Many will scratch their heads after encountering the word arbitrage whilst dipping their toes into the realms of financials, markets, or gambling for the first. Its a simple concept, but not one that arises in everyday talks, so misunderstanding and confusion are to be expected. This guide has been prepared to get those unfamiliar with the premise of arbitrage trading, and betting up to speed, with a specific focus on cryptocurrency. First, a definition is in order.
Noun | ar·bi·trage \?är-b?-?träzh\
The Merriam-Webster dictionary defines arbitrage as:
a) the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies
b) the purchase of the stock of a takeover target especially with a view to selling it profitably to the raider
Put simply, to carry out any form of arbitrage a trader buys on one market and sells on another for the purpose of getting an instant profit. This can happen in any marketplace. Take a basic example from sports betting: a tennis match. What are the possible outcomes in a tennis match? There are actually only two of them: Player A wins, or Player B wins. Whoever the winner is, the arbitrage opportunity still exists. Suppose the odds for Player A are 3.0 in one market, and the odds for Player B are 3.0 in another market. If you bet on both players simultaneously, it will yield profit, irrespective of outcome:
Bookmaker A: Back bet of £10 on Player A will return £30 at odds of 3.0.
Bookmaker B: Back bet of £10 on Player B will return £30 at odds of 3.0.
Our total expense for placing these two bets was £20, and our total profit, regardless of outcome is £10. This bet is known as an arbitrage bet.
Arbitrage trading is possible within any market – be the goods physical or otherwise. However, the most common form of arbitrage involves dealing with stocks and shares. Here, the arbitrageur (savvy trader) scours the markets for opportunities to purchase a security, commodity, or asset at one price, and to instantly sell higher. They are not relying on swings in the overall price of said commodity to profit, rather discrepancies between markets offering its exchange.
Arbitrage applied to cryptocurrencies
There are many different exchanges that require little verification to begin trading in Bitcoin, Ether, or any other crypto assets. With such diversified options available, arbitrage opportunities often present themselves within the various markets available. You might notice a particularly high price of Bitcoin on CEX.io when compared with that on a different exchange, and it doesnt take a genius to realise that if you were constantly able to buy at the low price and sell at the high one, youd make consistent profits.
Does it actually work?
Whilst making a quick arbitrage trade with cryptocurrencies is certainly possible, there are some practical barriers that stop everyone from attempting to take advantage of discrepancies in the market.
Firstly, it is essential to move both your fiat currency, and cryptocurrencies extremely quickly, thats the whole point of arbitrage. As there are many different exchanges, this represents a major stumbling block. Even with the relatively fast transfer times of cryptocurrencies when compared to fiat currency, it is highly likely that the market will correct the arbitrage opportunity before youre able to move funds to the required market. It is then best to avoid this problem by using the exchanges that allow quick deposits and withdrawals. This is where CEX.io proves to be advantageous. CEX.io is the leading cryptocurrency exchange that offers a perfect trading space for their customers both beginners and experts. For the convenience of users, the deposits and withdrawals are made directly to the credit card or via bank transfer. This innovative feature improves transfer time dramatically and facilitates trading operations. To ensure better flexibility CEX.io has also enabled card deposits and withdrawals in its mobile app. This means that any CEX.io user can manage his funds right on the go and make the most of the trading opportunities.
However, when it comes to arbitrage, there are all sorts of fees to contend with. Theres figure exchanges charge to even trade, there are bank fees for transferring fiat money to an exchange, and now there are jacked up transaction fees on Bitcoins network itself. When combined, these costs can diminish the profits of your arbitrage trade so much that it is no longer considered as such.
Additional risks when making cryptocurrency arbitrage trades
As mentioned, there are various fees youll encounter and they can certainly hinder your ability to make a capital on arbitrage trading. However, there exist some other risks for you to take into consideration prior to giving the premise a try for yourself.
Firstly, bear in mind that the market is very swingy. This fact greatly increases the importance of efficiency when trading. After the fees have eaten most of your profit, a rapid downswing in the price on the exchange you wish to sell on can destroy any profits from the trade. Worse still, it can result in negative equity if the swing is severe enough. The price of digital assets is incredibly volatile at this stage of their existence. As mainstream adoption increases, these swings should theoretically decrease, however the risk of price fluctuations eating all your arbitrage profits will likely remain a constant in these markets.
Additionally, crypto exchanges are the target of some of the planets most sophisticated hacking operations. Theres a lot of value in compromising an exchanges security, and being as most of these operations are unregulated, falling victim to a hack could cause the whole company to simply collapse, running to the hills with yours, and the balances of every other customer willing to risk storing funds on an exchange. Exchanges have been hacked before, and they will be hacked again. Arbitrage trading specifically requires you keep funds on exchanges be they crypto, or fiat. For this reason, it is incredibly high risk.
Finally, as well as compromise from a third party, a significant crash in the market price of the asset you are trying to arbitrage trade could also cause exchanges to fold. As the exchanges are largely unregulated, they are under no obligation to keep funds on their books to pay customers in the event of a crash. They might simply not have the money to refund everyone requesting withdrawals, causing confidence to drop on the exchange, and potentially resulting in the company itself calling it quits and disappearing with whatever meagre funds they could after a huge overall drop in the value of cryptocurrencies generally.
Whilst it doesnt necessarily take a genius to recognise the difference in price between two exchanges, the practical implications of doing so will likely make the process at best unprofitable, and at worst incredibly risky. If youre considering getting involved with crypto arbitrage, be sure you know all the fees youll encounter in the process deposit/withdrawal fees, rising transaction costs from cryptos, and exchange costs. Remember that international bank transfers (required to get fiat to an exchange in the first place) are very expensive. Also bear in mind the potential for events outside of the exchanges to affect your ability to successfully pull off these arbitrage trades, as well as remembering that you are trading in a completely unregulated environment. There will be no insurance you can call upon if all goes sour. Good luck in the markets.
Featured Image Credits: Pixabay