While arbitrage is not a trading strategy solely linked to crypto, there are countless opportunities to put it to use in the blockchain ecosystem. But before you consider crypto arbitrage trading, it’s important to properly understand why these trading opportunities exist to begin with. In this guide Ledger Academy will unpack the concept of crypto arbitrage, so that you can understand the underlying mechanics of this approach before you dive in.
Let’s start with the basics:
Table of Contents
What Is Crypto Arbitrage?
Crypto arbitrage is a method of trading which seeks to exploit price discrepancies in cryptocurrency.
To explain, let’s consider arbitrage in the traditional sense.
Arbitrage is a trading strategy in which a trader buys and sells the same asset in different markets, profiting from their differences in price.
For example, someone who uses arbitrage trading strategies within the footwear market may buy a pair of Air Force 1s on one platform for $130 and then sell them immediately on a different platform for $140. The trader gets to pocket the $10 difference.
In a similar sense, an article found in a “thrift” store might be marked at low price; but that same article may fetch a premium on a dedicated vintage marketplace. The key takeaway? The same asset may have differing values on separate markets, and there is always someone waiting to take advantage of that difference. Of course, crypto assets are no exception to this trading strategy.
How Does Crypto Arbitrage Work?
To understand how crypto arbitrage trading works, firstly, you need to know that crypto exchanges can have slightly different prices for specific assets, as well as different methods of determining those prices. Since crypto prices tend to fluctuate and the market is active 24/7, there will be countless minute discrepancies in crypto asset prices across the market, and arbitrage traders seek to take advantage of them.To understand the complexities of crypto arbitrage trading, firstly it’s important to understand how different exchanges determine prices of cryptocurrencies. Not all exchanges calculate cryptocurrency prices using the same method, which creates opportunities (pricing discrepancies) across different platforms. Let’s dive deeper into this now.
Pricing on Centralized Crypto Exchanges (Order Book)
On centralized exchanges, a crypto asset is valued at the most recent price it was bought or sold for.
Centralized exchanges use something called an order book system to determine pricing. This order book is simply a list of buy and sell orders for a specific asset. At the top of the book, you’ll find the highest bid, and lowest ask prices. These figures then determine the real-time price of that specific asset on the exchange. This is because these values represent the highest and lowest limits at which a transaction can be executed immediately. So in effect, order book systems see the price of an asset entirely controlled by supply and demand across the market, and respond in real time to those dynamics.
Pricing on Decentralized Crypto Exchanges (AMMs)
Rather than using order books, Decentralized exchanges operate using Automated Market Makers (or AMMs). But what does that mean?
Put simply, an AMM is a liquidity pool that executes trades with users according to pre-defined conditions. So instead of trades being peer-to-peer, users are really trading with the platform’s liquidity pools. These liquidity pools have no central authority – rather use smart contracts to operate.
What impact does this have on the price of assets?
In an order book system, the price of assets is determined by the free market, always prioritising the highest bid and the lowest offer price for users. Instead, an AMM determines the price of the asset in each liquidity pool by analysing the pool’s internal supply and how it balances with its trading pair. This means prices on an AMM automatically change depending on the demand within its own, closed ecosystem, rather than dynamics of the wider market.
For example, imagine a liquidity pool holding ten million dollars of Ether (ETH) and ten million dollars of USDC. A trader decides to swap $500k if their own USDC for ETH using the AMM. This means the balance inside the AMM would change; it would have $500k more USDC and $500k less ETH than before the trader came along. Removing $500k worth of ETH from this closed ecosystem made ETH more scarce, and therefore more valuable within it. Meanwhile USDC would be more abundant, and therefore less expensive within the same ecosystem.
Since assets in an AMM are valued by its internal dynamics, rather than conforming with the broader market, there is often a difference in prices between AMMs and centralized exchanges.
That gap is where the possibility of crypto arbitrage comes in.
Incidentally, arbitrageurs actually play an essential part in the smooth functioning of AMMs. In short, AMM liquidity pools rely on these traders spotting pricing inefficiencies, and correcting them via arbitrage trading.
To be clear, trading between AMMs and order book exchanges is not the only arbitrage option within the crypto ecosystem – but it is an option specific to crypto, and therefore essential information for anyone seeking to properly understand crypto arbitrage.
Types of Crypto Arbitrage
Crypto arbitrage strategies take a number of different forms, each one taking advantage of price discrepancies across different parts of the market. Let’s check out a couple now.
Triangular Arbitrage is a trading strategy that seeks to exploit pricing inefficiencies between three different currencies when their exchange rates do not match up exactly. This could be across different exchanges, or within the same platform.
Triangular arbitrage opportunities can be difficult to spot without trading equipment. Nonetheless, they can be very popular strategies for crypto arbitrage traders.
For example, say a crypto trader has noticed a discrepancy in the exchange prices for Bitcoin (BTC), Ether (ETH) and Tez (XTZ). Using triangular arbitrage strategies, they may exchange an amount of BTC to ETH at one rate, then convert the ETH to XTZ for another rate, then finally, exchange the XTZ back to BTC. As a result, the trader would cash in on the small difference and make a profit as a result
Price differences don’t just occur between centralized exchanges and AMMs. There are also often price differences between different decentralized exchanges (DEXs). Trading focused on AMMs is known as decentralized arbitrage.
Decentralized arbitrage traders seek out pricing discrepancies between DEXs. This has the advantage of incurring less fees than using a centralized exchange – as well as enabling the trader to retain full control of their private keys for the entirety of the process. This is because decentralized exchanges do not support custodial crypto wallets.
Flash Loans for Crypto Arbitrage
No summary of crypto arbitrage trading would be complete without a mention of flash loans.
Flash loans are an interesting (and pretty hi-tech) way to execute crypto arbitrage trades, using the power of smart contracts. Flash loans are an interesting concept for a couple of reasons.
First, they require zero collateral. Collateral is normally what provides certainty to a lender that you’ll repay the loan amount. However, since a flash loan will not even begin to execute unless the payback is already guaranteed (thanks smart contracts), it requires no collateral from the trader.
So there is no lengthy approval process, and no need to stake any other assets. If the loan can not be paid back immediately, and within the same transaction, it will not be executed in the first place. But where does that fit into our arbitrage equation?
Crypto Arbitrage: Flash Loans in Action
Well, imagine an exchange sells a particular token for $100 dollars and exchange Y sells the same token for $101. Using the aforementioned strategy, you would buy a token on exchange X and sell it on exchange Y, making yourself a profit of $1.
This may not seem like much, but what if you were to try investing $100,000 instead? Then you could profit $10,000 in a single transaction. The only problem is: Most of us don’t have $100,000 at our disposal. This is where flash loans come in.
As long as you can prove immediate yield from your trade, you can set up a flash loan and profit from arbitrage trades no matter your profile, background or collateral. Plus, the whole strategy is inherently low-risk.
That said, it’s not the simplest strategy to execute. This is because flash loans are technically advanced, and therefore tend to be limited to advanced traders rather than a retail audience (for now). Flash loans are also a playground for bots as they allow for automated arbitrage trading. To explain, these automated arbitrage bots can spot an opportunity then execute the trade within seconds. This leads to opportunities for other crypto arbitrageurs becoming scarcer than ever.
Finally, flash loans have enabled some pretty notorious hacks targeting big crypto platforms. Malicious hackers will spot and exploit weaknesses in the code of trading protocols, a type of hack that was prevalent between 2021 and 2022.
Crypto Arbitrage: Risks and Considerations
As with any trading strategy, arbitrage incurs some degree of risk. It’s important to consider the drawbacks of employing these strategies in your trading.
Sudden or Unfavourable Market Movements
Firstly, arbitrage trading won’t shield you from the risks of sudden and unfavorable market conditions. If you buy a token for $100, aiming to sell it on another platform for $101, but in a split second the token price drops significantly, you will no longer be able to sell it for a profit at all. Alternatively, the exchange could change its price and you would no longer have the upper hand.
The time inefficiencies of blockchain can also add a risk factor to your strategy. For example, blockchain transaction speeds are sometimes so slow that the price could change by the time the transaction is approved.
You can also have legal barriers, such as anti money laundering checks or geo-blocking. For example, an exchange can halt transactions for hours whilst investigating. Alternatively, they might decide not to serve a certain geographical location due to legal sanctions on or in specific countries.
Finally, since exchanges interact with the blockchain and the internet, they can fall victim to network outages and server issues. For example, you wouldn’t be able to trade SOL during one of the 10 Solana network outages in 2022.
Platform Fees (Particularly on Centralized Exchanges)
While arbitrage trading can look easily profitable on the surface, it’s important to note that withdrawing, depositing and trading crypto assets on exchanges usually incurs fees. Seeing as crypto arbitrage trades play on such miniscule differences in price, it’s important to consider how much it might cost you. Some exchanges charge anywhere from 1- 4% simply to withdraw your own funds. If you want to make maximum profits, you’ll want to try and avoid spending too much on exchange fees.
Crypto Self-Custody as you Trade
Whichever crypto trading strategies you employ and whichever platforms you use as you put these strategies into action, security of your crypto should always be your first consideration. Thus, it’s imperative to keep your private keys offline and in your control
Not Your Keys, Not Your Crypto
Using centralized exchanges comes with its own risks and limitations. Centralized exchanges control the private keys to your coins, leaving you relying on the platform for access to your crypto. Basically, if the exchange goes down, your crypto goes with it. Only self-custody of your private keys enables you to stay in control of your digital assets. Even if you need to use an exchange for some transactions, avoid using them to store your entire portfolio. Simply, an asset stored on a centralized exchange is not under your control.
Digital Keys, Digital Threats
When you’re using decentralized platforms like AMMs, you’ll always have self-custody of your private keys. However, making sure your crypto wallet is out of reach from digital hacks, remains an essential security consideration. The only way to ensure this is to protect your keys, and therefore your crypto, from the internet.
Ledger devices offer true self-custody of your assets, enabling you to stay in control of your private keys, while securing those keys in an offline environment. This lets you protect yourself from digital hacks and phishing attacks. No matter where you’re trading, or how you’re using your crypto, using a Ledger device means you’ll be starting with the best possible security foundation; and so you can explore the world of crypto with peace of mind.