DeFi 101: What is Crypto Arbitrage?
With the emergence of cryptocurrency, the number of opportunities has significantly increased for traders to make capital-efficient strategies such as crypto abritrage.
Overview
- What is Crypto Arbitrage?
- What Causes Crypto Arbitrage?
- CEXes & DEXes
- Different Types of Arbitrage Strategies
- Cross-exchange
- Arbitrage Strategies
- Risks & Volatility
- Transfer Times and Cost
- Summary
What is Crypto Arbitrage?
Crypto arbitrage involves buying digital currencies on one exchange and selling them on another at a higher price. The volatile nature of the crypto market makes it an ideal environment for traders looking to capitalize on arbitrage. As prices of digital assets can fluctuate significantly over time, there are numerous opportunities for traders to exploit price differences and make a profit. With crypto assets being traded around the clock on hundreds of exchanges worldwide, arbitrage traders can identify discrepancies in the prices of digital assets across different exchanges and take advantage of them.
What Causes Crypto Arbitrage?
CEXes
The lack of standardized pricing for coins or tokens is one of the primary factors contributing to price variation. On centralized exchanges, asset valuation is determined by the most recent bid-ask order recorded on the order book. This means that the current price of a digital asset is determined by the price at which market traders buy or sell the asset on that specific exchange. Establishing the market price of a digital asset is an ongoing process that involves taking into account the most recent selling price. Moreover, the trading volume on crypto exchanges can differ significantly, with some more prominent than others. This can cause discrepancies in the level of supply and demand across different exchanges, which can impact the asset price.
DEXes
Decentralized exchanges (DEXs) differ from traditional centralized exchanges in their approach to pricing digital assets. Instead of an order book system, DEXs utilize an automated market maker (AMM) system that relies on crypto arbitrage traders to maintain price consistency with other exchanges.
Liquidity pools are used in DEXs to determine the prices of digital assets. Each trading pair has its own pool, and an algorithm controls the prices of the assets in the pool to maintain a balanced asset ratio. To obtain assets, traders must add tokens to a specific asset pool and remove another, causing the ratio of assets to change and a rebalancing of prices. However, significant deviations between the prices of assets in the pool and their market value can occur if a trader executes a large trade that significantly alters the asset ratio in the liquidity pool.
Different Types of Arbitrage Strategies
Cross-exchange
The most simple form of arbitrage is cross-exchange arbitrage, which involves buying an asset on one exchange and transferring it to another where the price is higher. This is the basic principle of arbitrage trading.
Spatial
Spatial arbitrage is a form of cross-exchange arbitrage trading where the trader buys and sells digital currencies across two different exchange platforms located in different regions. This is a straightforward method of conducting crypto arbitrage, but it does expose traders to risks such as high transfer times and costs.
Triangular
Triangular arbitrage is the process of moving funds between three or more digital assets on a single exchange to capitalize on the price difference of one or more cryptocurrencies. This strategy can be executed by creating a trading loop that starts and ends with the same currency. By exploiting price inconsistencies among different pairs of assets on a single exchange, triangular arbitrage enables investors to start with one cryptocurrency and trade it for another that is undervalued compared to the first, then trade that for a relatively third crypto overvalued compared to the first one. Finally, the investor trades the third cryptocurrency back to the initial one, potentially earning a profit in the process.
Risks
Although crypto arbitrage is generally considered a lower-risk strategy due to the absence of predictive analysis, that does not mean traders are immune. Volatility and transfer times can decrease profits.
Volatility
One of the main risks associated with crypto arbitrage is the volatility of the crypto market. The prices of cryptocurrencies can fluctuate wildly in a short period, making it difficult for traders to execute profitable trades. This volatility can also make it difficult for traders to predict the direction of the market, which can lead to significant losses.
Transfer Times and Cost
Another common risk associated with crypto arbitrage is the risk of transfer times and costs. When trading across different exchanges, traders must transfer their funds between applications, which can take some time and incur fees. These fees can eat into a trader’s profits, making the trade less profitable or unprofitable. In addition, transfer times can vary greatly depending on the exchange and the method used, making it difficult for traders to execute trades quickly and take advantage of price discrepancies.
In Summary
Crypto arbitrage is a trading strategy that involves buying and selling cryptocurrencies across different exchanges to take advantage of price discrepancies. The crypto market is a perfect place for traders to take advantage of arbitrage as it provides a highly volatile environment with prices varying significantly over a certain period of time. The 24/7 global trading nature of crypto assets across hundreds of exchanges creates abundant opportunities for arbitrage traders to exploit price differences and earn profits. Traders can use different arbitrage strategies like cross-exchange, spatial, and triangular arbitrage to capitalize on the price differences. However, they should be aware of the risks associated with this strategy, including volatility, transfer times, and costs.
