A term that you may not hear very often in the world of cryptocurrency is crypto arbitrage. While the phrase itself is intimidating, it's actually a pretty simple concept to understand. However, don't confuse understanding with doing. Crypto arbitrage is a sophisticated trading technique that many investors avoid due to the volatility of the market and the precise timing required.
But what is crypto arbitrage? How does it work? What are the advantages and disadvantages of this type of cryptocurrency trading? Read on to find out everything you should know about the world of crypto arbitrage.
What is crypto arbitrage?
As a concept, arbitrage trading has been around for a while. Since bonds, stocks, and foreign markets first hit the scene, arbitrage has been a thing. Simply put, arbitrage is the process of buying an asset on one market, then selling it on another market at a different price to realize a profit. Simple, right?
For example, if Ethereum (ETH) is listed on Binance for a higher price than Coinbase, a trader would buy some ETH on Coinbase, then immediately turn around and sell it on Binance. This type of trading exploits inefficiencies in the crypto market, allowing the trader to profit.
Crypto arbitrage opportunities arise when a sudden surge in trading volume causes the price of a crypto asset to spike. Smaller cryptocurrency exchanges typically get their crypto prices from larger platforms through the use of an API. However, the adjustment doesn't happen instantaneously, which creates price differences. This is when arbitrage trading happens.
Types of Arbitrage
Keep in mind there is more than one type of crypto arbitrage. We’ve listed a few of the more popular options here, but there are plenty of other arbitrage methods available.
01-Between Platforms
This first type of arbitrage is the simplest. You buy a cryptocurrency on one exchange, then sell it for more on a different one. However, there are a few problems with this type of crypto arbitrage. For starters, the price difference may only last for a few seconds, whereas the time it takes to transfer your funds might take minutes.
You should also consider the issue of fees. Moving your crypto between different exchanges is rarely free. You may pay withdrawal fees, network fees, deposit fees, or all three.
02-Statistical Arbitrage
WIth statistical arbitrage, traders rely on the sophisticated algorithms performed by arbitrage bots. These trading bots use quantitative models to gather data that can help predict when a user may benefit from going "short" or "long" on a trade.
Typically, arbitrage bots give digital assets scores based on their performance in the cryptocurrency market. Any trading bot worth using provides excellent arbitrage strategies that successfully predict the price of different cryptocurrencies while trading them against one another.
03-Triangular Arbitrage
With triangular arbitrage, you're taking three different cryptocurrencies on one exchange and trading the difference between them. This type of crypto arbitrage occurs when a cryptocurrency is undervalued on the platform. The beauty of triangular arbitrage is that since everything takes place on the same exchange, there are no transaction fees.
If you're wondering how this type of arbitrage works, let's take a look at a quick example. A crypto trading opportunity arises on Kraken between Ethereum, Bitcoin, and Litecoin. To successfully perform the triangular arbitrage, the trader sells the Ethereum for Bitcoin, then sells the Bitcoin for Litecoin. The last step is to sell the Litecoin for Ethereum. If everything worked successfully, the trader ends up with more Ethereum than when they began.
04-DeFi Arbitrage
Decentralized finance arbitrage is a type of arbitrage that recently became popular. With DeFi arbitrage, various platforms provide users a way to find opportunities in the market. Protocols find the best possible yield while users rely upon the security provided by smart contracts. We’ll go more in-depth with DeFi arbitrage in a bit.
Advantages of Crypto Arbitrage
There are a lot of reasons traders like crypto arbitrage. If you’re interested in exploring crypto arbitrage further, here are some of the benefits to this type of trading.
01-Various Opportunities Available
There are a variety of exchanges and platforms in today's cryptocurrency market. With a proliferation of trading pairs comes plenty of arbitrage opportunities. A quick glance at CoinGecko reveals almost 500 centralized exchanges and over 100 decentralized platforms. It's fair to say there is no shortage of opportunity out there.
02-Quick Returns
With traditional trading, you buy and hold your crypto assets to sell at a later date. While this is a fine strategy, with arbitrage trades, you'll realize your profits much quicker. Using arbitrage, traders see their returns as soon as the transaction completes, which could take a matter of minutes.
03-Early Investment in a Developing Market
Cryptocurrency has yet to reach peak adoption, which means it's still a nascent industry. The truth is, the crypto market has yet to fully mature, which creates opportunities for arbitrage trading. There are areas in the industry that are disjointed and erratic, which creates a lack of communication and information between platforms. Plus, with fewer traders and less competition, market prices are likely to be different between platforms.
04-Industry Volatility
Even though Bitcoin (BTC) has been around for a decade, it seems as though it's been much longer. However, BTC and other cryptocurrencies are still a new industry, and one of the most volatile in the world. Its volatility is primarily due to significant changes in supply and demand on a regular basis. How is this an advantage? With such huge price changes in the market and between exchanges, an opportunity for crypto arbitrage arises.
Disadvantages of Crypto Arbitrage
No trading method is perfect, especially in the world of cryptocurrencies. With that in mind, here are a few of the drawbacks to crypto arbitrage.
01-Potential Withdrawal Limitations
Not all exchanges and platforms offer unlimited withdrawals. Keep that in mind if you plan on withdrawing funds from your account that you may have deposited earlier that day. This is especially true if you're performing large trades.
02-Transaction Fees
Most cryptocurrency exchanges aren't going to let you deposit, buy, sell, trade, and withdraw funds without paying some type of fee. Before you begin using an exchange, determine what fees are charged so you know exactly how much you'll be charged. This way, you can calculate precisely how much you'll profit from your arbitrage.
03-Know Your Customer Restrictions
Know Your Customer — often shortened to KYC — is a way for a cryptocurrency exchange to confirm your identity. For almost all centralized exchanges, you'll have to provide some type of identification. However, those who prefer to avoid these types of requirements typically migrate to decentralized platforms.
The challenge with KYC is that oftentimes you're required to hold a bank account located in the same country as the exchange. Additionally, you may have to wait a day or two for KYC verification before the exchange will let you trade.
04-Slow Transaction Times
As more and more users enter the world of cryptocurrency trading, the more trading volume goes up. As a result, it takes more time for transactions to complete, which makes crypto arbitrage more challenging. This is a significant problem if you need to move funds quickly. Additionally, keep in mind that some cryptocurrencies, like Bitcoin, take more time to complete than others, like Ethereum.
05-Precision Timing Needed
It can take up to 10 minutes for a cryptocurrency transaction to be verified and completed. During this time, the market may turn against you, so it's important that you don't risk any more than you're willing to lose. There have been plenty of instances when a crypto arbitrage profit quickly turned into a loss.
06-Increasing Competition
The world of cryptocurrency isn't getting any smaller, which means there are more investors and traders entering the fray daily. As more traders join the market, trading volumes go up, which can lead to fewer opportunities for crypto arbitrage.
Crypto arbitrage in the world of decentralized finance
The last type of crypto arbitrage we briefly touched on is decentralized finance arbitrage, or DeFi arbitrage. These types of non-custodial, code-heavy protocols are what make decentralized finance perfect for cryptocurrency arbitrage. As a result, there are several different types of arbitrage trading strategies traders can employ.
A popular DeFi strategy regularly used is through various yields offered by different lending protocols. For example, if one platform is offering 8% yield from an asset while another is offering 11% on another, then it makes sense to convert to the asset that is offering the higher yield to earn the extra 3%.
Another method often used is similar to arbitrage between exchanges. The difference is that in the world of DeFi, the platforms are decentralized, like Uniswap. Similar to centralized exchanges, decentralized platforms may offer different prices for assets, so it's possible for traders to earn profits from the differing values.
One other strategy traders like to use is through a Curve pool when the ratio is skewed. Many users take advantage of this method through GUSD. For example, both GUSD and USDC stablecoins are both redeemable at one for one. So, as gas fees allow, traders can trade 1 USDC for 1 GUSD, even though both are pegged to one U.S. dollar. However, keep in mind that DeFi arbitrages are more expensive to execute than other arbitrage methods due to the cost of gas involved with each transaction.
The last method I want to talk about is flash loan arbitrage. A flash loan is a DeFi loan that has to be borrowed and repaid on the same Ethereum transaction. The idea is to let a borrower purchase a digital asset on one decentralized exchange, sell it on another, pay back the loan, and pocket the difference.
How does this apply to DeFi arbitrage? Let’s look at an example. You spot a drastic price difference of an asset, like Ethereum, on two exchanges. Instead of using your own funds, you take out a flash loan for USD 5,000. You purchase the ETH on one exchange, then sell it on the other exchange for a profit. Now, you sell your ETH, pay back the flash loan, and pocket the difference. It's worth noting that flash loans requires technical knowledge to be executed and is not as simple as it seems. It can appear in a form on an attack on a protocol too.
A simple concept with challenging strategies
As you can see, there are plenty of opportunities and techniques that allow traders to benefit from crypto arbitrage. However, as more investors and traders enter the market, these opportunities begin to diminish and decrease. As a result, the market begins to stabilize, and the price differences across different markets disappear.
But don't be discouraged. There are still plenty of platforms out there working for you and helping you make sense of the market in a more simple manner. Platforms like Unagii, with its Vaults, can help you maximize your investments via yield farming by locking a variety of crypto assets in DeFi strategy pools for high yields.
Buying, selling, trading, and investing in cryptocurrencies can be intimidating. It's nice to have exchanges and platforms available to help guide you when you run into issues. Plus, it doesn't hurt if you're making some money in the process.
Crypto arbitrage isn't for everyone. Just like everything else, it has its advantages and disadvantages. The concept behind it is easy to understand, but timing the market and accounting for all the variables makes it a difficult trading strategy to execute.
