Crypto arbitrage is a popular method to generate profits from the price difference in cryptocurrency markets. Buying and selling crypto can be done in such a way that it will generate consistent profits. How exactly does crypto arbitrage work, and what are the different types of arbitrage traders can perform? Learn about the facts to look out for when seeking cryptocurrency arbitrage opportunities.
KEY TAKEAWAYS
► Crypto arbitrage involves buying a cryptocurrency at a lower price on one exchange and selling it at a higher price on another.
► Arbitrage is the most popular type of MEV strategy on Ethereum and the cryptocurrency market abroad.
► The benefits of crypto arbitrage include lower risk compared to long-term investments and the ability to profit in different markets.
► Successful crypto arbitrage requires careful consideration of trading fees, transaction times, and the use of automated software.
What is cryptocurrency arbitrage?
In a nutshell, cryptocurrency arbitrage is when someone acquires a cryptocurrency for a lower price and then resells it at a higher price. Usually, this practice can be made using two different crypto exchanges that have different prices.
Crypto arbitrage is a maximal extractable value (MEV) strategy. While difficult to define, MEV is any action where profit is made by reordering transactions or that can be extracted from a smart contract, application, or protocol. Crypto arbitrage typically accumulates the most MEV profit overall on Ethereum, as compared to.
Arbitrage is the most common MEV extracted on Ethereum. According to EigenPhi, arbitrage amounted to about half of all the MEV extracted on Ethereum in 2022.
Although smaller platforms are more likely to follow larger exchanges’ prices, this is not always the case. That’s how price differences or market inefficiencies may create arbitrage opportunities for traders. There are two main types of crypto arbitrage:
- Arbitrage between crypto exchanges
- Arbitrage within the same crypto exchange (Triangular arbitrage)
The first type of arbitrage, between two exchanges, is fairly easy. For instance, if Bitcoin (BTC) has a higher price on Binance than on Kraken, you can purchase Bitcoin using Kraken and sell it on Binance for a profit.
To perform a crypto arbitrage within the same crypto exchange, you have to purchase two different cryptocurrencies and sell them at a lower price.
However, it’s important to be aware of the risks posed by crypto arbitrages, as cryptocurrency prices are extremely volatile and can thus influence the outcome of the arbitrage.
What is arbitrage?
Arbitrage is when you buy a security on one market and then sell it on another market for a higher price, benefiting from the price difference. Simply put, arbitrage is the act of capitalizing on the variation in an asset’s price across different markets.
This was a common practice among traders long before the advent of the cryptocurrency market when traders were using the stock, bond, and foreign exchange markets.
Traders, commonly called arbitrageurs, that use this trading strategy have the potential to make a profit from these market inefficiencies due to this adverse selection between asset prices.
Why does crypto arbitrage occur?
Arbitrage occurs due to a multitude of factors, such as adverse selection, the properties of the account model, or the constant product function in an automated market maker (AMM). Let’s break this down from the perspective of a liquidity provider (i.e. market maker).
AMM
A liquidity provider (LP) is someone who creates a market or provides liquidity for traders to trade an asset. For example, if you want to trade Ethereum, an LP may create a liquidity pool with the trading pairs ETH and USDC. Traders can deposit USDC into the pool when they want to buy ETH and deposit ETH in exchange for USDC when they want to sell.
AMMs use a constant function product to manage the supply of liquidity (e.g., ETH and USDC) in a liquidity pool. The constant product function in a liquidity pool automatically causes some level of slippage.
Slippage is when an order is executed at a price that is different from the quoted price. This can create significant price differences, especially with large orders. This price difference is the first prerequisite to set up an arbitrage.
Adverse selection
Adverse selection is a scenario where one market participant has more information than another. In our example, a trader has just made a trade on an exchange, which has resulted in an automatic price change in ETH. Let’s say that the original price of ETH was $1,000 before the trade and $1,000 after the trade.
However, there is another exchange with another LP. The LP is isolated from the exchange where the trade occurred and is unaware of the change in price. A trader notices this price discrepancy and purchases ETH for $1,000 from the LP on the second exchange and sells it to the first exchange for $2,000.
Account model
The entire arbitrage interaction occurs within a single block, typically — this can differ from CEX arbitrage. When the price discrepancy occurs, an arbitrageur creates two transactions within a single block, one to purchase and another to sell.
These transactions must occur sequentially and immediately so that another arbitrageur may not benefit. This is possible because in an account model (such as with Ethereum), changes to the balance of an account only occur sequentially or one after another.
This allows one transaction to update the balance of an account before the next one. In arbitrage, this ensures that the price discrepancy can be immediately capitalized upon by the same user in the same block
Because transactions happen within the same block, the arbitrageur doesn’t risk price movements between transactions either, which can occur on centralized exchanges (CEX).
Pros and cons of crypto arbitrage trading
| Pros | Cons |
|---|---|
| Low risk | Technology |
| Volatile markets | High expertise required |
| Bull/bear market agnostic | Minimum mispricing |
| Pricing efficiency | LVR |
Advantages of arbitrage trading
The main benefits of crypto arbitrage are:
- Low Risk: Since you are buying and selling simultaneously, there is less risk than long-term investments. Arbitrageurs may utilize flash loans to accomplish this.
- Requires volatile markets: Arbitrage trading can be successfully performed in volatile markets without taking too many risks.
- You don’t need to rely on bear or bull markets: Money can be made regardless of market direction. However, large bull markets will offer more opportunities for arbitrage. This is because bull markets are more important to traders than arbitrating.
- Pricing efficiency: Arbitrage trades can be positive because they bring markets into balance. They can provide an accurate pricing mechanism for the market of a particular asset.
Disadvantages of arbitrage trading
The risks of crypto arbitrage that traders should be aware of are:
- Technology: To become successful with crypto arbitrage, traders need up-to-date technology to allow them to trade quickly and make a profit.
- Minimum mispricing: Traders must take into consideration all the costs and transaction fees, to ensure that they will make a profit.
- Loss versus rebalancing: Arbitrage may be particularly detrimental to liquidity providers because they may miss the opportunity to rebalance their portfolio to earn more profit.
- Experience: It is important to gain enough trading experience before attempting to profit from crypto arbitrage. New traders may jump at an asset too quickly without taking into consideration the competition.
How to find a crypto arbitrage opportunity
Firstly, you need to know that not all cryptocurrencies can be used for arbitrage. Bitcoin, for instance, is much too available and widely traded and doesn’t present too many crypto arbitrage possibilities to traders. However, traders use two main ways to find arbitrage opportunities that can make them a profit.
Using software
It can be difficult to find the right opportunities when so many cryptocurrencies are available on so many exchanges. That’s why many traders use software programs that monitor hundreds of cryptocurrency exchanges at a time.
This is how they can find price differences and other market anomalies, but the trick is that arbitrage needs to be executed as soon as possible. Humans might not be capable of setting buying and selling orders as fast as they need. The profit might not be realized once the price of crypto changes, and most of the time, it changes faster than a trader can set limit orders on the exchange.
That’s why a piece of software can help traders automate crypto arbitrage. However, this requires some technical knowledge from the trader using the software. at can be found online, and they can be used for these fast automated traders. Most arbitrageurs create trading bots to monitor the blockchain.
It is important to use fast programming languages to gain milliseconds worth of time as and advantage. This makes a big difference in the arbitrage opportunities that one can execute.
Finding less popular cryptocurrencies
Investors may find greater price spreads for cryptocurrencies if they are less popular or less frequently traded. These cryptocurrencies can experience rapid price fluctuations. However, this volatility can be good news or bad, but it also adds risk to arbitrage strategies, leading to big losses if the price moves too low and too fast.
Some arbitrageurs may also benefit from discrepancies in intermediate cryptocurrencies. This is a scenario where a trader uses the price discrepancies from three or more cryptocurrencies to execute an arbitrage trade.
Making a profit from crypto arbitrage is possible
Traders that make a profit from crypto arbitrage are carefully planning their trading strategy, and consider all factors of their trading, such as trading fees, transaction volumes, and the time it takes to perform the trades. Moreover, arbitrageurs always have hedge strategies.
Crypto arbitrage is possible when the markets are different and present anomalies. That’s how a trader can make small profits that can add up over time. The most important thing is to have a strategy set in place and research cryptocurrencies and trends before investing. With the right tool, strategy, and knowledge, crypto arbitrage can generate profit for traders.
Frequently asked questions
How do you use arbitrage in crypto?
How does crypto arbitrage make money?
Can crypto arbitrage make you rich?
Is bitcoin arbitrage legal?
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