What is arbitrage?
“Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.”Source: Investopedia
Let’s illustrate this with a simple example.
There are 2 markets one in town A and another in town B. 1 kg of apples costs $1 in town A and the same 1 kg of apples costs $1.5 in town B.
Let’s buy 100 kg of apples in town A.
100 kg × $1/kg = $100
Now sell these at the market in town B
100 kg × $1.5/kg = $150 $150 - $100 (initial investment) = $50
We’ve just netted a profit of $50!
Of course, by removing several kilograms of apples from the market in town A we are reducing the supply in town A. With a lower supply and the same demand, the price will obviously increase when more buyers try to outbid each other. In town B the market will end up with more apples than potential buyers. To sell the apple surplus the price will have to come down to attract buyers. Over time both prices will converge and the arbitrage opportunity will disappear..
In short, arbitrage is a mechanism that ensures prices don’t deviate much over time.
How do you make money with crypto arbitrage?
The key to making money with arbitrage is to discover price divergence between assets, this applies to apples just as much as it does to coffee or crypto. For simplicity’s sake, let’s focus on price divergence between different exchanges to illustrate opportunities for arbitrage in crypto.
According to a research paper titled “Trading and Arbitrage in Cryptocurrency Markets” the maximum difference in bitcoin prices across exchanges was more than $3000 for a total of 15 days between December 2017 and January 2018.
What is Kimchi Premium
During the same period the price divergence between US and Korean exchanges was more than 15 percent and reached even 40+ percent on some days. The profits from arbitrage during this time are estimated to be at least $1 billion. This is more commonly known as the “Kimchi premium”.
Nowadays, South Korea is no longer the dominant force in the crypto market it was during 2017-18 when it accounted for almost 10% of all crypto trade while now it’s less than 2%.
Crypto prices are extremely volatile, and coins or tokens are traded against different base pairs over various centralized and decentralized exchanges. The price discrepancies create many arbitrage opportunities.
How do you find arbitrage opportunities in crypto?
The most common way to find arbitrage opportunities would be to monitor price differences across exchanges.
Crypto Arbitrage 101 – Bid, ask, amount & price
To discover arbitrage opportunities we need to look at the order books on different exchanges. An order book consists of bid, ask, price and the amount being traded.
The bid side is representative of the demand or buy orders, the ask shows the supply or the sellers.
To find an opportunity you need to identify the highest bid price on 1 exchange and the lowest ask on another exchange. The difference is called the spread. If the highest bid price > the lowest ask price, you’ve got an opportunity for arbitrage.
There are some more to consider:
Price slippage during arbitrage between crypto exchanges
Slippage happens when the bid/ask spread changes between the time a market order is requested and the time an exchange executes the order or if the order is larger and ends up consuming higher ask or lower bids.
Ideally you want to use a limit order to avoid slippage and to get the exact ask and bid but with arbitrage your window of opportunity is small and your orders need to go through swiftly. If you have a substantial order it might not even be executed and filled.
Transaction time and fee for sending crypto
The average confirmation time for BTC is about 10 minutes, plenty of time for the price to change.
The fee is another uncertainty, it’s not a fixed price. When the amount of transactions is high it’s like a queue at Disneyland. Those who pay for a FastPass can leapfrog queues. If you pay a higher transaction fee you can jump to the front of the transaction queue and your transaction will be faster. Of course a higher fee reduces your profit margin.
Exchange fees for arbitrage crypto
Depending on the exchange there could be a deposit fee and even an address fee to set up your receiving crypto address on the exchange
Withdrawal fees and restrictions
There’s a huge difference in withdrawal fees on different exchanges and these can be significant. Some exchanges also have a withdrawal minimums and maximums.
Trading fees are usually low but differ from exchange to exchange.
Credit Card fees to convert fiat to crypto and fees to withdraw to your bankaccount will cut significantly into your arbitrage profits.
Some exchanges require a bank account in the country of the exchange, others limit your withdrawal limits depending on KYC verification status.
Some countries tax withdrawals or limit the opening of accounts on exchanges.
Is arbitrage still possible?
Arbitrage opportunities still exit and can be profitable, but considering the costs and time delays and limitations it is difficult for the average crypto trader. Market makers with more competitive trading fees can easily outcompete other traders with lower, zero or even negative trading fees.
To profit from arbitrage opportunities it is best to use an automated system that identifies arbitrage opportunities and executes the required trades.
3 Arbitrage strategies you should know
This is the simplest type of arbitrage and the one we’ve discussed until now. We look for differences in price for one coin pair between exchanges. We buy at price A on exchange 1, transfer the crypto to exchange 2 and sell at price B, whereby price B > A and net the profit. Due to all the costs involved this method is hardly ever used in practice.
A better way.
Usually, the person doing the arbitrage will hold for example USDT and ETH on 2 exchanges, sell ETH high on one exchange and buy ETH cheaper on the other. The total amount of ETH will stay the same while USDT increases. When the funds on 1 exchange are at risk of running out, the exchanges are balanced again. This significantly reduces the costs and time delays from sending and processing crypto. It also makes it possible to automate the process using an automated system.
This is a form of trading that can happen between exchanges or on one exchange or any combination thereof where you exchange one asset for a second asset and then exchange the second for a third and finally trade the third for the first. Or, as in the example below, trade assets between exchanges and within one exchange.
This sort of arbitrage relies on market imperfections that occur when sellers and buyers of different but correlated assets are not fully aware about changes in each market. This temporary and short-lived glitch gives rise to an arbitrage opportunity.
This type of arbitrage is rare and requires sophisticated computer algorithms to automate the trades successfully.
This type of arbitrage is a type of arbitrage that is often used in currency markets. Triangular arbitrage can be between different exchanges but also within one exchange.
As an example, assume we have $1 million and the following exchange rates:
- 1 USD = 0.84 EUR
- 1 EUR = 0.87 GBP
- 1 GBP = 1.37 USD
With these exchange rates there is an arbitrage opportunity:
- Sell dollars for euros: $1 million × 0.84 = €840,000
- Sell euros for pounds: €840,000 × 0.87 = £728,840
- Sell pounds for dollars: £728,840 × 1.37 = $1,000,974
Subtract the initial investment from the final amount:
- $1,000,974 – $1,000,000 = $974
Crypto triangular arbitrage
This is a fictional example for illustrative purposes.
The most promising form of arbitrage is spot-futures arbitrage.
What are Perpetual Futures Contract?
Futures are contracts to buy or sell a commodity, currency, or any other instrument at a predetermined price at a specified time in the future, hence the name future. The name “derivative” is often used in this context because the value of a futures contract is “derived” from the underlying asset.
In commodity markets, when contracts are settled and physical goods, such as coffee or wheat, are exchanged, there’s a need for storage and transport, this creates additional cost known as carrying costs. The market price of those goods can differ from their price at settlement date due to market fluctuations and carrying costs. The longer in the future the higher the carrying costs and the more the price can diverge from the current market price.
Although initially designed for trading commodities, futures can be used to trade any derivative including digital assets. Trading futures contracts has some advantages over trading in a traditional spot market. You can short sell an asset or use leverage, for example.
Futures contracts usually settle on a monthly or quarterly basis. That’s the moment the price converges with the spot price and all open positions expire. With perpetual futures there’s no expiration. You don’t actually need to own the underlying asset because there’s no settlement. Any deviation from the underlying spot price needs to be addressed to ensure prices converge regularly. That mechanism is known as the Funding Rate.
How to do Spot-futures arbitrage
Whenever a perpetual futures contract is trading on a premium (the price is higher than the underlying asset on the spot market), long positions have to pay a Funding Rate to the short positions. Whenever the price is lower than the price of the underlying asset on the spot market, we can hedge our investment if we buy Bitcoin on the spot market and short sell the same amount for the same price on the futures market. In a bullish market our investment will gain in our spot trading account but will lose in our futures account. Since we invested the same amount of the same coin, this evens out. We are now market-neutral.
Usually the futures price trades higher than the spot price, especially in neutral to bullish markets because more investors hold long positions than short positions. Consequently, the long positions have to pay the short positions. This will attract short sellers creating a balancing act between longs and shorts that ensures prices converge with the spot market. Holding a short position on the futures market while holding the same long position on the spot market makes us market neutral but entitles us to receive the Funding Rate every 8 hours.
What is funding rate?
The Funding Rate has two components, the interest rate and the premium. The former is fixed e.g 0.01% for 8 hours on Binance. The premium varies and depends on the price difference between the Mark Price and the perpetual futures contract. This Mark Price attempts to establish a fair price and prevent price manipulation, when the market is volatile. A Mark price consists of two components, Price Index and Moving Average(MA) Basis. Price index is an aggregated index of different spot markets (exchanges) weighted by their relative volume, this prevents price manipulation. The other component uses a moving average to smooth out price and prevents unfair liquidation when the market is highly volatile.
For most coins this Funding Rate is mostly positive meaning the long positions pay the short positions. Every 8 hours the Funding Rate is paid out, which means in a day there are 3 payouts.
For ETH the Funding Rate is on average 0.0852% per 8 hours or about 0.2556% per day. Assume we have $10,000 USD, and we’re going to trade ETH/USDT
We divide the 10K into 5K on the futures account and 5K on the spot account and buy ETH with it on the spot account and short 5K in ETH on the perpetual futures market. If the current Funding Rate is 0.05% then we get on our 5K (in our futures account)
5K × 0.05% = 2.5 USDT
The 2.5 USDT is paid out 3 times a day. After one year (if the average Funding Rate is constant) that adds up to
3 × 2.5 × 365 = 2737.5 USDT 2737.5 USDT return on 10K USDT 2737.5 / 10000 × 100% = 27.375% APR
That’s without any leverage. Let’s assume that we take a little more risk and short our position with 3x leverage.
This means we only need 1/3 of the money in our futures account of what we have in our spot account. For 10k this means we put 7500 USDT in our spot account and 2500 USDT into our futures account.
(0.75 × 10000) × 0.05% = 3.75 USDT
After 1 year that’s:
3 × 3.75 × 365 = 4106.25 USDT 4106.25 USDT return on 10K USDT 4106.25 / 10000 × 100% = 41.0625% APR
What are the risks for crypto arbitrage?
The risks, when doing price arbitrage, are mainly the unexpected additional costs and possible time delays. On top of that you have to keep your trading accounts balanced across exchanges.
With triangular arbitrage there are fewer costs involved, especially when done on the same exchange, but it requires an automated algorithm to monitor and discover anomalies in the market. Risks are relatively low unless the market is extremely volatile, but the opportunities will be short-lived and not that frequent.
This type of arbitrage is reliable and low risk because the Funding Rate is paid every 8 hours and offers a consistent way to gain from arbitrage, without complex algorithms, transfer fees or delays and on top of it all it is market neutral.
It has none of the disadvantages of the other methods, however there are some things to keep in mind.
- You’re not always able to decrease your position in the spot market when auto-deleveraging is occurring on your futures account.
- In case of a sudden price increase, liquidation might happen on your short position because you were unable to close your futures positions in time.
These risks can be mitigated by using no or low leverage and by monitoring your strategy using an automated system such as Pionex Spot-Futures Arbitrage that minimizes these risks in real-time, turning it into a very reliable and low risk strategy.
Is crypto arbitrage legit?
It’s legit both as in legal as well as in doing what it is intended to do. It’s not just legal but also encouraged because it improves market efficiency and provides extra liquidity to exchanges. It’s also legit in that it does generate profit through a reliable, low-risk strategy in nearly any market. But let the numbers speak for themselves.