For many traders, arbitrage trading on the foreign exchange market has long been no longer a secret, but a source of stable profits. Meanwhile, this strategy can also be successfully applied to the cryptocurrency market.
We will look at the three most common bitcoin and other altcoin arbitrage schemes and assess their advantages and disadvantages.
What is arbitration?
Arbitration is The execution of several transactions to buy and sell identical assets, the profit of which is derived from the difference in their value.
There are two types of arbitration:
- spatial - when trading operations are conducted on different trading floors, but at the same time;
- temporary - transactions are conducted on the same trading floor, but at different times.
The most common type on the financial markets is spatial arbitrage. In simple words, its scheme looks like this: the price of the same asset on two exchanges differs significantly. The trader buys the asset where it is cheaper and sells it where it is more expensive. The difference in the price of the asset goes to the trader's profit.
It is worth noting that spatial arbitrage is possible solely because of the low efficiency of quoting assets within a single trading floor in particular and the system as a whole. There is also a key dependence: the less the system itself is centralized, the worse the interaction between exchanges is. Due to the fact that the entire cryptocurrency system is based on decentralization, this provides an excellent opportunity for cryptocurrency arbitrage.
Scheme #1. Interchange spread
Using the difference in the price of cryptocurrency looks something like this:
On the cryptocurrency EXMO exchangeFor example, 1 bitcoin is trading at $8,500 per coin. At Livecoin exchange the price of a bitcoin is $9,000. The trader buys 1 BTC on the first exchange, transfers it to the second exchange and sells it there. He ends up with a $500 profit, which is the inter-exchange spread.
Disadvantages of Arbitration Scheme #1
Ideally, everything looks great, but in practice the resulting profit will be much less, because any cryptocurrency exchange charges a certain commission from the operations of the trader.
Commissions can be charged for the following operations:
- when transferring funds from a personal wallet to a trading deposit on the exchange № 1;
- for depositing funds on the exchange;
- for buying cryptocurrency on exchange number one;
- for transferring cryptocurrency from exchange #1 to exchange #2;
- for selling crypto on exchange #2;
- when withdrawing funds from the trading deposit on the exchange №2 to a personal wallet.
Traders who use arbitrage operations necessarily take these costs into account, preferring to work with an interchange spread of 2-3%. Additionally, there are various ways to reduce commissions.
Lack of liquidity
As a rule, the difference in quotations of the top cryptocurrencies is rather insignificant, which makes it difficult to use them for arbitrage. Much larger price differences are observed among altcoins, figuratively speaking, "second-tier" coins. But there is a rather serious problem here. The liquidity of altcoins is quite low - it is impossible to buy or sell them in large volumes.
Crypto traders-professionals increase their profit due to large trading volumes, which, by the way, gives an opportunity to minimize commissions for trading and transactional operations. With many altcoins, which have an attractive difference in quotations, this will not work.
In addition, you should take into account that arbitrage is not a secret for anyone, and you are not the only one who is so smart and cunning. That is, if enough difference appears in some cryptocurrencies for arbitrage operations, the available volumes of such an asset are quickly redeemed. As a result, the inter-exchange spread also narrows quickly and can leave the trader without profit.
The risk of wasted time
As we mentioned earlier, the essence of spatial arbitrage is that buy and sell transactions must be conducted at virtually the same time. That is, the shorter the time interval between buying a cryptocurrency on one exchange and selling it on another, the lower the risk that the price of that asset will change, reducing or depriving the trader of profit, at best. At worst, such purchased cryptocurrency will have to be sold at a loss.
The inter-exchange spread scheme is literally rife with the risks of missing time.
You transfer cryptocurrency from exchange #1 to exchange #2, but while you were buying, the second exchange began unscheduled technical work, which is not uncommon for cryptocurrency exchanges. Time lost - money lost.
In addition, the increased popularity of cryptocurrencies has had a negative effect. Network congestion has led to a significant drop in transaction execution speed. By the time your funds get to the right place, the market situation can change dramatically, rendering arbitrage on the selected cryptocurrency meaningless.
Scheme #2. Use of Exchange Deposits
The second scheme is designed to solve the key problem of fast transfer of cryptocurrency between a buying exchange and a selling exchange. Scheme #2 is based on storing funds used for arbitrage on cryptocurrency exchanges' deposits. It will be most effective when investing in the medium and long term, as well as in the "Pump and Dump" scheme.
In simple words, funds do not need to be transferred anywhere, because they are already on the right trading floors.
For example, on two cryptocurrency exchanges you have deposits of 2 BTC and 100 Ripple. When there is an inter-exchange spread in the Ripple/Bitcoin pair, we buy XRP on the first exchange for bitcoins, and sell all XRP on the second exchange. After that, we equalize our deposits on both crypto exchanges.
Schematically it looks as follows:
Such arbitrage operations resulted in the profit of 0.08 BTC. Thus, in the scheme #2 the risks of losing time to perform transfers are excluded, but it must be taken into account that commissions for trades and transactions have not gone anywhere, so the real profit will be less than the estimated one.
Disadvantages of the arbitrage scheme using exchange deposits
Despite the fact that scheme #2 is more attractive than scheme #2, it has a number of disadvantages:
If in the scheme №1 trader is free in the choice of trading floors and, in principle, can use any two exchanges when the situation is favorable on them, then in the scheme №2 such operational space is excluded.
Indeed, not every trader can afford to hold deposits in several cryptocurrencies on a large number of exchanges. Therefore, the arbitrage space for scheme #2 is limited to two or three exchanges. In this case, the trader does not look for the best moment for himself, but sits and waits for it to appear on "his" exchanges.
Transaction costs are doubled because the result of such arbitrage is a double transfer between cryptocurrencies.
Scheme #3. Intra-exchange triangle
Sometimes opportunities for arbitrage transactions arise within the trading floor itself. For example, when the quotes of several cryptocurrencies diverge. Such an arbitrage scheme is called intra-exchange or triangular.
Schematically it looks like this:
As a result of this arbitrage scheme profit will be 8235 - 8000 = 235 dollars, not including commissions, which the exchange charges from trade transactions.
The second name of the scheme - triangular - is conditional, because there may be more than three assets in the chain.
The downside In intraday or triangular arbitrage, there is a risk that cryptocurrency quotes may change during the selection of an optimal chain of cryptocurrencies. To minimize it, traders use a kind of cryptocurrency trading robots.
In turn, some cryptocurrency platforms have special delays for such orders, which can have a negative impact on profits from such arbitrage.
In fact, there are many more arbitration schemes on the market. All of them, in one form or another, have already been tried on . However, the cryptocurrency market, with more than a thousand and a half cryptocurrencies traded, and its decentralization, looks much more attractive for arbitrage operations at the moment.