Arbitrage is a trading strategy that involves buying assets in one market or an exchange, and selling them in another for a higher price, profiting from the price difference.^[8]

Overview

Traders constantly monitor multiple cryptocurrency exchanges to identify instances where the price of a particular cryptocurrency differs significantly between platforms. Once an arbitrage opportunity is detected, the trader buys the cryptocurrency at a lower price on one exchange and simultaneously sells it at a higher price on another exchange. The aim is to complete both transactions as quickly as possible to lock in the price difference. The difference between the buying and selling prices, minus transaction costs and fees, constitutes the profit generated from the arbitrage trade.^[1]

Given the speed required for successful arbitrage trading, many traders employ automated trading bots or algorithms that are programmed to identify and execute arbitrage opportunities instantly.^[6]

Forms and Strategies

Spatial Arbitrage

It is also called Cryptocurrency Arbitrage. Exploiting price differences for the same asset in different geographical locations, such as cities or countries, due to transportation costs or local supply-demand imbalances.^[3]

Example

Let CryptoX, is trading at different levels on these two exchanges.

• Exchange A: CryptoX is priced at $10,000.
• Exchange B: CryptoX is priced at $10,500.

In this scenario, there is an arbitrage opportunity for traders to profit from the price difference between the two exchanges.

Temporal Arbitrage

It is also called Convergence Arbitrage. Taking advantage of price discrepancies that occur over time, particularly in futures and spot markets.

Example

Let CoinX trading on both the spot market and the futures market.

• Spot Market: CoinX is currently trading at $50.
• Futures Market: The one-month futures contract for CoinX is priced at $55.

This creates a scenario where there's a price difference between the current spot price and the price of the one-month futures contract.

Statistical Arbitrage

Utilizing statistical models to identify and capitalize on price relationships between correlated assets, aiming for convergence to the mean.

Example

Let two highly correlated cryptocurrencies, CryptoA and CryptoB are

• CryptoA: Priced at $200.
• CryptoB: Priced at $210.

Historical analysis of the particular cryptos reveals the price ratio between CryptoA and CryptoB tends to remain relatively stable over time. Assume that historically, the average ratio has been 0.95 (CryptoA's price divided by CryptoB's price). However, if the current ratio of the two cryptocurrencies is 0.90, it suggests a potential deviation from the historical average. If the historical price ratio of 0.95 is re-established, CryptoA's price would ideally rise relative to CryptoB's price, potentially resulting in profits for the trader.

Risk Arbitrage

It is also called Merger Arbitrage. Profiting from price inconsistencies during mergers, acquisitions, or other corporate events where the target company's stock price differs from the acquisition offer.

Example

Consider two tokens "TokenX" and "TokenY."

• TokenX: Currently trading at $100.
• TokenY: An acquiring company offers to buy TokenX at a price of $120 per token.

This scenario presents a risk arbitrage opportunity, assuming that the acquisition offer is likely to be completed and that the market has not fully priced in the acquisition price.

Triangular Arbitrage

The traders take advantage of price discrepancies among three different cryptocurrencies in various pairs.

Example

The arbitrageurs might trade BTC for ETH, ETH for XRP, and XRP back to BTC, aiming to profit from the imbalances between the three.^[2]

Risks

Market Volatility

The crypto market is highly volatile, which can lead to sudden price swings that affect the profitability of arbitrage trades.

Transaction Fees

Fees for trading, transferring funds between exchanges, and withdrawing cryptocurrencies can impact potential profits.

Exchange Policies

Different exchanges have varying withdrawal limits, trading fees, and verification processes that traders must consider.^[7]

Network Congestion

High network activity can lead to delays in transferring cryptocurrencies between exchanges, affecting the execution of arbitrage strategies.

Regulatory Landscape

Cryptocurrency regulations vary by jurisdiction, which can impact the feasibility of cross-border arbitrage. As of August 27, 2022, different bills have been proposed in U.S. Congress to make the regulation of cryptocurrencies consistent.^[4]

Taxes

In certain regions, individuals must fulfill tax obligations on their cryptocurrency holdings when they engage in selling, trading, or disposing of them. Additionally, cryptocurrencies can be taxed as income if an individual receives the crypto as a gift, from mining, or for services rendered.^[5]

Flash Loans

A flash loan is a defi transaction type that enables users to borrow significant cryptocurrency assets from a lending platform without requiring collateral or a credit score. However, the borrowed funds are returned within the same transaction block. It aims to use the rapid speed of blockchain networks to facilitate quick borrowing and repayment.^[9]

Such loans minimize risk for lending platforms. These usually span the duration of a single blockchain transaction block. It is a very short period for about a few seconds. With the available borrowed funds, the user can engage in various decentralized finance activities, including arbitrage trading, swapping tokens, or providing liquidity on decentralized exchanges. The borrower must initiate and complete the loan, execute their intended trades, and repay it within this brief period. If the user does not pay the entire borrowed amount, including the fee, within the block, the whole transaction reverts, ensuring that the lending platform is not exposed to losses. There is no fund transfer.

Example

Aave is a DeFi lending platform that offers flash loans. Users can borrow a wide range of cryptocurrencies without the need for collateral, as long as they return the borrowed funds and interest within the same transaction. Aave provides a robust smart contract infrastructure for flash loan transactions.

For instance, if the user takes advantage of an arbitrage opportunity between two DEXs, where a cryptocurrency token is priced differently, the flash loan process takes place.
Flash Loan Process:

1. A smart contract on Ethereum should be written, that uses Aave to request a flash loan of 1,000 ETH.
2. The smart contract borrows 1,000 ETH from the flash loan service provider, without needing to provide collateral.
3. In the same transaction, the smart contract:
   • Swaps the borrowed 1,000 ETH for the target cryptocurrency on DEX A, where it's priced lower.
   • Transfers the acquired target cryptocurrency to DEX B, where it's priced higher.
   • Sells the target cryptocurrency on DEX B for more ETH.
4. After successfully arbitraging and earning a profit, the smart contract repays the flash loan with a fee to the provider.
5. Any remaining profit belongs to the user itself.

If the user fails to repay the flash loan within the same transaction, the entire transaction will be reverted, and won't profit, but the user, also won't owe anything to the flash loan provider.^[10]

Kimchi Premium

Kimchi Premium is the difference between the trading prices of Bitcoin and other cryptocurrencies when they are traded on South Korean exchanges and various foreign exchanges worldwide.^[11] The Kimchi premium in arbitrage can present an opportunity for traders to profit by exploiting this price disparity between South Korean exchanges and global exchanges.

The Kimchi Premium was first identified as a phenomenon around the beginning of 2016. According to professors from the University of Calgary, between 2016 and 2018, the discrepancies due to Kimchi Premiums being the highest are caused due to the high demand for a limited supply of Bitcoins.

The Kimchi Premium is not constant, but when it appears, Bitcoins can be as much as 50% more expensive in South Korea. During such periods, arbitrageurs who try to earn from such gaps in the prices of financial instruments can profit by buying Bitcoins in markets, such as the USA or Europe and selling these in South Korea.^[12]

Back in 2017, SBF used crypto arbitrage techniques to gain strong crypto positions. He realized the large price differences in different countries and on different exchanges. At the time that SBF benefitted from the Kimchi Premium, Bitcoin was $10,000 in the US, but it was being traded for $15,000 on exchanges in South Korea due to extreme demand for digital currency in Korea. Other arbitrages also arose in Japan around this period of time, although the premium in Japan was not quite as high as in Korea, due to the restrictions on foreign traders.^[13]

The opposite of Kimchi Premium is Kimchi Discount. Kimchi Discount means Bitcoins trade cheaper in the South Korean exchange than other foreign exchanges at a given time.^[12]