Crypto Arbitrage Explained: What is Arbitrage?
What is Crypto Arbitrage?
Arbitrage is the purchase and sale of the same asset in different markets to take profits from the price differences. Arbitrage traders exploit the price deviation on other markets of identical financial assets. It can occur on any financial market such as cryptocurrency, stocks, commodities, fiat currencies, etc.
So, crypto arbitrage is a strategy of purchasing and selling cryptocurrency between different markets, and profits will be generated from the different prices on the same asset.
An easy-to-understand example is when a convenience store owner purchases cheaper loaves of bread in a nearby store and then sells them in his store for a higher price. The store owner does an arbitrage of the bread price on two different markets (his store and the nearby store).
The profit from the price difference also depends on the sale volume. It might be minor at a small scale, but the potential profit of arbitrage is highly margined on a large scale. Therefore, arbitrage is a low-risk but high-gain opportunity for investors who are able to spot and execute.
Arbitrage is somewhat a product of market inefficiency where all markets’ data and liquidity are fragmented rather than connected. At the moment, it is still a big challenge for market makers to solve arbitrage. In other words, it is inevitable that profit from arbitrage is getting big, being fueled by the advent of Decentralized Finance (DeFi) in the crypto space.
How does crypto arbitrage work?
For traders, the goal of arbitrage trading is to make profits from buying an asset at a price and then selling it at a higher price. Here is a simple example of how a profitable arbitrage works:
- A trader spots a Bitcoin price difference between two markets (crypto exchanges).
- He buys 1 Bitcoin at $20,000 in market A.
- He transfers his 1 Bitcoin to the other market named B.
- Thanks to the $1,000 price difference, he makes a $1,000 profit from selling 1 BTC at $21,000.
- Note that if fees are included, the profit will be less than $1,000.
The price difference is the above-all condition for a profitable arbitrage to occur. If traders do the calculations wrong, the arbitrage might be a loss. The mentioned example is the most simple one of arbitrage. Traders sometimes conduct more complex transactions by converting assets multiple times before profiting.
Besides making profits for traders, arbitrage enhances the liquidity of the markets and partially eliminates market inefficiencies. It bridges the gap between different exchanges by narrowing the price differences of identical assets.
Types of crypto arbitrage
Exchange arbitrage
Arbitrage on exchanges is the most basic type of arbitrage. Traders only have to purchase the assets on one exchange and sell them on another exchange for profits. The higher the spread, the more profits traders have.
Some markets are each other partners, and the liquidity is connected, while others have their own independent liquidity. This creates market inefficiencies that lead to arbitrage opportunities.
Spatial arbitrage
Exchanges are located in different countries, and people only have limited access to some exchanges because of their nationality. Coinbase is accessible for investors from the countries decided by the exchange and complied with U.S. regulations. Therefore, spatial arbitrage exists to bridge the gap between regions.
Sam Bankman-Fried (SBF), a crypto billionaire and the founder of FTX, is a notable example of spatial arbitrage traders. In retrospect, he discovered the difference in the Bitcoin price between Korean and U.S. exchanges, called the Kimchi Premium. In addition, SBF found the same opportunity with a 10% premium in crypto markets in Japan. He put things together to arbitrage between exchanges to make millions of dollars in profits. According to SBF, the hard part was to create a framework on a global scale.
Spatial arbitrage exists due to the crypto views of each country. Crypto exchanges are localized, while decentralized exchanges (DEX) can eliminate localization. However, DEX can not prevent investors from price arbitrage. Let’s explore more in the next section.
Funding rate arbitrage
The funding rate (denoted in percentage) bridges the gap between the prices of perpetual contracts and the underlying assets. Perpetual traders have to pay fees periodically to others, based on which positions they are opening, long or short.
If the funding rate is positive (an uptrend), long-positioning traders will have to pay funding fees to short traders over time, and vice versa. So how can we do arbitrage with the funding rate?
Investors use the funding rate arbitrage strategy to earn profits from funding fees that they receive while opening any long/short positions. To mitigate the loss from the price movement of perpetual positions, investors open an opposite position with the same volume.
For example, investors can open a short position of $10,000 and buy $10,000 worth of the same crypto in the spot market. Therefore, investors bear no losses from price movements and profit from funding fees if the funding rate is positive.
Profit from funding rate arbitrage depends on the funding rate and the position size. Therefore, we should take into consideration many mentioned factors in order to not conduct any unprofitable investments.
Risks of arbitrage
Trading fees
During arbitrage trading, many fees occur, such as trading, withdrawal, deposit, etc. Every exchange and decentralized exchange (DEX) charge users a certain amount of fees for service usage. This amount accumulates over time, which might eventually outnumber profits from arbitrage.
The solution to this problem is to choose trading platforms with reasonable fee tiers. Furthermore, selecting arbitrage opportunities with high-margined profits can mitigate the risks from fees.
Timing the price
Traders have to be very sensitive about the timing of an arbitrage because the purchase and the sale simultaneously occur in a short period of time. Both retail and institutional investors now trade arbitrage so the opportunity can slip away fast. The price disparity is filled after each successfully-conducted arbitrage. Therefore, arbitrage benefits the price balance for stable assets like USDT and USDC.
A fast arbitrage on Solana when Wormhole was exploited
Automation
Arbitrage at a high frequency is hard to conduct manually. This is why automating arbitrage comes in and is profitable in the long run. Arbitrage trading bots are programmable. However, there is a risk that the bots do not work as instructed, putting arbitrage funds at risk.
Bots can help execute arbitrage trades fast, but funds might be unsecured during transactions. For example, an arbitrage trade among DEXs is automated using smart contracts that might cause funds to be locked if malfunctions occur.
Another scenario is other traders who are also involved in the same arbitrage. During the time of your confirmation, other traders might accomplish the arbitrage first. Then your funds might get stuck in the middle of the trade, which takes time to return. This is a big opportunity cost for high-frequency traders.
Security
Since arbitrage is a capital-intensive investment, traders have their funds available on many trading platforms and markets. There is inevitably a slight risk with the deposited fund.
Rug pull or hacks are some of the inherent risks in the crypto market, and nobody is able to anticipate when they will come. Putting funds on exchanges with high reputations is a usable option to avoid losing funds due to unforeseen circumstances.
Learn more: 5 tips to avoid rug pull in crypto.
FAQs about crypto arbitrage
Is crypto arbitrage legal?
Arbitrage emerges due to market inefficiencies. The profits incentivize traders to conduct arbitrage, which helps markets more efficiently.
Should we use arbitrage bots?
Bots are suitable for time-sensitive automation tasks. They can execute trades in seconds or even microseconds to make small profits that can accumulate to a huge sum. Besides automation, bots might be programmed to detect potential price differences that have large spreads. Therefore, detection bot users are able to spot rare opportunities to make huge profits.
However, arbitrage bots can not guarantee investors any profits. It is better to consider carefully before building arbitrage bots, especially buying ones.
How much can we make in crypto arbitrage?
The profits from arbitrage are often small due to narrow price disparity. The opportunities to have price differences of about 10% are rare, primarily in just a few percent. However, each arbitrage is fast executing, and traders can do many ones each day, making the profits cumulatively significant.