Arbitrage Trading in Crypto: Explained

The opportunity to get low-risk profits is represented by a trading mechanism called arbitrage trading.

In order to make the most out of this concept, there are certain things that you should know about.

Here’s a brief read on the workings of arbitrage trading and what arbitrage trading means in the world of cryptocurrency.

Let's get started...

What is Arbitrage Trading?

Defining arbitrage, in general, will help you grasp the understanding of arbitrage in forex and crypto trading.

In the simplest terms, arbitrage is a specific trading practice that traders use to make the most from price discrepancies of related or similar financial instruments.

In cryptocurrency, the concept of arbitrage revolves around prices of cryptocurrency coins evaluated by different companies or marketplaces, just like stock prices, forex trading, bonds, etc.

Arbitrage traders use the different price structures on varying markets and trade them to sneak out profits.

For instance, if the price of a certain cryptocurrency, say Bitcoin, is higher on 'marketplace A', and at the same time, it’s a bit cheaper on 'marketplace B,' you can buy some Bitcoin from 'marketplace B' and sell them at 'marketplace A', where the price is higher and profit from the difference.

These differences may occur due to reasons like quick surges in trading volumes or exchange inefficiencies.

Bigger exchanges have better prices, while smaller ones try to stay put.

Additionally, many smaller exchanges may take time to update their listings following the big guns and create opportunities for arbitrage traders to seize in a little profit.

How Crypto Arbitrage Trading Works

One of the biggest reasons that make arbitrage trading possible is the trade volume difference between small or big exchanges.

What happens is that, in smaller exchanges, the trading volume is lower, and as a result, the prices of cryptocurrencies listed there are also high. On the other hand, the prices of cryptocurrencies in bigger exchanges with high trading volumes are quite on the lower side.

This makes room for arbitrage trading to occur when a trader buys from the bigger market and sells on the smaller ones.

However, there are several instances where traders even bought cryptocurrencies from smaller marketplaces and successfully sold them on bigger marketplaces, making a profit.

The popularity of a certain exchange also plays a huge role in successful arbitrage trading.

In addition to that, geography and time of the day also determine whether it would be easier and profitable to trade or not.

It’s better to document these changes somewhere, plan effectively on how much you can potentially make, and then execute your decision accordingly.

The time it takes to process a cryptocurrency transaction also plays a crucial role in arbitrage trading.

This is because the 15 to 20-minute timeframe for transaction confirmation can take more time than it takes for the prices to drop in the other high-price market where you want to sell the bitcoins.

This means that simultaneous arbitrage is very difficult in the world of cryptocurrency because it’s a growing market and is very volatile.

Different Types of Arbitrage Trading

Even though it might seem illegal, arbitrage trading is legal in most states due to the market efficiency getting better. Since there are several financial markets throughout the world for you to trade securities, there are several types of arbitrage trading possible!

Spatial Arbitrage

Being the simplest form of arbitrage, the spatial arbitrage form is applied by many. It occurs when you trade the security simultaneously in different countries. For example, if you have bought security from a Vietnamese dealer and sold it to an Indian dealer to gain profit, it’s called spatial arbitrage. The ease and low risk of this method enable most traders to opt for arbitrage.

Merger Arbitrage

In case of merger arbitrage, you get to buy or hold the stocks of a company that’s moving towards a takeover. Following that, you sell the stocks to the acquiring company at a higher price. Since the acquiring company wishes to take over the targeted company, it’ll agree to pay a higher price than the market price of those stocks. Hence, you earn some profit through merger arbitrage. The difference between your selling price of the stocks and their market price is your gained profit!

Municipal Bond Arbitrage

This sort of arbitrage is ideal for investors with high taxable income. In the municipal bond arbitrage, you first purchase the tax-exempt municipal bonds’ portfolio that ensures no payment of taxes is required. Simultaneously, you sell similarly taxable corporate bonds that enable a ‘shorting’ event. Hence, you gain some profit due to the tax exemption characteristic of the municipal bonds!

Convertible Bond Arbitrage

Convertible bonds are generally the bonds that can be converted into stock or equity by the bondholder. If you are the bondholder of a convertible bond, you may switch it to stock when the stock prices rise. As a result, you shall get a high-priced stock without having to pay the market price for it. This scenario results in a convertible bond arbitrage. The difference between the convertible bonds' buying price and the stock's market price currently is your profit from the arbitrage.

Cross-border Arbitrage

This sort of arbitrage indicates the profit you gain by selling the same stock in different countries. For instance, if the same stock’s price is higher in the USA than in France, you may buy it from France and sell it to a USA dealer. That enables a profit from the difference in prices in France and the USA. However, cross-border arbitrage depends on the exchange rate between those two countries at that time; thus, it can be both profit and loss.

Regulatory Arbitrage

Interested in the regulatory laws and identified some loopholes? Well, if you’re an investor, you may use these loopholes to make profits. Regulatory arbitrage feeds on these loopholes in the regulations of different regions to gain. The regulatory laws of separate states are disparate, which means you can utilize the differences in regulatory practices if you manage to identify any loopholes. Even though this practice is legal, it remains unethical as you are avoiding the laws knowingly. Hence, regulatory arbitrage is discouraged in most places.

Telecom Arbitrage

This type of arbitrage is tremendously discouraged due to its fraudulent properties. In telecom arbitrage, telecommunication companies route the international calls made by the customers through a third party. This third party, in return, enables lower settlement rates to the telecommunication company. Hence, the customers pay more than the calls are worth, which counts as a profit by those companies. As this is the exploitation of the customers and their money, the telecom arbitrage is termed fraudulent in most cases.

Risks of Arbitrage Trading

Several risks are associated with arbitrage trading. The main idea of closing multiple deals concurrently is risky itself, as it’s close to impossible to make profits on every bargain. Moreover, the volatility of the financial markets adds to the risk. The prices may shift again and decrease before you have even sold the security, leaving you with loss and zero profit. In addition to that, the transactions may fail as you struggle with multiple deals worldwide. Hence, the risks of arbitrage may result in a massive loss or even bankruptcy.

Final Thoughts

Arbitrage trading is a way of making profits through the differences in security prices in distinct financial markets. The market inefficiency enables investors to gain by buying and selling the stocks at different prices. Even though many ways are available for arbitrage trading, not all of them are legal and ethical. The exploitation of innocent customers and general people is highly discouraged to the ones taking part in arbitrage trading. Moreover, the profits from arbitrage trading aren’t always assured; there are multiple risks associated with this phenomenon.