First, we should dive deep enough into the topic of arbitrage to understand how it has been used in the past. We also need to know how we might be able to map it to something relevant to us crypto-obsessed people. In the most basic sense, you are buying some assets in one place and then selling it for a slightly higher price somewhere else. So the general idea is pretty simple.
Let us imagine you notice that in one part of town the price of something like apples is higher in one market than at another. If the apples cost $1 in market A and then take them to the market B before it closes where they cost $2 and you are able to sell them, then your profit is the difference between the prices. So: $2 – $1 = 100% profit minus any overhead costs like transportation and taxes of course.
Beyond the simple definition
As it turns out, arbitrage is actually quite a bit more fascinating and deep a subject in finance. In fact, there are many different types and theories as to how or even if it’s possible. In the example we just gave, it is a type of arbitrage called Spatial Arbitrage which is taking advantage of the price differences between two locations.
This is typically what people mean by arbitrage. It’s buying assets in one location and usually physically taking them to another location selling them there. Although this may be what you think of when you think of arbitrage it is just one of the types. Other kinds of arbitrage do not involve selling the exact same assets per se or in the direct sense.
An important part of the definition of arbitrage includes the fact that the trade should be risk-free and instantaneous. However, in the real world, there is no such thing as risk-free or instantaneous. There are always risks in any type of trading or investing. So we will settle for low-risk and fast.
Conditions for Arbitrage
According to modern thought, if at least one of these conditions is true, arbitrage is likely possible.
- The same asset is traded at different prices in different markets.
- Two assets, such as stocks, with the same cash flow, are not trading at the same price.
- When an asset has some known future price but does not trade and that price.
Types of arbitrage
Here are some of the arbitrage types that would be common in the cryptocurrency space.
Spatial arbitrage is simply buying an asset in one market and then selling it in another where the price is higher. And in most definitions, this includes moving it in “digital space” from one online exchange to another.
Like spatial arbitrage, cross-border arbitrage involves selling the asset in different locations. But specifically in different countries across borders where there may be a price difference.
Or “stat arbitrage” means identifying statistical arbitrage opportunities using mathematical models.
Are markets efficient?
Many investors, traders, and economists believe in the efficient-market hypothesis. This is a hypothesis that at any given point in time the market prices of assets are accurately reflecting all available information.
- The implications with this hypothesis include: It is impossible to beat the market.
- Assets are always fairly priced and only change when new information becomes available.
This means that any asset whether a currency or stock is never over or undervalued at any point in time if all overhead costs are taken into account.
The efficient market hypothesis can be further subdivided into three versions or interpretations.
All asset prices are a perfect reflection of both public and private information. Therefore the asset’s price is always equal to its true or intrinsic value. There is no way to beat the market via strategy. Only being lucky can produce above-average returns as this version of the theory predicts that there is a normal distribution of returns for investors.
The idea here is that even if all the market participants don’t have all the information about an asset like a stock, that as long as some participants do have that information they will act on it in a rational way and buy or sell the stock, which then affects the price of it accordingly.
This is ironically and arguably the weakest form of the hypothesis. Because the research and empirical evidence seem to suggest that this isn’t the case as the value of assets, like stocks and especially cryptocurrencies, can fluctuate wildly in short periods of time. Even without new and important information being widely disseminated into the market. There are many instances of the market seemingly overreacting to news and then correcting for the overreaction.
Also, it’s impossible for markets to always be an accurate reflection of information. This is due to the fact that information takes time to propagate in any system or network like a market. Traders need to eat and sleep and certain markets only trade during certain hours. So it seems rather doubtful that the strong form is accurate.
The semi-strong form is similar to the strong form. But it is limited to all public information rather than all the information available. It also gives more wiggle room and time for information propagation. Although prices do adjust very rapidly to information.
This version suggests that neither of the most common trading strategies (fundamental and technical analysis) will give investors or traders any advantage in the market. Essentially, the only way to get an advantage is to have insider knowledge. But of course, that’s illegal in most places.
The weak form says that asset prices are random and not influenced by the prices in the past. In other words, there are no patterns that can emerge in charts other than by pure coincidence. Therefore technical analysis doesn’t work.
The weak form has no room for the idea of price momentum which says that previous price movements affect future prices. Although it does allow room for some fundamental analysis to allow investors to potentially beat the market and make wise investment decisions.
Law of One Price
In the context of arbitrage, it would seem that the semi-strong form of the efficient market hypothesis is probably the more accurate version. That’s because different arbitrage opportunities do arise in markets but generally don’t last for long periods of time if the strategy is actually profitable. It is believed that arbitrage is generally good as it makes the market more efficient. Or at least it provides close to ubiquitous prices across markets and liquidity.
The Law of One Price says that identical goods sold in any location should be the same price if you control for the costs of overhead like transportation. Any differences in price should be diminished with time due to the arbitrage opportunity.
Arbitrage and demand
Buying the asset in the cheaper market will cause an increase in demand and therefore an increase in price as well. Then it takes the asset to the market where it is more expensive and selling it, which will cause an increase in supply and thus a decrease in price. Doing this repeatedly will cause the prices in both markets to converge to roughly the same. Or at least eliminate the profit taking opportunities.
The prices may not precisely converge because the risks and/or cost of moving the asset from one market to the other might outweigh the profit that can be made on average. And so the market enters a state called the arbitrage-free or no-arbitrage condition. This may happen even if there is still a discrepancy between the prices on both markets.
The legality of arbitrage
Arbitrage is actually legal in most jurisdictions and in most situations. This is despite the negative connotations the word might have in popular culture. This negativity may have partially come about as a result of the drama film starring Richard Gere called, “Arbitrage”.
It’s usually legal because the arbitrageur is fundamentally a market maker. Market makers are generally encouraged in most free markets as they help to provide liquidity in by increasing overall transaction volume. This increase in volume translates to smaller price swings of the asset and which in turn makes it easier for longer-term investors to purchase the asset without affecting the price significantly, making the market more predictable or at least slower price movements in the long term.
Low liquidity is one of the biggest issues with the cryptocurrency market in general, which we could then arguably infer that this translates to lots of opportunity for arbitrage.
Arbitrage is probably as old as trade itself. There is some evidence of arbitrage in the middle east in ancient times. Spatial or geographic arbitrage with merchant networks was common. They often traveled long distances to many locations with varying local currencies. These merchants would often share information about prices of goods in different locations, which helped them to identify good arbitrage opportunities along the trade routes.
In the Mediterranean around 400 BC, there was an increase in arbitrage opportunities among money changers due to Persia using a bimetallic coinage system. This system offset the value of silver relative to gold causing an increase in exports to Greece and arbitrage activity.
Academic thoughts on arbitrage
Much like the Efficient Market Hypothesis itself, there are multiple camps to the idea of arbitrage which are extensions of the EMH.
The first camp is weak no-arbitrage, which says that arbitrage is rare but not impossible. Generally, opportunities can be found where there is low liquidity in an asset or market.
The second camp is strong no-arbitrage, which says that under no circumstances is arbitrage actually possible. If you do somehow make a profit it’s because of dumb luck and market fluctuations and not real arbitrage. If you were to try a strategy enough times, you would find its no more profitable than random buying and selling of an asset. This view of arbitrage is consistent with the efficient market hypothesis. It also assumes markets are always perfectly efficient.
Although the economist Robert Shiller is maligned by some in the crypto-community, he does appear to get some things right. He is the author of the book “Irrational Exuberance” whose title has entered the common parlance to describe market bubbles. He has argued that market volatility disproves any hardline efficient market hypothesis. In essence, people are too irrational and there are too many dynamic factors at play in markets for them to be truly efficient.
This should give us some hope that we can exploit these inefficiencies to our profit.
Arbitrage in cryptocurrency markets
In the brief history of cryptocurrency, there have been periods of time which produced cross border arbitrage opportunities. This was most notably seen in places like India, which had periods of time with a 30% premium or more compared to the global average on Bitcoin and other cryptocurrencies. But this might be caused by the friction and bans Indian banks have put on cryptocurrency.
A paper from the University of Calgary highlights the potential arbitrage opportunities in Korean bitcoin markets, which is colloquially called the “Kimchi Premium”.
The paper showed that the average premium was about 4% from 2016 to 2018. At times, the premium was as high as 54%. The study identifies two main causes of the premium; capital controls and friction caused by the Bitcoin network itself (transaction speed and fees).
This type of arbitrage is likely a lot more difficult to exploit. It would come down to knowing the more intricate details of the financial system in your area. So it’s something beyond the scope of this article, but worth looking into if you are interested in arbitrage.
Verdict on the Kimchi premium
With that said, the study concluded that cryptocurrency arbitrage is not likely possible. At least arbitrage on the Kimchi premium:
The results are consistent with our assumption of capital controls driving the Kimchi premium. If one of the other crypto currencies had no premium or a lower premium than Bitcoin arbitrageurs could use that currency to move funds out of Korea and complete the arbitrage. Since cryptocurrencies are not subject to capital controls no arbitrage opportunities between cryptocurrencies should be possible…
and further saying:
The analysis shows that the Kimchi premium is therefore not something unique to Bitcoin but rather a result of Korea’s capital controls that prevent arbitrageurs from aligning Korean prices with those of the world market
Despite this, there are plenty of traders in all kinds of markets who claim to make a profit out of arbitrage strategies. So if we continue with the hope that there still might be an opportunity in the market for us to make money, let’s look at what steps might be necessary.
The spread of an arbitrage trade is defined as:
Bid(exchange A) - Ask(exchange B) = Spread
If the spread increases past a preset trigger value we attempt to make a trade. The trigger value should be some specific number, ideally derived from some kind of risk analysis that takes into account market volatility, exchange fees, past trade attempts, etc.
Most arbitrage strategies require holding sums of both assets on both markets and simultaneously buying and selling respectively. The reasoning here is that it is a risk-free trade because it happens nearly instantly. However in the case of cryptocurrency, you can argue that this would not be risk-free. This is because cryptocurrencies are so volatile. Holding them indefinitely during trading time waiting for arbitrage opportunities could offset trading profits by a substantial margin. This is also called “price risk”.
So in outlining our strategy here, we will use more of the typical spatial arbitrage. This involves actually sending the asset from one market to another. With the information here you could adapt it to be one of the other types of strategies to your liking.
Identifying market inefficiencies
It will be logistically unlikely that you will be able to have a very profitable trading strategy of any kind without writing some scripts or bots. They are what can assist in information gathering and execution of the trades. This is especially true with arbitrage since you need to make the trades as fast as possible. Basically, it’s how many trading strategies in the modern world work. So if you are serious about it, it is advisable to learn how to program or use advanced pre-made trading software.
In order to find our market inefficiencies, we can’t waste large amounts of time searching multiple pairs of currencies and multiple exchanges by hand. It could take hours and we probably wouldn’t be able to find them fast enough to actually act on them.
Aside from the normal arbitrage conditions stated earlier, with cryptocurrency trading, we will need an additional set of criteria and heuristics. That’s how we’ll know if an arbitrage trade will be possible.
Exchange trading fees must be low for things to be profitable.
If the trade is spatial arbitrage, the asset being transferred should be fast. This will be determined by the speed of the blockchain, TX fees, and the minimum amount of confirmations the exchange requires before debiting your account for the trading of the asset. This will vary drastically depending on the exchanges you use, the fees set, and the blockchain you are using.
The volume must be sufficient (mitigate volatility price risk). If the volume is insufficient, then you could risk being stuck bag holding more of the asset than you would want as a market maker.
Now let’s gather some data. One of the most common sources for price data is CoinMarketCap. It is one of the first exchange prices aggregating websites in crypto and has over 2000 crypto assets listed.
You can use the CoinMarketCap API (if you are familiar with programming). However, the free version has limited functionality. Instead, we will use the API from CoinGecko which is also a good source for price information. Lucky for us, it has well-maintained API wrappers in several languages. Plus it’s close to the same amount of coins and exchanges listed on their website.
Or to follow along, you can go to coinmarketcap and click on the currency you would like to do arbitrage on. Then press the exchange tab and click “sort by price” to see if there are any major differences. It should look something like this.
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