Arbitration is the simultaneous buying and selling of the same asset in different cryptocurrency markets in order to profit from temporary price differences arising from market inefficiencies.
What is arbitrage trading?
Arbitrage trading is a trading strategy that uses temporary price divergences on different exchanges to profit from the simultaneous buying and selling of the same asset on different markets. The existence of many cryptocurrency exchanges around the world, available around the clock, increases the likelihood of capitalizing on such price discrepancies.
For example, if you notice a difference in the price of a crypto asset like bitcoin on different crypto exchanges, you can buy it at a lower price on one market and sell it at a higher price on another. This makes arbitrage trading a relatively low-risk way to make quick money. However, arbitrage trading relies heavily on market inefficiencies creating price differentials for the same asset. Therefore, despite the continued volatility of cryptocurrencies, advances in blockchain technology may eliminate such price fluctuations in the near future, making it difficult to profit from arbitrage trading.
How does arbitrage work in trading?
Arbitrage trading in cryptocurrencies, in fact, uses the price discrepancies that occur on different crypto exchanges. Prices can vary between multiple assets, and even by quantity or geographic differences. Below are some examples of arbitrage trading.
Between crypto exchanges
The simplest crypto arbitrage occurs on different crypto exchanges that offer minor price differences for the same asset. To make a profit, a crypto arbitrage trader must have an account on each exchange with sufficient free funds. This allows the trader to easily buy and sell to catch temporary price differences without being hindered by transaction delays that can take up to half an hour.
Across geographic boundaries
Price differences can also be observed in the cryptocurrency markets of different countries. For example, the price of bitcoin may differ on an American crypto exchange compared to an Asian crypto platform. A trader needs to have a cross-border account in order to immediately buy and sell through geographic arbitrage. This is especially true for South Korean exchanges, which has led to a phenomenon called the Kimchi premium.
Various assets
Although arbitrage trading most often uses the same asset, it is also possible to trade different assets three-way to capitalize on price differences on each trade. For example, a trader can hold bitcoin (BTC) and execute a buy/sell order. An example would be buying Ethereum (ETH) at a lower price with BTC and then buying Solana (SOL) at an even lower price with ETH, after which SOL is sold for more than the original BTC used to buy ETH. This head-turning technique is also known as triangular arbitrage.
Speed and Quantity
Cryptocurrency arbitrage trades can benefit institutional investors more than retail traders due to the sheer volume and speed. With fewer assets, retail traders can only earn marginal profits by passively observing price differences in different markets. This results in a higher latency where more time passes before a price difference can be noticed. Thus, institutional investors are in a better position to acquire assets at better prices due to the high speed of trading with large volumes.
Why does arbitration exist?
To get the most out of crypto arbitrage, traders must be persistent in monitoring different markets and quickly spot market inefficiencies that lead to price differentials. While crypto arbitrage returns can be quite small for individual retail investors, due to the limited number of assets, numerous arbitrage opportunities can crop up throughout the week, helping traders make decent profits.
Ultimately, arbitrage exists because markets are inefficient. Such inefficiencies can be particularly pronounced in the cryptocurrency market, which is still growing and generally volatile, leading to potential disruptions in pricing and communication.
However, with the rapid improvement of blockchain technology, these inefficiencies can be quickly corrected and corrected to bring them into line across different markets. Therefore, a trader needs to act quickly to take advantage of the price difference and profit through arbitrage. As a result, arbitrage trading allows you to make a profit in a much shorter time than the traditional method of holding crypto assets and then selling them for a significant profit.