What is arbitrage?
Arbitrage involves taking advantage of profit opportunities that arise from the price disparities between various markets for a specific asset.
Let’s consider an asset X that is traded on two markets, market A and market B. If the price of X is 100 in market A and 105 in market B, an individual can reap a 5% profit opportunity with no risk, assuming transaction costs are not considered.
Before exploring cryptocurrency arbitrage, it’s crucial to have an understanding of how cryptocurrencies are traded.
How are cryptocurrencies traded?
Cryptocurrencies are predominantly traded on centralized exchanges. In these exchanges, users can place a bid or ask for the cryptocurrency they wish to trade. Once a match is made between a buyer and seller’s order, the exchange of assets takes place between them.
Following this logic, cryptocurrencies are traded 24 hours a day, 7 days a week worldwide, and the same cryptocurrencies can be traded on thousands of different exchanges.
For example, you can see some of the markets in which BTC is traded below:
What is cryptocurrency arbitrage?
Cryptocurrency arbitrage involves taking advantage of the price differences of a cryptocurrency on different exchanges by simultaneously buying it on one exchange and selling it on another with a slightly higher price.
As seen in the price column of the list of Bitcoin Markets, there are minor variations in prices among different exchanges. Although these minor differences may not cover transaction costs, net arbitrage opportunities can still be realized during times of high volatility.
Why do cryptocurrency arbitrage opportunities occur in the market?
As previously noted, cryptocurrencies are traded on thousands of exchanges globally, in various fiat currencies and major cryptocurrencies. There are several factors that create arbitrage opportunities between different markets.
Local Restrictions Imposed to Fiat Currency Transfers
In some countries, restrictions on the movement of capital out of the country result in local cryptocurrency investors being unable to access markets outside the country, causing imbalances in supply and demand on local cryptocurrency exchanges.
The best-known example of this phenomenon is the Kimchi Premium. In South Korea, capital controls are strict for cryptocurrency investors, and foreign investors are not permitted to trade on local cryptocurrency exchanges. This results in cryptocurrency prices in the country diverging from those in other cryptocurrency markets.
The chart below illustrates this deviation. It is evident that the price of Bitcoin is usually higher in South Korea compared to other markets, and this scenario is referred to as the “Kimchi Premium” among cryptocurrency investors.
Sudden Changes in the Prices
Cryptocurrencies are known for their high price volatility, as evidenced by history. The prices can fluctuate by as much as 20% in a single day, making it challenging for manual traders to cancel their orders.
Additionally, some cryptocurrency exchanges may react more slowly or quickly to these price movements due to differences in liquidity.
For instance, if cryptocurrency prices start to decline, market orders in a less liquid exchange could result in steeper price drops, presenting arbitrage opportunities.
Transaction and Transfer Costs
Even in the absence of restrictions and high volatility, price differences can still exist due to transaction costs.
While these price differences may not seem like arbitrage opportunities, it’s important to note that transaction costs in cryptocurrency exchanges vary depending on the investor’s trade volume.
Investors with high trade volumes usually enjoy lower transaction costs, so these small price differences represent slight arbitrage opportunities for them.
How to identify cryptocurrency arbitrage opportunities
There are two main approaches to identifying arbitrage opportunities: manual calculation and automated screening.
Given the sheer number of exchanges and cryptocurrency pairs, manual calculation is not a practical option.
The most efficient way to identify cryptocurrency arbitrage opportunities is to use an automated solution such as a cryptocurrency arbitrage bot. This is due to the fact that these opportunities often arise briefly and require a quick response.
However, simply having a cryptocurrency arbitrage bot is not sufficient. In order to take advantage of arbitrage opportunities, you need to have both fiat currency and cryptocurrency available on the exchanges you are monitoring, as you may need to act as either a buyer or a seller in the event of an arbitrage opportunity.
One advantage of the cryptocurrency market is that market data is readily available and can be accessed through APIs. This means that there’s no need to pay for market data or create algorithms from scratch to connect to an exchange’s server and obtain real-time information.
Most cryptocurrency exchanges offer pre-built client packages that make it easy to access real-time data, execute trades, and monitor account balances simply by calling functions within the package.
An example of utilizing a cryptocurrency exchange’s API is Binance’s python package, which can be easily accessible. To use it, one must install the package by typing the command in the terminal or command line of the computer.
pip install binance-connector
Now you can reach real-time and historical data, and place orders by using python. An example would be fetching the candlestick data by using ‘klines’ function:
|from binance.spot import Spot|
|client = Spot()|
By following this process, you can fetch tick data from multiple exchanges and compare the prices to see if there is an arbitrage opportunity.
Types of arbitrage opportunities in the cryptocurrency market
Due to the numerous benefits and advancements brought by cryptocurrencies, there are numerous opportunities to be found in this market. In this section, various methods for capturing risk-free profits in the cryptocurrency market will be explored.
Pure Spot Arbitrage
In this type, you buy a cryptocurrency from one exchange and then sell it in another one at a higher price.
You can see the real-time price difference of Bitcoin between two different exchanges below.
In order to take advantage of an arbitrage opportunity, such as the one depicted in the illustration, you would need to have both fiat currency (USDT) at the exchange on the left and Bitcoin (BTC) at the exchange on the right. This way, you can instantly sell on one exchange and buy on the other to reap the benefits of the price discrepancy.
However, it’s important to note that these opportunities tend to be fleeting, so transferring cryptocurrency from one exchange to another in order to sell it at a higher price may not be a risk-free strategy, as the price of the asset can fluctuate while the transfer is in progress. Moreover, it’s also possible to capture arbitrage opportunities by simultaneously buying and selling, without necessarily having to transfer the asset.
For instance, after taking advantage of the first arbitrage opportunity, a second one may arise in a short period of time, as shown in the example.
The above scenario illustrates that capturing an arbitrage opportunity requires simultaneous buying and selling of the cryptocurrency. You must have both fiat currency and the cryptocurrency in the exchanges you are operating in order to take advantage of an arbitrage opportunity when it arises.
However, such opportunities may only be available for a short time and transfer of the cryptocurrency from one exchange to another may result in a change in price, making it a non-riskless trade.
On the other hand, low transaction costs due to high volumes on the exchange can be an advantage in capturing these small arbitrage opportunities. It’s important to note that these opportunities tend to occur during low market volatility periods, but during high volatility times, there may be more widespread arbitrage opportunities.
This form of arbitrage operates under a similar principle as pure spot arbitrage, but without the exchange of ownership of the fiat currency and cryptocurrency between exchanges. Instead, profits are realized by opening positions on the exchanges and then closing them once the prices converge to a common level.
For instance, let’s say an arbitrage opportunity to buy on the left side presents itself in the Bitcoin futures market. Instead of physically buying on the left exchange, you open a long position and instead of selling on the other exchange, you open a short position. Once the prices reach convergence, you can close both positions, where the profit from one exchange will outweigh the loss from the other (as you have taken opposing positions, convergence can occur at either a higher or a lower price).
This type of arbitrage does not entail holding cryptocurrency assets on the exchanges, thus avoiding the price risk of holding cryptocurrency. It only requires holding fiat currency at both exchanges.
Interest Rate Arbitrage
Cryptocurrency exchanges offer borrowing and lending services to their users, with interest rates determined by supply and demand. This presents an opportunity for risk-free profits by borrowing at a lower rate from one exchange and lending at a higher rate on another.
How to begin cryptocurrency arbitrage trading?
To capitalize on cryptocurrency arbitrage opportunities, you need to have the ability to trade on multiple exchanges and quickly identify and act on fleeting opportunities.
One effective way to achieve this is by learning Python for algorithmic trading. Python enables you to easily monitor cryptocurrency prices, backtest and automate your strategies, and quickly capture arbitrage opportunities.
Our collection of Python courses, available at different levels, can help you build your programming skills and develop an arbitrage trading bot.
Advantages of cryptocurrency arbitrage
The advantages of cryptocurrency arbitrage trading make it a desirable strategy compared to others.
Firstly, it is low-risk as you aim to exploit price differences across exchanges, resulting in not having an open position.
Secondly, it offers the opportunity to profit regardless of the direction of price movement.
Finally, profits can be realized quickly, as even positional arbitrage opportunities can be closed in a short period of time due to rapid price convergence.
Drawbacks of cryptocurrency arbitrage
Cryptocurrency arbitrage trading also has some important drawbacks that you should consider before starting to trade.
To participate in cryptocurrency arbitrage, you must have some of your funds invested in the digital currency. For capturing simultaneous arbitrage opportunities, it’s necessary to buy and sell cryptocurrencies at the same time. In the case of interest-rate arbitrage, holding cryptocurrency is a prerequisite for borrowing fiat currency.
Secondly, to effectively engage in spot or positional arbitrage trading, you need a reliable trading bot that can keep track of the prices of cryptocurrencies on different exchanges and also monitor the funds in your wallets and the interest rates for borrowing and lending offered by the exchanges.
Additionally, even though arbitrage opportunities may arise during high market volatility, there’s also the potential for exchanges to crash under the increased pressure, as we’ve seen in the past. This can result in issues for your trading bot – for example, it may successfully purchase on one exchange but be unable to sell on another due to a crash, leaving you with open positions that could incur significant losses if the market suddenly shifts in an unfavorable direction.
In this article, you have been introduced to the concept of arbitrage and its application in the cryptocurrency market. Cryptocurrency arbitrage involves buying a cryptocurrency on one exchange and selling it simultaneously on another exchange for a higher price, thereby realizing a profit.
In order to profit from cryptocurrency arbitrage, it is necessary to have a system in place that can swiftly detect and seize upon fleeting opportunities. This is because opportunities for arbitrage can arise and disappear quickly due to the numerous cryptocurrencies and exchanges available. Automation through the use of a bot is thus crucial in the successful implementation of cryptocurrency arbitrage.
Additionally, you learned that there are different methods of cryptocurrency arbitrage, including spot trading and opening positions, as well as lending and borrowing cryptocurrencies on different exchanges to take advantage of interest rate differences.
If you want to expand your knowledge of trading strategies in the cryptocurrency market, consider enrolling in the course “Crypto Trading Strategies: Advanced” offered by Quantra. This course covers advanced topics in cryptocurrency trading, including the strategy of cryptocurrency arbitrage.