What Is Cryptocurrency Arbitrage?
Cryptocurrency arbitrage is a strategy in which investors buy a cryptocurrency on one exchange, and then quickly sell it on another exchange for a higher price.
Cryptocurrencies trade on hundreds of different exchanges, and often the price of a coin or token may differ on one exchange versus another. That’s where the strategy of arbitrage comes in: Similar to using arbitrage in capital markets, crypto arbitrage is a legal way to earn a potential profit when an asset is selling cheaper in one market and at a higher price in another.
That said, crypto arbitrage comes with some potential risk factors. Here’s a closer look at how crypto arbitrage works, and trading strategies that use the tactic.
Why Are Crypto Prices Difference Across Exchanges?
Crypto markets are not regulated, and cryptocurrencies are decentralized and therefore — with the exception of stablecoins — are not pegged to government or fiat currencies like the dollar. This is one of the primary reasons why the prices of different crypto can vary widely: there is no standard price for any particular coin or token.
Related to this, some crypto exchanges are bigger than others, with higher trading volume. Thus the supply and demand on one exchange could be quite different from another, affecting the price.
Finally, crypto trading fees also vary, and can add to the cost of your trades.
What Types of Arbitrage Exist?
There are some different ways investors can conduct crypto arbitrage with different types of cryptocurrencies.
Spatial arbitrage involves trading virtual currencies across two different exchange platforms. Spatial arbitrage is a straightforward way of conducting crypto arbitrage.
While this is a simple tactic that can take advantage of price discrepancies, spatial arbitrage exposes the traders to risks like transfer times and costs.
Spatial Arbitrage Without Transferring
Some traders try to avoid the risks of transfer costs and times that spatial arbitrage poses. For example, in a hypothetical case, they may go long Bitcoin on one exchange and short on another, and wait until the prices on the two exchanges converge.
That allows them to avoid transferring coins and tokens from one platform to another. However, trading fees may still apply.
Triangular arbitrage takes advantage of pricing inefficiencies among different pairs of cryptocurrencies on the same exchange. With this strategy, an investor starts with one cryptocurrency and then trades it for another cryptocurrency on that same exchange — one which is undervalued relative to the first crypto.
The investor would then trade that second cryptocurrency for a third cryptocurrency which is relatively overvalued when compared with the first. Finally, the investor would trade that third cryptocurrency for the first crypto, completing the circuit potentially a little richer.
How to Take Advantage of Crypto Arbitrage Algorithmically
At first glance, cryptocurrency arbitrage seems like a simple matter of looking for gaps between the prices on one exchange and another, and then executing a buy and a sell.
Famously, in 2017 there was a moment when the price of Bitcoin on Kraken was $17,212, but only $16,979 on Bitstamp — presenting an arbitrage opportunity. In that instance, an investor could potentially make $233 per Bitcoin by buying them on Bitstamp, and then quickly selling them on Kraken.
While spreads aren’t always as wide as in the above example, there are times when other, less well-known forms of crypto could offer even wider gaps. Since cryptocurrency prices can vary from exchange to exchange, arbitrage opportunities can pop up at any time, with thousands of cryptocurrencies trading on hundreds of exchanges for people investing in cryptocurrency.
There are a number of apps investors can download that will track the prices of Bitcoin and other cryptocurrencies for arbitrage opportunities. This way, investors can take advantage of algorithms that automatically scan for arbitrage across different crypto exchanges. This automated approach can allow crypto-arbitrage traders to take advantage of multiple different price discrepancies.
Recommended: How Do Crypto Trading Bots Work?
How to Find a Crypto Arbitrage
Not every cryptocurrency digital asset is created equal when it comes to arbitrage, and there are multiple ways to find arbitrage opportunities.
Method 1: New Software
With so many different cryptocurrencies on so many exchanges, finding those opportunities is a daunting task. That’s why many traders use software applications that track the hundreds of cryptocurrency exchanges in real time.
There are a growing number of companies that specialize in software to automate crypto arbitrage. Some companies have a tool that allows investors to choose an automated arbitrage strategy and execute it across different exchanges.
Method 2: Less Popular Cryptocurrencies
Investors can find bigger price spreads for the same cryptocurrency digital assets among less-popular, less-frequently traded forms of crypto.
Because they’re less popular, though, these cryptocurrencies are prone to rapid price fluctuations. That volatility can be good or bad news, but it adds another level of risk to an arbitrage strategy.
Recommended: Top 30 Cryptocurrencies By Market Cap
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What Are the Dangers of Crypto Arbitrage?
Like any kind of arbitrage, crypto arbitrage involves some potential risks.
To succeed in crypto arbitrage, investors need to execute the trades quickly in order to take advantage of cryptocurrency price differences from exchange to exchange, while those differences are still profitable.
With the thinly traded forms of crypto that offer the widest spreads, a trader has to be careful not to increase the purchase price and decrease the sale price of a digital asset by their own trades.
The crypto exchanges all work similarly, pricing crypto based on the last trade on that exchange. But it’s important to note that not all exchanges are created equal. Some of them have enormous trading volumes, while others aren’t as active.
The trading volume on each affects the liquidity and the available prices on a given exchange.
Low volume may mean that the exchange can’t execute a trade large enough to deliver the profit an investor is hoping for. Low volume may also mean that the trade is possible but will take too long to seize the pricing opportunity.
At the same time, traders need to keep an eye on the transaction fees that come with purchasing cryptocurrency across trading platforms. As the cryptocurrency markets evolve, these fees continue to fluctuate, varying from exchange to exchange.
Cryptocurrencies are largely unregulated, which is one of the key things to know before investing in cryptocurrency.
As a result, trading crypto comes with more risks from hacks, fraud, and outright currency collapse. That’s why securely storing your cryptocurrencies is a hot topic among investors.
In the U.S., where cryptocurrency adoption has skyrocketed in recent years, the IRS has created a tax guide which categorizes cryptocurrencies as property, like stocks, bonds, and other capital assets.
Investors are required to pay capital gain taxes on cryptocurrency when selling, trading, or disposing of their holdings. Additionally, cryptocurrencies can be taxed as income if an individual receives the crypto as a gift, from mining, or for services rendered.
With that in mind, investors must account for any capital gains taxes on their federal income tax return, but may also be able to take deductions based on any losses.
Though the IRS treats cryptocurrencies as property for tax purposes, this categorization is not consistent across all federal government agencies. The question as to whether crypto is a security or a commodity is a long-standing debate. The Securities and Exchange Commission (SEC), has called cryptocurrencies a form of security — and the Commodity Futures Trading Commission has called them a type of commodity.
As of August 27, 2022, different bills have been proposed in Congress to make the regulation of cryptocurrencies consistent.
Arbitrage exists across the capital markets, in stocks, bonds, and commodities, wherever the same asset trades for different prices in different places. Since cryptocurrencies are digital and aren’t based on an underlying asset, it is harder to place a value upon these currencies, and they don’t have the same pricing conventions as equities and bonds, which are tied to the performance of a company, municipality, or nation.
Cryptocurrency is complicated, and arbitrage strategies can be even more complex. But the practice is legal, and has the potential to yield high rewards while also exposing an investor to high risk.
As with any investment strategy, it is important for investors to do their own research when exploring crypto arbitrage, including looking at different, lesser-known cryptocurrencies, and available software to track cryptocurrency exchanges in real time.
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