While cryptocurrencies are more popular than ever, in the grand scheme of things, the market for these assets is still relatively young. Given the hundreds of exchanges and thousands of new tokens created over the years, it's not surprising that cryptocurrency arbitrage remains a viable strategy in this growing market.

While cryptocurrency arbitrage may sound complicated, the underlying principles behind this strategy are surprisingly simple. Here's what you need to know about cryptocurrency arbitrage.

What Is Arbitrage Trading?

Arbitrage is the act of buying a security or asset in one marketplace and simultaneously selling it in another market at a higher price, making a profit in the process. It's a way for traders to take advantage of market inefficiencies and price discrepancies that otherwise go unnoticed.

For instance, traders can exploit arbitrage opportunities in the stock market by buying a stock in foreign exchanges. Across different markets and exchanges, stocks often trade at slightly differing prices, whether due to exchange rate differences or some other reason. During this brief window, an arbitrage trader can buy the same stock in one market and sell it in the other while pocketing the difference.^[1]

Nowadays, most arbitrage is done through algorithmic trading, which is able to spot and execute arbitrage opportunities faster than any human can. The rise of high-frequency algorithmic trading means that any remaining arbitrage opportunities tend to be incredibly narrow in margins, and even those don't go unnoticed for long.^[1]

What Is Crypto Arbitrage?

Crypto arbitrage is applying the same arbitrage strategies we see in stocks, commodities, and forex to the cryptocurrency markets. While arbitrage opportunities are much rarer in these more mainstream financial markets with significantly less volume and more volatility, arbitrage opportunities can still be readily found. ^[2]

That's especially true for crypto markets, which don't experience nearly the same amount of algorithmic trading. Most institutional investors and hedge funds are still avoiding the altcoin market, even more so thanks to the crash of 2022.

While arbitrage opportunities in more mainstream tokens, like Bitcoin (BTC), have narrowed alongside a rise in popularity and trading volume, there are hundreds of other opportunities available.

There's also the rise of countless new cryptocurrency exchanges, alongside decentralised finance (DeFi) liquidity pools and decentralised exchanges like Uniswap. All these new marketplaces mean that a single cryptocurrency could vary significantly in price between all of these exchanges. Multiply the number of exchanges by the number of tokens, and you can see why the raw potential for arbitrage is staggering.

How Does Cryptocurrency Arbitrage Work?

As explained, crypto arbitrage trading involves spotting price discrepancies across different exchanges. If different prices exist for a specific crypto asset, there is potential for an arbitrage trade.

While arbitrage opportunities with wide margins are rare, they do exist. When Filecoin went public on exchanges in October 2020, some exchanges listed the new token for around US$. On other exchanges, the price soared to over US$200.^[2]

There are a few different types of arbitrage to know.

Cross-Exchange Trade (Simple Arbitrage)

One is what's known as a cross-exchange trade, also just known as simple arbitrage. This is where you buy a cryptocurrency on one exchange and then transfer it to another, where it's sold for a higher price.^[3]

The problem with this method is that transferring between exchanges can take a few minutes, if not longer. During this period, an arbitrage opportunity might disappear, or slippage can happen, which means the price of a token moves before you can finalize your trade.

Holding Same Asset On Different Exchanges

Another method of crypto arbitrage is to hold the same digital asset on two different exchanges simultaneously. Once this is done, you'd execute an arbitrage trade by buying a token on one exchange while selling it on another at nearly the exact same time. The only downside is that you need to have enough startup capital on hand to buy crypto on both exchanges, which means you'll have to invest more money upfront.

Triangular Arbitrage

Triangular arbitrage involves taking advantage of price differences between three currencies. For example, a trader could buy Bitcoin in a fiat currency like the USD then sell it to another, like the euro. To finish his trade, he could then exchange those euros back to USD. This is a bit more complicated, but given exchange rate differences, it expands the possibilities of crypto arbitrage significantly.^[3]

Is Cryptocurrency Arbitrage Profitable Today?

Arbitrage is considered a low-risk trading strategy and could be profitable depending on your market. Margins for arbitrage trading tend to be inversely correlated with how much trading volume there is. Nowadays, margins on crypto assets are usually quite small, but it's still possible to make 2-3% per trade if the spreads are wide enough.

Benefits Of Cryptocurrency Arbitrage

There are a few notable advantages to using cryptocurrency arbitrage as a trading strategy.

### Much Shorter Investment Horizon

Because you can buy at one exchange and sell at another in a matter of minutes, it is possible that crypto arbitrage can earn you a return in a narrow time frame. That's in contrast to swing trading or other technical-based trades, which require you to deploy capital for significantly larger periods.

Lower Risk

Given how quickly money moves in and out of any particular arbitrage trade, that means there's significantly less risk involved. Even in volatile crypto markets, a trade lasting a couple of minutes means there's lesser room for prices to change, provided you don't face delays in your transactions.

In contrast, buy and hold or other strategies can keep your liquidity tied in with the markets for significantly longer periods of time. Given how volatile the crypto markets can be, that's a lot of room for things to go wrong.^[4]

Diversity Of Opportunity

There are hundreds of cryptocurrency exchanges, most of which offer dozens or hundreds of different altcoins for trading. That means there are plenty of opportunities to find arbitrage opportunities that others might have missed.

It's also worth noting that the crypto market continues to grow—quickly. In 2014, there were around 500 different cryptocurrencies. As of 2022, there are now over 18,000 in circulation. Even with the popularisation of Bitcoin, only a small population of investors trade in crypto. That means there's plenty of growth potential for new coins and, as a result, new arbitrage opportunities..^[5]

Lack Of Competition

Arbitrage trading in traditional financial markets is almost impossible for an ordinary retail investor. There are too many existing hedge funds and other institution entities using advanced, AI-powered trading bots that spot and execute on arbitrage opportunities in seconds.

On the other hand, there aren't as many institutional investors dabbling in the altcoin market. While some funds experiment with holding Bitcoin and Ethereum, most other altcoins remain relatively untouched. The only other competition in the crypto market is other retail traders, whose trading bots either aren't as advanced as institutional investor's, or simply trade in much smaller quantities.

Disadvantages Of Crypto Arbitrage

While crypto arbitrage may sound appealing, it has its own risks and challenges.

Fees

One of the bigger problems for new arbitrage traders are trading fees. As we saw earlier in 2021, transaction fees for cryptocurrencies can range wildly. At one point, as Ethereum congestion reached its peak, each trade could cost up to US$100 in ETH gas fees. Given the high-speed, high-volume nature of arbitrage trading, these fees can quickly add up.^[2]

That's in stark contrast to other financial markets, where high-frequency trading is nowhere near as expensive. While blockchain technology promises to reach a point where fees eventually become almost nonexistent, we have a way to go before we reach that point.

Transaction Delays And Slippage

High gas fees also go hand in hand with delays. Especially when it comes to decentralised exchanges, transactions could sometimes take several minutes to clear, if not longer. That's also something to keep in mind: an arbitrage opportunity may not exist in five or ten minutes, depending on the market.^[2]

Know Your Customer Regulations

Know-your-customer (KYC) regulations can be a problem for some arbitrage traders. Many exchanges require you to live in the same country where the exchange is based, while others have restrictions on users from other nations.

An American crypto trader won't be able to access the full Binance exchange, for instance, due to regulatory issues in the U.S. Not all exchanges have all the popular altcoins either, like Coinbase, which carries just a small fraction of the total number of popular cryptos on the market.^[4]

Best Techniques For Crypto Arbitrage

The following are some of the better techniques employed by crypto arbitrage traders.

Check For Newly Listed Coins

A token that recently underwent an initial coin offering (ICO) or was added to an exchange likely won't be priced the same as other exchanges that already have said token. Additionally, new tokens often see wild price spikes. Just like in the stock market, where an initial public offering (IPO) can swing wildly on its first day of trading, newly tokens on an exchange can also drastically change in price.

Keep Up With Local Laws

Arbitrage can also be a big opportunity in countries where crypto legality is changing. Back in November 2021, digital assets were trading at steep discounts on news that the Indian parliament may crack down on crypto traders. An arbitrage trader could have bought crypto on an Indian exchange and then transferred/sold it on another.^[6]

Limit Your Exposure

As always with any trading strategy, it's important to remember to limit your exposure. Never arbitrage an amount that you're not comfortable losing. Allocate only a portion of your portfolio to any specific trade, no matter how short or how much of a sure thing it seems.

Summary

Arbitrage is a potentially profitable cryptocurrency trading strategy. With enough seed capital and discipline, it's possible to earn decent returns from this strategy as you profit from discrepancies across asset prices.

The cryptocurrency markets are in a unique position right now. With thousands of cryptocurrencies and hundreds of exchanges, the opportunities for arbitrage have never been better. At the same time, crypto is still off most institutional investors' radars, meaning you won't face the same degree of arbitrage competition in the traditional world of finance, where high-frequency algorithms dominate.

As long as you're willing to play it safe and hedge your bets, crypto arbitrage is a practical and reliable strategy for potential success.