What is crypto arbitrage?
The crypto arbitrage is a strategy to take advantage of asset trading at different prices at different exchanges.
To put it simply, if we buy a crypto asset for a lower price on one exchange and sell it for a higher price on another exchange, we have used the crypto arbitrage method.
This article focuses on finding cryptocurrency mispricing across several exchanges to do a crypto arbitrage. We’ll cover how to calculate the opportunity for a crypto arbitrage and make a profit off it.
Why does crypto arbitrage occur?
According to most financial textbooks, it is believed that markets are efficient and thus that an arbitrage opportunity simply can’t occur. (Un)Fortunately, the reality is far from theory and traders have found a way to exploit it.
There are many reasons behind the occurrence of crypto arbitrage, and I’ve extracted the most notable ones:
Liquidity variance across several exchanges
Most of the exchanges have their own order books that tend to be different with varying liquidity for a particular asset. For those new to trading, an order book is an automated list of current sell and buy positions for a specified asset.
For example, if we are buying Bitcoin, it might be easier to convert it into cash on a particular exchange without causing a loss. This can easily have something to do with the order book of an exchange.
If one exchange has a wide order book and the other a more filled one, it would be wise for us to buy our assets on the latter, as the former would end up in us paying a higher price.
But why does this happen if both order books show the same price for our assets?
Well, one exchange (with the wide order book) can be made up of small orders of BTC at the very top of its book price.
After we buy these orders, we automatically move into the lower levels of the order book to make the rest of our order, and thus pay a higher price.
Different types of exchanges
Not all exchanges are the same. Some of them are most suitable for retail investors while others are built with a preference for institutional ones.
If we take a look at the varying behaviors and preferences of these two types of traders, a crypto arbitrage opportunity occurs.
For example, the institutional traders tend to have gaps between their large limit market orders while the retail traders don’t.
This gap allows us to buy a particular asset on the retail trader exchange and then commit to a sell position on the other one. With the power of algorithmic trading, most arbitrages can offer an instantaneous profit.
Withdrawal and deposit times vary across exchanges
As exchanges don’t have the same deposit and withdrawal times the opportunities for crypto arbitrage grow. If we could move our fiat and crypto assets instantaneously, the market differences between several exchanges would flatten out.
This means that the exchanges with a faster transfer time catch up with the market sooner while the other ones slowly crawl up to the updated market sentiment levels.
Moreover, the cost of transferring our fiat/crypto holdings also varies and thus creates even more arbitrage opportunities.
The supply and demand vary across countries
As countries can have different supply and demand levels, we can exploit the crypto arbitrage opportunities.
If Japan has a lukewarm sentiment for Ethereum while the US is going bullish, we can buy the ETH in Japan and sell it to the US.
Foreign currency rates
For example, if we’re trading Lithium, the varying currency exchange rates can create arbitrage opportunities.
Imagine a scenario where the USD gains against the JPY, while the asset price for Lithium remains the same on Japanese and US exchanges.
This creates an arbitrage opportunity where we convert USD to JPY, buy Lithium on a Japanese Exchange and then sell the Lithium on a US exchange.
Some of the other notable reasons are the following:
- Tight capital controls outside of the US and EU
- Lack of traders (i.e. market makers)
- Regulations across exchanges