Arbitrage exploits price differences of an asset between various exchanges and independent brokers, since each exchange has a slightly different supply/demand ratio.
The difference in prices is often found between local exchanges, which is tied to the economic situation in the countries where the exchanges are based.
Exchanges also have different processing capacities, meaning that smaller exchanges will often be lagging behind larger ones, creating additional opportunities for profit.
The ultimate difference between crypto and traditional markets, the difference in volatility, comes into play here too, since the extreme volatility of the crypto market reliably produces price differences that can be used for profit.
Arbitrage examples in crypto
When a trader spots a price difference between exchanges, they may buy an asset at a cheaper price and sell it at the exchange where the price is higher. The mechanism also works the other way around.
However, many traders will be aware of the difference, making it an urgent matter, since the prices are quick to even out. In addition, service charges need to be taken into account, since the price difference is usually small.
That makes the profit margin extremely low and may not accommodate the extra commissions on the trades.
Exchange arbitrage is further divided into spatial and cross-border that have the same procedure, but the cross-border one involves exchanges located in different countries.
This form of trading has the word triangular in its name, since it’s easier to visualise the algorithm by cracking it down into three logical steps.
Say, we’ve got Bitcoin to work with. We might sell Bitcoin for Ripple (XRP/ BTC), then sell Ripple for Bitcoin Cash (BCH/XRP) and finally convert Bitcoin Cash back to Bitcoin (BTC/BCH).
Thus, with triangular arbitrage in crypto, to net a profit while assuming low transaction costs, traders utilize a discrepancy between three foreign currencies, which occurs when exchange rates do not match up.
During impulse movement, when the price difference of an asset between a broker and an exchange occurs, the trader can simultaneously buy the asset on the exchange and sell at the broker, or vice versa.
Once the price difference is back to the normal value, the profitable trade value is higher than that of the loss trade, yielding an overall profit.
Note that brokerage is quite an unusual category for the crypto niche. It is blurring the boundaries between traditional money and cryptocurrencies, adding to the stock characteristics of the crypto token.
And yet, buying and selling cryptocurrencies with a broker is possible for those who don’t care if they actually have ownership of the currency they wish to trade.
Say, you’re a Forex-oriented investor and just want to extend your existing portfolio with new instruments and you don’t have time to explore crypto exchanges and just want to use the existing functionality of your trading terminal, such as MetaTrader.
Is arbitrage worth the effort with cryptocurrencies?
Cryptocurrency arbitrage has undeniable potential for profit, as it is accessible to most traders and can be scaled up efficiently. However, to make steady profit from arbitrage, the trader must be constantly monitoring the exchanges as well as the market situation in general.
As with any trading, the competition is high, so one must not only identify an opportunity, but also use it before the price difference is evens out. Because of this, traditional arbitrage in the cryptocurrency market may become obsolete, but can still be done for now with the correct software and skills.
Low initial investment makes it even more difficult to extract profit, because one must also pay attention to commission values to make sure that the trade is profitable.
Some coins will also have low liquidity, making it difficult to conduct simultaneous trades necessary for arbitrage, especially given the fact that multiple traders will likely be attempting to do so.
Despite the challenges, arbitrage remains a popular strategy in the crypto market, with new peer-to-peer services being created to connect cryptocurrency traders from different countries for easier cross-border trades.