This is where things get interesting (and also what I am most interested in).
Quoting Wikipedia, “Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.” In its simplest form it is simultaneously buying something, say bitcoin, on one exchange that is pricing it lower and selling it on another exchange that is pricing it higher to earn a profit.
There are many variants to this type of strategy in which I will cover in a future article. But to illustrate how this can be done I will look at one of the simplest form of arbitrage in the cryptocurrency space which is the cross exchange arbitrage.
Cross Crypto Exchange Arbitrage
Cross crypto exchange arbitrage is the act of buying a cryptocurrency on one exchange and selling it simultaneously (or in this case as quickly as possible) on another exchange. The most traditional way to do this would be:
- Deposit money into exchange A (the lower priced exchange)
- Buy your crypto on exchange A
- Transfer the crypto from exchange A to exchange B (the higher priced exchange)
- Sell the crypto on exchange B making a profit.
- Withdraw your money from exchange B so you can repeat from Step 1 again.
Profit = Price sold on exchange B — Price bought on exchange A
This method has worked in the past where the most famous case was that certain Korea exchanges were pricing bitcoin and other cryptos at a premium to non-Korean exchanges. Hence arbitrage between the two could reach 10% or more and this was known as the “kimchi trade”. However this method could only work if you were a Korean resident as it was hard for foreigners to open a Korean crypto exchange account as well as get your money in and out of Korea.
Typically though, arbitrage trades generate a small return only which make them not really worthwhile unless you are able to do this at scale such as via automation or you have a unique advantage to help you earn larger a profit per trade (such as the example of the Korean exchanges).
Risks/Things to Consider
You may notice that the suggested method doesn’t actually buy and sell the crypto simultaneously which means there are brief moments of exposure (or lack of exposure) that you do not wish to have which is one of the major drawbacks of this method.
Another issue is that having to deposit/withdraw money that frequently means you run the risk of your assets getting frozen somewhere along the way either by an exchange or by the bank. One of the most likely situations would be that a bank might suspect you for money laundering and freeze your assets.
Lastly as with all strategies that involve trading on exchanges, there is always exchange default risk so you need to be careful of which exchanges you use as some smaller exchanges might have higher arbitrage returns but have a much higher risk of default.
Implementing This In Practice
This method can work as long as you are comfortable in taking the short term exposure/lack of exposure when you transfer your money between the exchanges. There are also ways to work around this that I can’t disclose (as our company uses it) but all of them have other drawbacks as well.
Also this method usually works well if you have some sort of operational/structural advantage. For example if you owned a Korean crypto account and could move money in and out of Korea efficiently than you could capitalize on the “kimchi trade” described above. Alternatively, in my view, you would have to build automated systems to capture these opportunities at volume to make it add up.
For Crypto Investors: To implement this whilst maintaining your core exposure to cryptos can be done by depositing in your core currency, such as bitcoin, and make your arbitrage in pairs against it. For example you could trade ETHBTC by buying ETH using your BTC on the lower priced exchange and selling it back to ETH on the higher priced exchange.
For Fiat Investors: You would simply be implementing this as per the suggestion above and take on the short term cryptocurrency exposure. Alternatively you could try to hedge out your cryptocurrency exposure but more often than not your cost of hedging would be greater than the profit you can make on the arbitrage trade.