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Spotting the Difference: What is Crypto Arbitrage?

Prices are not the same on every exchange. Arbitrage is when a trader spots a difference in the price between the same asset on two different marketplaces, and buys the asset from one marketplace in order to sell it on the other, pocketing the difference in profit. It occurs in both traditional and crypto markets.

To give a simple example, if the price of Bitcoin is $42,000 on Gemini but $42,200 on Binance, an arbitrageur can buy it on Gemini, send it to Binance, and sell it — making $200 (minus fees) along the way.

Crypto arbitrage is both more accessible and more essential than traditional arbitrage. Crypto’s immaturity as a market, its 24/7 always-on nature, and ease-of-trading make arbitrage both more widespread and more important. Rather than just profiting the individual (e.g. the ‘kimchi premium’, which reportedly has helped create popular venture funds), arbitrage also supports the health of the market as a whole.

Why Arbitrage Is So Important

Arbitrage has been a feature of financial markets since their inception. Although it might be easy to dismiss arbitrage trading as a niche trading activity, or even as profit scalping — neither is true.

Arbitrage is essential for the fundamental health of markets as it ensures healthy price discovery and price stabilisation. It stops price outliers and protects general consumers as arbitrage traders quickly close any gaps in price back from deviation.

Crypto, as a new financial market, is ripe for arbitrage. As crypto markets are more volatile, arbitrage opportunities are far larger in crypto and do not require the warchest of a small country to take advantage of. The sheer variety of marketplaces — centralised and decentralised — also make arbitrage in crypto more profitable for even mid-level traders than traditional financial arbitrage.

Arbitrage and Decentralized Exchanges

Perhaps most importantly, arbitrage is the fundamental glue that keeps prices on decentralised exchanges stable cross-platform. Decentralised exchanges that are automated market makers determine their prices through a mathematical function. Nothing inherent to the trading model (such as counterparties) keeps the prices ‘correct’.

The prices are kept at ‘market price’ through the actions of arbitrageurs alone. Furthermore, large orders on small pools produce slippage, where asset prices can suddenly veer substantially from the market price. Arbitrage, performed by traders and, more commonly, trading bots, brings that price back in line. Slippage can work the other way too, damaging the possible gain arbitrageurs can make — and they must be careful.

DeFi opens up more sophisticated arbitrage possibilities through yields, too. If a DeFi protocol offers 10% rate to loan a stablecoin, and another offers 11% for lending that coin, then a trader can yield farm thanks to the innate composability of DeFi. These activities form the crux of many of the opportunities that abound with DeFi.

Arbitrage and Centralized Exchanges

The easiest type of arbitrage is cross-exchange arbitrage. Like the example in the introduction, this involves buying an asset on one exchange and moving it to another where the price is higher.

Spatial arbitrage is another kind of cross-exchange arbitrage that occurs by trading in different geographical markets. For the longest time in Bitcoin’s early days, Bitcoin was subject to a ‘kimchi premium’, where it would reliably be more expensive on South Korean exchanges. This premium has eroded now, as arbitrageurs exploited the difference consistently to restore balance.

Finally, triangular arbitrage is when you move assets through different trading pairs on the same exchange to end up with more than you started with due to the price dynamics between particular pairs. So a trader could move BTC to ETH, ETH to ATOM, then ATOM to BTC and — if the pair pricing is out of step, end up with more BTC than they started with.

As mentioned before, there are a wealth of available centralised crypto exchanges on which to exchange assets. This is in stark difference to traditional markets where there are very few stock exchanges. This makes opportunities plentiful, but there are many risks and roadblocks associated with this kind of arbitrage.

Chief among them are fees, which can cripple any profit made from the trades. Also, exchanges can take a long while to process withdrawals, by which time the arbitrage opportunity may be missed or even net-negative. Also, the high volume and accessibility of exchanges means arbitrage opportunities frequently vanish within a blink of an eye, gobbled by hungry bots or even — dare we say it — the exchanges themselves.

Capturing Arbitrage Opportunities with Onomy

Onomy, with its custom cross-chain bridges that connect all chains, will allow for arbitrage traders to operate efficiently. Rather than having to use multiple wallets and DEXs, and perhaps losing out on opportunities due to inefficiency. The Onomy Wallet will be able to hold all assets and interface with the DEX on multiple chains, opening up new opportunities. It will also be simple to send every major asset to the Onomy Wallet with minimum friction.

Another unique opportunity will be arbitrage between the NOM token available on the BCO and the NOM tokens listed on exchanges. If the exchange price goes higher due to interest and volume (and wider accessibility by the retail market), savvy traders would be able to buy NOM from the BCO and bridge it out on exchanges for a higher price.

Arbitrage is seen as a ‘low-risk’ trading strategy as it requires no predictive analysis and, theoretically, it is impossible to lose money by enacting the correct trades. Of course, arbitrage is being done en masse by individuals and bots at all times, meaning that if your trading strategy lags, either in speed or efficiency, losses can be incurred.

Most sophisticated arbitrage traders use bots to operate at the high frequency required, but even then it can be risky. Despite all this, arbitrage is a common trading strategy that not only benefits the individual, but helps price-discovery market wide and ensures no discrepancy becomes so great as to dislodge trust in the market as a whole.

About Onomy

Onomy Protocol is a layer-1 Cosmos chain powering a multi-chain & intuitive DEX that combines AMM liquidity pools with an order book UI facilitating market, limit, and stop orders, alongside FX markets via its stablecoin minting system, and multi-protocol asset management through the multi-chain Onomy Access wallet.

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Originally published at https://coinmarketcap.com.



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Onomy Protocol

Onomy Protocol

Offering the infrastructure necessary to converge traditional finance with decentralized finance.