What is Crypto Arbitrage and should I engage in it?

2 May, 2019

For every person who loves the idea of playing slots using a bitcoin deposit, there is someone else whose purchase of bitcoins is seen as an investment. For every person who views Bitcoin as a monetary system there is another who sees it as a store of value. We say all that to say this: there are a lot of different ways to use cryptocurrency. Some people use it as an asset for generating profits.

There are lots of ways to profit from cryptocurrency. One of them is something known as arbitrage. If you are new to the whole cryptocurrency thing, you may have never heard of crypto arbitrage before. If you're an experienced crypto user though, you have probably at least heard the term.

The goal of this post is to introduce you to crypto arbitrage. By the time you finish reading, you should fully understand what it is, how it works, and whether or not you should get involved with it. Please note that nothing you read here should be construed as financial advice. This post is for informational purposes only. Should you choose to engage in crypto arbitrage, you do so at your own risk.

A basic definition of arbitrage

The Merriam-Webster online dictionary defines arbitrage as "the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies". That definition is pretty consistent across most online dictionaries and financial information websites.

To put it simply, arbitrage is the practice of purchasing a security from one source at a lower price, then turning around and selling it elsewhere at a higher price. Applying this to cryptocurrency is pretty simple. You buy and sell on different exchanges depending on the price you're looking at.

The key to remember with the arbitrage strategy is that you are buying and selling the exact same asset on different markets. So let's say you're looking to make money on Bitcoin Cash (BCH). You would find an exchange where the current price is below average. You would purchase your coin and transfer it to your digital wallet. You would then run over to another exchange where the sale price is higher than average. That's where you would sell your BCH.

How it's possible

At first glance it might seem as though arbitrage isn't really possible. After all, aren't cryptocurrencies fungible? They are, but only in theory. It is true that you can go to just about any crypto chart and see a static price for your favorite crypto. Bitcoin might be trading at USD $5,200 per coin while Ethereum is hovering around $179. But guess what? Those prices are linked to the exchanges from which they come.

Arbitrage is possible because prices differ from one exchange the next. And by the way, the practice of arbitrage is not limited just to cryptocurrencies. You can do it with most kinds of securities. Take stocks, for example.

You could buy shares in TD Bank on both the New York Stock Exchange and the Toronto Stock Exchange. If there are significant price discrepancies between the two exchanges - which does happen - you could make some good money via arbitrage. You buy on the market with a lower price and sell on the market with a higher price.

The key to making arbitrage work is timing your trades. Price discrepancies do not tend to last that long because markets eventually settle in as volume cools. That's why the Merriam-Webster definition of arbitrage includes the phrase "nearly simultaneous." You make money in arbitrage by purchasing and then instantly turning around and selling.

The risks of arbitrage

Crypto arbitrage, and arbitrage in general, are both seen as very low risk practices in terms of day-to-day trading. Deals are occurring so quickly that getting stuck with large losses is rare. However, it can happen. There are four particular risks of arbitrage that apply as much to cryptocurrency as any other investment vehicle.

1. Execution risk

The first risk is what is known as the execution risk. This risk plays out when the investor cannot pull off trades quickly enough to make the desired profit. It is a bigger risk in traditional securities than in crypto, but it's still a risk for crypto investors, nonetheless.

You might purchase some Bitcoin at one exchange and then immediately turn around and attempt to sell it on another. Due to high traffic, execution of the sale may not occur as quickly as you want it to. You might not even be able to list your sell order for a couple of minutes after your purchase. In that time, Bitcoin's price could drop enough that you will not make the profit you were hoping for. If the price swing is serious enough, you could even lose on the deal.

2. Mismatch risk

The next risk is one of asset mismatch. This is rare in cryptocurrency markets due to the nature of cryptocurrency itself. When mismatch occurs, you have an asset being traded on multiple markets where it is assumed the asset is equivalent. If it turns out the asset is not equivalent on both markets, you have a mismatch.

3. Counterparty risk

Next is a risk that is directly related to future movement of cash. It is known as the counterparty risk because it involves both parties in a given transaction. Let's say you purchase Bitcoin on one exchange and turn around and sell it on another. If the other party does not fulfill his or her obligation to actually purchase the Bitcoin you offered, you could be left holding the bag.

Again, this risk is rare in crypto markets due to the irreversible nature of transactions. But it is still possible that the purchaser could accept your offer to sell only to have the deal canceled because that person's credit card or bank account will not facilitate the purchase.

4. Liquidity risk

Finally, there is a liquidity risk with arbitrage when you're trading on margin. What is margin trading? It is the practice of borrowing money in order to purchase assets, with the intent of repaying what is borrowed through one's profits. Margin trading in crypto is extremely dangerous because of crypto's price volatility.

If you were to practice crypto arbitrage via a margin strategy, you would be borrowing money to buy coins. You might make a decent profit with every deal you pull off. But will you make profit fast enough to pay off what you borrowed? And what happens if a significant price swing reduces the value of your holdings considerably?

Practical and ethical concerns

We have now reached that place of asking whether or not one should engage in crypto arbitrage. There are some definite practical and ethical considerations to think through. In terms of the practical, it is wise to look at arbitrage as a gamble of sorts. It's a lot like betting online when you think about it.

Arbitrage trading requires that you gamble on a future outcome you cannot guarantee. You are betting you will be able to pull off trades fast enough to make a profit. With every asset purchase you are betting that there will be a buyer on another exchange. You are betting that you will not be left holding a worthless asset in the event of a price swing.

If you are buying and selling crypto as a way to make a profit, you always have to be willing to lose what you are spending. It is no different than online gambling. Your chances of winning are pretty high with an effective arbitrage strategy, but the risk of losing is always present as well.

As far as the ethics of arbitrage trading go, there are some who say you shouldn't do it. They liken arbitrage trading to pump and dump schemes that rely on convincing a bunch of people to buy just for the purposes of pumping up the price so you can sell.

Profits from arbitrage trading do not come from any increased value of the asset. They are derived solely from price discrepancies between markets, so arbitrage trading is viewed by some as nothing more than taking advantage of exchanges that do not settle at the same rate. Critics of arbitrage trading consider it 'gaming' the market.

The many opportunities of crypto

We are not here to take a position one way or another on cryptocurrency arbitrage. Our goal is to simply explain what it is and leave the rest to our readers. In light of that, you should now have a thorough understanding of how arbitrage trading works. It might be something that appeals to you as a crypto holder and investor. It may be something you have absolutely no interest in. There is no right or wrong.

The most fascinating aspect to all of this is that crypto arbitrage is yet another example of the many opportunities found in the cryptocurrency space. While some people are buying up bitcoins so they can play slots online, others are putting their money into cryptocurrencies in hopes of making a good return on investment. Who knew something as simple as a white paper outlining the benefits of digital currencies would become what it is today?