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What is Crypto Arbitrage? A Beginner’s Guide

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Illustration of man holding bitcoin to illustrate the topic of crypt arbitrage

The crypto world is in some way an uncharted territory for financial experimentation, from leveraging decentralised financial services to becoming a crypto arbitrageur, that is someone who makes money from crypto market arbitrage.

As exciting as the crypto world may seem, you should tread carefully as it is still regarded as the “digital wild west”, where you’re responsible for your own financial safety since nearly everything is decentralised and (for the time being) partially unregulated.

As always, do your own research, and find financial advice from a professional, since this article was written for educational purposes only. 

Related: Learn more about decentralized finance (DeFi).

What is crypto arbitrage?

Arbitrage is nothing new and has existed for as long as financial markets have existed. Arbitrageurs take advantage of market inefficiencies in the distribution of the supply of assets. 

What is arbitrage?

Arbitrage is the practice of buying an asset from one market, and nearly instantly selling it in another market while gaining a profit from price discrepancies between those markets. 

For example, in the online forex market, one exchange may have an oversupply of the US dollar (perhaps due to national regulations that limit its liquidity), while another market in another country may charge more for the US dollar due to investors flocking in to buy before the sellers can supply them.

With a few clicks of a mouse, an arbitrageur can make online buy and sell orders almost simultaneously and make a few percentages of profit, without having to wait for any price movements.

Can arbitrage happen in the crypto market?

Cryptocurrencies may be decentralised, but their distribution points are not. Most people gain exposure to cryptocurrencies from exchanging fiat currencies at a crypto exchange like Easy Crypto. 

Therefore, some price discrepancies can occur because the crypto market in one country may be more liquid than another. This is however rarely due to government regulations, and more to do with sentiments of the majority of buyers and sellers from a particular location. 

Most of our customers come from New Zealand (that’s where we are!) and Australia. If crypto good news happens in New Zealand, there will likely be massive buy orders and higher prices compared to other exchanges in other places.

Can crypto arbitrage bring about instant profits?

Yes, and instant losses, too. It depends on how well an arbitrageur recognises price differences, and how fast one can make decisions about which assets to buy, and where to sell and when. 

But being the fastest hand in the digital wild west is not the only factor for profitability.

How profitable an arbitrage can be also depends on the market’s valuation of a particular coin or token. A great number of arbitrage happens after ICOs occur, or after an exchange lists a new crypto coin or token. Why is that?

During ICOs, or initial coin offering, the issuer of the digital asset determines the price to sell to the primary market (the first folks who hold these coins or tokens). At this moment, the valuation of the crypto is purely speculative and may not equal to the original price after mere minutes of changing hands with the primary market.

Some primary markets will highly value the new crypto, while others will undervalue it. This causes massive differences in prices, which is quickly targeted by arbitrageurs. 

In case when an exchange lists a new cryptocurrency for the first time, price differences can occur as the cryptocurrency can experience wildly different liquidity in this exchange compared to one that already has this cryptocurrency listed earlier.

Related: Click here to learn more about ICOs.

Can arbitrage be profitable in mature markets?

Photo of a calculator to illustrate the idea of proof of work.

ICOs and coin listing are rare events that can make or break a trading account. However, the majority of the time, arbitrageurs still make money in mature markets that involve bitcoin, ether, and some altcoin.

There are actually two different types of arbitrage — cross-exchange arbitrage (which I have discussed earlier) and triangular arbitrage, which occurs within an exchange.

Due to the complexities of market sentiment, timing, and the multiple ways that two cryptocurrencies can be paired, the same cryptocurrency can be quoted slightly differently, even within minutes.

The next section will illustrate how triangular arbitrage works. We’ll explain from a very basic and beginner’s level of understanding before going deeper into the granular details. 

How does a triangular arbitrage work?

How can the same asset be quoted differently in the same market? Well, that depends on the currency that you base it on. Let’s start by considering an ordinary fruit market in a Swiss village.

In this village, the Swiss accept both the euro and the Swiss franc, to simplify trades between the locals and the Schengen tourists. In the village market, an apple costs 0.50 euros per kg, while it costs 0.40 francs per kg. The exchange rate for EURCHF is 1.10, or 1.10 CHF per EUR as the base currency. 

Let’s assume that you can sell the apple for any of the two currencies for the price mentioned above. Do you see an arbitrage opportunity? Maybe you’ve already realised that it’s cheaper to buy the apple in francs than it is in euros (trust me, this happens a lot in the Swiss-German border!)

But what to do next? Well, now consider if the apple is “accurately priced” according to the currency exchange rate. Then what we should have is the following price data:

1 kg apple = 0.50 EUR

1 kg apple = 0.55 CHF

If we divide the price rate of the apple in euro with the apple in Swiss franc, so that we “compare apple to apple”, we get this ratio:

1 apple / 0.5 EUR  ÷  1 apple / 0.55 CHF =  1.10 CHF / 1 EUR (the ‘apple’ terms cancel out)

This is the way to check that the apples are priced according to the exchange rate, which is really 1.10 CHF per EUR.

Let’s now use the same method to see which of the original pricing schemes is more expensive (i.e. which currency is quoted cheaper or more expensive in relation to the apple).

1 kg apple = 0.50 EUR

1 kg apple = 0.40 CHF

1 EUR = 1.10 CHF         (the quote given by the exchange in the village)

1 apple / 0.5 EUR  ÷  1 apple / 0.40 CHF =  1 EUR / 0.8 CHF 

Your intuition was correct; the apple costs more in euros, because the euro is overvalued while the franc is undervalued in this fruit market.

Using triangular arbitrage, we can make a profit by buying the apples in Swiss franc, selling them for euros, and gaining a profit when exchanging back to Swiss franc. 

Let’s say you have 100 CHF. With this, you can buy 250 kilograms of apples. If you then sell the same amount of apples for euro in the same market, you’d get a revenue of 125 EUR. If you then convert that into Swiss francs with the exchange rate of EURCHF = 1.10, then you’d get 137.50 CHF.

From this arbitrage, you gain a profit of 37.50 CHF by selling apples without ever leaving this Swiss village.

How does a crypto triangular arbitrage work?

Using the same principle, we can do a triangular arbitrage in the same crypto exchange. 

Consider the following market quotes:

ETHBTC = 0.039491

ADABTC  = 0.00002301

ADAETH = 0.00058168

Remember, the second currency quotes how much of that currency will get us one unit of the first (base) currency.

First, we divide ADAETH by ADABTC to find the arbitrage ratio in BTCETH.

ADAETH ÷ ADABTC = 1/0.00058168 ÷ 1/0.00002301 = ratio = 0.039557

Notice that our ratio is bigger than the market quote for ETHBTC = 0.039491. Because we put ADABTC as the denominator for our ratio, the fact that our ratio is bigger than the market quote suggests that ADABTC is overvalued while ADAETH is undervalued. 

Therefore, to take advantage of this price discrepancy, we should buy ada with ether. By buying ada with 25 ether, and then selling ada for bitcoin, we will earn a revenue of 0.988945 bitcoin. 

This amount in bitcoin, when converted in the same exchange, is 25.04230 ether, which is a 0.17% profit to our name.

That’s… not a lot of profit.

Realistically, this is one of the more decent profits, with 2% being such a rare gain. I took the above prices from one of the biggest crypto exchanges. To make sure that these values are from a specific instance, I took the closing prices of all three cryptos on the same day.

Then again, you may ask yourself, how is 0.17% worth all that hard work put into calculating ratios, and clicking on Buy and Sell as fast as a cowboy draws his gun? 

Not to mention the risks of slippage (when prices move and ruin the whole set up). In some exchanges, the transfer fee may be larger than the most common earnings from crypto arbitrage.

Well, most professional arbitrageurs use bots to calculate the ratio and execute trades automatically. How these bots work and how to implement one is beyond the scope of this article.

It’s sufficient to say that crypto arbitrage — well, arbitrage in any market — poses a lot more risks than actual gains for beginners, unless a trader invests in bots and/or has large starting capital. It can be a profitable strategy because some of the biggest financial institutions do this on a daily basis.

Is there a safer way to make money while holding cryptos?

If you are a beginner who holds a cryptocurrency, but is interested to earn additional income using cryptos, there are various ways to do so:

1. Swing trading

The crypto market is perfect for swing trading, and for most markets, swing trading is a great way for beginners to take advantage of periodic price swings. Mine Digital is a platform to do any form of crypto trading. 

Before conducting any kind of trading, it’s crucial to start learning about technical analysis, price action strategy, and risk management so that you can time the market right and minimise your losses.

2. Crypto lending 

Many DeFi projects offer ways to earn passive income by locking in your crypto assets on a certain wallet, and earn interest. 

There are DeFi platforms like Nexo, which claims to let you earn interest of up to 8% annually with cryptocurrency and 12% annually with stablecoins and fiat currencies. There is also Yearn.finance, which is a decentralised asset management protocol that claims to optimise earnings of staked assets through multiple lending services.

By the way.. When you’re ready, grab yourself some Yearn Finance (YFI) tokens here in Easy Crypto at unbeatable rates. 

3. Staking pools

With the coming of age of Ethereum 2.0, staking your ether is now possible on Ethereum staking pools. Services like Rocket Pool specialise in affordable Ethereum 2.0 staking, requiring you to lock in as little as 0.01 ETH to participate. 

Staking will become an important part of the future of the cryptocurrency industry. Many new cryptos that were modeled after Ethereum have run proof-of-stake protocols (in part, if not completely) to create an efficient and sustainable blockchain network that can perform hundreds of times better than their predecessor, Bitcoin.

Note that at the time of writing (April 2021), staking your ether is an irreversible process. Once you’ve converted your ETH into ETH2.0 to join the Beacon Chain, your new coins will be incompatible with the Ethereum blockchain.

What’s the price of ether now? Check out our crypto exchange rates.

The takeaway

Crypto arbitrage is an instant way to make profits off of the crypto market inefficiencies. Price discrepancies between exchanges are due to the difference in liquidity due to many factors, such as market sentiment and speculation (in the case of newly circulated coins).

Arbitrage within the same exchange can be done using triangular arbitrage, by using three cryptos, calculating the ratio between the rates of two coin pairs, and determining whether one rate is undervalued. Buy decisions will be based on the undervalued pair. 

In order for crypto arbitrageurs to stay competitive and profitable, they often have to use bots to make automatic trades, and a large capital to realise considerable profits.

There are better ways for beginners to earn additional income by holding crypto, three of which are swing trading, crypto lending, and participating in a staking pool. 

Visit our Learn Site to discover more topics on all things crypto.

That’s all there is to crypto arbitrage – at least at the beginner level. If you have read this far, then you must have enjoyed this article.

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