in this article. Simple arbitrage buys and sells the same crypto asset on different exchanges as quickly as possible to take advantage of the inefficiencies of pricing across exchanges.
This form of arbitrage does not require any additional trades outside those necessary to swap the two assets which are shared by the asset pair which is exhibiting the arbitrage opportunity.
Triangular arbitrage is an event that can occur on a single exchange (or across multiple exchanges) where the price differences between three different cryptocurrencies lead to an arbitrage opportunity. Since many exchanges have a number of markets with a variety of quote currency options. This opens up a long list of triangular trading patterns that can be leveraged to take advantage of inefficiencies in an individual exchange pricing.
Perhaps the simplest and most common method is spatial arbitrage. This involves looking at one instrument on two different exchanges. If these exchanges list the crypto at different prices, traders can buy from the cheaper exchange and immediately sell from the more expensive one, instantly making money from the discrepancy.
The easiest way to do this is to buy, let’s say Ethereum, from one exchange, transfer it to another and then sell it. Unfortunately, this is inefficient, both taking extra time to complete the transfer and incurring additional charges.
To avoid this issue, traders can hold their fiat currency in one exchange and their crypto in the other. When the opportunity presents itself, the same buy and sell order can be placed at the same time across the two exchanges. This would give the trader additional fiat currency while maintaining the same crypto capital. This method performs trades without transferring from one exchange to another, taking less time and incurring fewer fees.
Triangular crypto arbitrage is a little more complex, involving three trades instead of two, all of which are usually carried out on the same exchange. This method looks at three different cryptos, trading through each of them until you are back to the original asset.
For example, a trader might spot an opportunity in Bitcoin and Ethereum exchange rates. They could then exchange their Bitcoin for Ethereum, which could then be traded for Ripple and finally back to Bitcoin. If the spot rates are inconsistent, the trader could end up with more Bitcoin than they had initially owned, despite trading around a loop.
A slightly trickier form of crypto arbitrage, flash loan arbitrage, takes advantage of the advanced technology behind altcoins and lending approaches. Flash loans are instant cryptocurrency loans that allow traders to borrow large amounts of digital coins without any collateral. This presents a lending arbitrage opportunity to take advantage of differences in interest rates by flash loan providers.
Arbitrage goes beyond the strategies explained above, providing opportunities to traders both inside and outside of the altcoin world. Crypto derivatives arbitrage works in the same way as those, though it uses securities and derivatives of digital currencies, rather than the tokens themselves. One method that is common among hedge funds is to buy cheap stocks of companies before a merger when the market is inefficient and unsure.
Crypto arbitrage stands above many trading strategies in how quickly profits are realised. Exploiting the price inconsistencies over such short periods means that profits are made as soon as the transactions and trades have gone through.
Cryptos provide a wide range of arbitrage opportunities. With over 500 exchanges and more than 4,000 cryptocurrencies around the world, the likelihood of altcoin arbitrage opportunities presenting themselves is huge.
One of the reasons for the popularity of cryptocurrencies in the trading world is the consistently high levels of volatility they demonstrate, even Bitcoin, which has been around for over a decade. The decentralisation and proof systems of cryptos help to ensure varying levels of supply and demand, keeping volatility high. This volatility is great for crypto arbitrage, as the more that prices change, the more likely it is that markets will show inconsistent rates.
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