Educational Byte: What is Arbitrage and How is it Done in Crypto?

Even if they weren’t designed to offer profits, cryptocurrencies could be a great tool just for that. Not only are there professional traders around, but also entire platforms and methods that indeed have been built for it or that have been imported from traditional finances to apply here as well. Arbitrage is one of those methods.

In traditional investments, this is the practice of taking advantage of price differences for the same asset in different markets. For example, if a company stock is cheaper on one exchange and more expensive on another, an arbitrage trader would buy the stock at the lower price and immediately sell it at the higher price to make a profit. This process helps keep prices consistent across markets and is considered a low-risk trading strategy because it involves buying and selling almost simultaneously.

We can sum up this concept into a tidbit: buy low, sell high —as quickly as you can. Of course, it also applies to cryptocurrencies. Traders (or anyone, really) buy a certain cryptocurrency or token at a lower price on one exchange (centralized or decentralized) and then sell it at a higher price on another, profiting from the price discrepancy.

How does arbitrage work in crypto?

Cryptocurrency prices can vary between exchanges due to factors like differences in liquidity, trading volume, and regional demand. For example, if one exchange has fewer buyers or sellers for a particular coin, the price might be slightly lower or higher than on another exchange with more active trading. Additionally, market inefficiencies and delays in price updates can also lead to temporary price differences.

To take advantage of these price differences, a trader can monitor multiple exchanges using tools or platforms that aggregate real-time prices. These tools, namely crypto price aggregators, trading bots, and arbitrage-specific platforms, allow the trader to quickly spot where a cryptocurrency is selling for less on one exchange and more on another. By acting fast, the trader can buy the coin at a lower price and sell it at a higher price, profiting from the difference.

However, it’s worth mentioning that manual arbitrage is rare: traders usually use bots (faster than humans) to trade on their behalf. Arbitrage opportunities, especially on active markets, close very fast, often within milliseconds, and humans are unable to catch them.

To make a quick scenario around it, let’s say the native coin of the Obyte platform, GBYTE is trading at $6 on Exchange A and $8 on Exchange B. An arbitrage trader would buy GBYTE on Exchange A for $6 and then sell it on Exchange B for $8. In this scenario, if the trader bought 10 GBYTE, they’d spend $60 and sell them for $80, making a $20 profit before considering any transaction fees. Rinse, repeat, and add more investment, and profits will likely be greater.

Challenges and risks

Of course, there’s no such thing as a free lunch. While arbitrage in crypto can be profitable, it comes with some not-so-smooth things to consider. One of the main challenges is transaction fees. When moving coins between exchanges, traders often have to pay fees for both the transaction and the trade itself. If these fees are high, they can eat into or even eliminate the profit from the price difference. Besides, network congestion can lead to delays in transferring funds, and by the time the cryptocurrency reaches the other exchange, the price difference may have already closed, leaving little to no profit.

That’s another risk, indeed: price volatility. Cryptocurrency prices can change rapidly, sometimes within seconds. If the market shifts suddenly while a trader is in the process of transferring or trading their coins, they could end up selling at a lower price than expected, potentially resulting in a loss. Additionally, there’s the risk of exchange-related issues, such as withdrawal limits, technical problems, or even the possibility of the exchange freezing funds (if it’s centralized), all of which can complicate the arbitrage process.

To reduce this risk on active markets, arbitrageurs (or rather their bots) do both trades first, then transfer the funds between exchanges. Therefore, they don’t need to transfer after each trade, and they can transfer the amount aggregated from several trades at once.

Arbitrage on DEXes

In decentralized exchanges (DEXes), arbitrage can have positive effects on the market by contributing to its efficiency. When traders engage in arbitrage, they help close the price gaps between DEXes, effectively making the prices of cryptocurrencies more uniform across exchanges. This process benefits the market by keeping prices fairer for all participants.

Besides, arbitrage on decentralized exchanges (DEXes) offers key advantages over centralized exchanges (CEXes), particularly in terms of transparency and user control. On a DEX, traders retain custody of their assets, eliminating the need to trust a centralized entity, which can be a risk in CEXes. DEXes also operate on open networks, ensuring that all trades and prices are publicly visible, allowing for greater transparency and reduced chances of market manipulation by the platform.

There’s no central authority on DEXes that can halt withdrawals or restrict access, offering more freedom and security for arbitrageurs. The more decentralized they are, the more autonomy their users can get. For instance, Obyte, where there are no middlemen between transaction sending and approval, offers truly decentralized platforms.

Our main DEX, Oswap.io, provides access to 32 pools (fund reserves), where users can serve as liquidity providers and earn rewards or simply exchange between different coins. Arbitrage traders can use it too, taking into account a 90% arbitrageur tax on the profits, designed to earn more money for liquidity providers (LPs) without killing the arbitrage incentive.

Considering all the above, while arbitrage can be a low-risk strategy in theory, these factors make it important for traders to act quickly and carefully calculate potential profits after accounting for all costs, exchange terms, and risks. It’s important to do your own research, as always in crypto!

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