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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 crypto 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.
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.
However, 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.
Arbitrage is typically made possible by a difference in trading volumes between two 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 crypto 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.
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 that are 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 $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:
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To explain how arbitrage works, let’s look at a hypothetical case study. Let’s assume that we have two exchanges that both list bitcoin:
Now let’s assume that there’s an important announcement that’s 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 $9,240 on Exchange A, but only rises to $9,070 on Exchange B, which is where arbitrage comes in. You could do the following:
Please note that this example is entirely hypothetical and ignores trading and transfer fees, transaction processing times and potential price movements between transactions.
Why would you consider cryptocurrency arbitrage? There are several reasons:
Cryptocurrency arbitrage sounds like a piece of cake in theory, so why isn’t everybody and their dog 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:
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: