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Arbitrage has been around since long before cryptocurrency existed and has been a major tool for making money in traditional financial markets. How many times have you listened to advertisements from info-gyms about how it can make you millionaires from the comfort of your couch with minimal expenses. In most cases these guys themselves are not experts in it and just want to make more money from their courses. However, today we will try to get to the bottom of it and tell you what cryptocurrency arbitrage is all about, what types of cryptocurrency arbitrage exist and, most interestingly, can you actually make money here?
How did arbitrage originate and what is it?
We'll probably start at the very beginning, which is how arbitrage originated. Since ancient times people earned money by offering different prices for the same goods in different places. And the most sophisticated could buy where the goods were cheaper and sell where they were more expensive, in effect, making money by speculation. This way of earning works on any market up to now. Thus, arbitrage is a trading practice that takes advantage of price differences in the same asset in different locations. Although there are many styles of arbitrage trading, they all involve quickly buying and selling an asset to take advantage of the deviation in price. As you might have guessed by now, there is arbitrage in cryptocurrency as well. And since the cryptocurrency market is one of the most volatile, it's no surprise that this approach to earning here is quite popular.
How does cryptoarbitrage work?
Cryptocurrency arbitrage trading works the same way as in traditional markets. Traders have to quickly buy and sell an asset on different platforms when they notice price inefficiencies. The only difference is that cryptocurrency arbitrage traders focus on crypto-assets such as Bitcoin or Ethereum (ETH). Another difference between traditional arbitrage and crypto-exchange arbitrage is that the latter can target centralised exchanges (CEX) and decentralised exchanges (DEX).
Why are the prices on crypto exchanges different?
If we are talking about centralised exchanges, the first thing you need to know is that asset pricing on centralised exchanges depends on the most recent order with a bid-ask match in the exchange order book. In other words, the most recent price at which a trader buys or sells a digital asset on an exchange is considered the real-time price of that asset on the exchange. Exchange price discovery is therefore a continuous process of determining the market price of a digital asset based on its last sale price.
Decentralised crypto-exchanges, however, use a different method of pricing crypto-assets. This system is called an 'automated market maker'. It relies directly on crypto-arbitrage traders to keep prices in line with those quoted on other exchanges. Instead of the order book system of a centralised exchange, where buyers and sellers are matched together to trade crypto assets at a specific price and amount, decentralised exchanges rely on liquidity pools. A separate pool must be created for each crypto-trading pair. For example, if someone wants to exchange bitcoin (BTC) for ether (ETH) he will need to find a BTC / ETH liquidity pool on the exchange. Each pool is funded by voluntary contributors who contribute their own crypto-assets to provide liquidity that others trade with, in exchange for a proportionate share of the pool's transaction fees. The main advantage of this system is that traders do not have to wait for another trader to buy or sell assets at a certain price. The trade can be executed at any time.
Types of cryptocurrency arbitrage
Intra-exchange arbitrage
Intra-exchange arbitration
International arbitration
Intra-exchange arbitration
The simplest type of arbitration is intra-exchange arbitration. The essence of this type of arbitration is to resell cryptocurrencies within an exchange. The algorithm for this type of arbitrage is as follows:
We choose the cryptocurrency we are interested in and buy it for fiat money or for stabelcoins (e.g. USDT)
Next, we must find a trading pair that, firstly, contains our previously selected cryptocurrency, and secondly, the purchase price of this pair must be higher than what we bought at the first step.
At the end we sell the initial number of coins at higher price and pocket the difference
So, the whole point of intra-exchange arbitrage is that we buy cryptocurrency for fiat money, and sell it paired with another cryptocurrency at a better price for us.
Inter-exchange arbitrage
Inter-exchange arbitrage is where we look for the same asset on different cryptocurrency exchanges and go through the same process as in intra-exchange arbitrage. That is, we buy where it is cheaper and sell where it is more expensive. As we mentioned, the difference is due to the different liquidity pools on the exchanges.
International Arbitrage
The type of arbitrage, which has shown itself well in CIS countries, because it takes into account the political and economic situation in different countries and, as a consequence, prices on such cryptocurrency exchanges will differ more than on the same intra-exchange arbitrage. International arbitrage involves buying and selling assets between international exchanges. The process looks the same as in intra-exchange arbitrage. In order to make this type of arbitration you need the following:
You must have a bank card from the bank of your country
You must have a cryptocurrency wallet
You must have verified accounts on exchanges you will be manipulating.
While the first two are more or less clear, the third one may cause some difficulties. At least it may be difficult, because verification on foreign exchanges often requires residency of the country, in which the exchange is trading. But often they also require account statements or other documents proving your residency in that country.
What is P2P cryptocurrency arbitrage?
P2P(or person-to-person/peer-to-peer) is the direct exchange of cryptocurrencies between cryptocurrency holders. P2P crypto-trading occurs when people directly interact to buy or sell cryptocurrency without a third party being present. For this type of trading, people can interact on a website or directly through other social platforms. In addition, large cryptocurrency exchanges such as Binance have a P2P trading feature. That is, Binance itself connects you directly with other exchange users.
What are the disadvantages of arbitrage trading?
The risk of slippage: Slippage is a significant deviation in the quoted price of an asset you intended to buy or sell. This phenomenon tends to occur on small and illiquid exchanges or with small-cap tokens. If the arbitrage trader is unable to close his trades quickly on the chosen exchange, there is a risk that the final selling price will negate his trading setup.
Finding a profitable mapping: In order to trade profitably, you need to find profitable mappings. However, finding such mappings is a challenge.
Transaction fees: Cryptocurrency trading often involves transaction fees, which can reduce profits and make arbitrage trading less profitable.
Spreads and latency: Cryptocurrency exchanges can have large spreads and slow trade execution, making it difficult to make arbitrage trades quickly and efficiently.
Lack of liquidity: Depending on the choice of cryptocurrency exchange, markets may have low liquidity, which will make it difficult to make large trades and potentially lead to lower prices.
Foreign currency exchange rates: International arbitrage traders should consider the exchange rates of foreign exchanges' fiat currencies. While cryptocurrency prices may seem inflated in other regions, consider how much it will cost to convert the host country's fiat currency into the desired currency.
Taxes: In most countries, arbitrage trading is subject to short-term capital gains taxes. Even if the arbitrage trader is successful, he will have to report his profits to the tax authorities. For example, in Russia and Belarus, any income that comes from digital currency is subject to 13% income tax.
Withdrawal
Cryptocurrency arbitrage is a legal way to make money from cryptocurrency (unless, of course, it's used as money laundering). It's not some magic pill to make money. Of course, you can make money, but, first, it's not as easy as most people think, and second, you can also lose. As with any investment, it is important to carefully research and consider all the risks before engaging in cryptocurrency arbitrage.