Crypto Arbitrage 101

Here is how arbitrage works. Let’s take a tradeable digital asset, like Ether. If it’s the case that there are at least two markets and in one of the markets people are willing to pay more for ETH at the same time as in the other market, then you could buy 1 ETH in the cheaper market and turn around and sell it in the more expensive market and have an immediate and risk-free profit. (The caveat is in how risk-free this actually is.)

As an example, let’s suppose there are buyers in Chicago ready to pay $250 for 1 ETH and there are sellers in New York who will sell you 1 ETH right now for $220. All you need to do is buy the ETH in New York ($220) and sell this to the buyer in Chicago ($250) and you should be left with $30 minus fees. But after you buy in New York, your ETH is now in New York, not in Chicago. Fortunately, these are digital assets and, unlike physical commodities such as grain or oil, delivery can happen at nearly the speed of light. At least in the ideal case.

In reality, there are a number of delays to deal with.

A trade takes time to execute and settle on the exchange. This is the smallest delay. Requesting an exchange to transfer your coins out takes time to get through their authorization and security procedures. (On many occasions, the exchange isn’t currently processing transfers for that coin, and it might be days or weeks before you’re able to finally move them off.) Once the exchange is okay with your withdrawal request, they have their own schedule for broadcasting the transaction to the given blockchain. And then you’ll deal with network congestion where your transaction is competing with all the other transactions happening around the world to get into the next block. Periods of high trading volume also coincide with high demand for transacting on the blockchain. Once you make it into a block, you start the procedure again on the receiving exchange, assuming you did send it directly to the second exchange. But once the exchange in Chicago sees the deposit, they will have their own policy on how many blocks they must wait for before considering the deposit transaction confirmed. At that point, they may credit your account with the 1 ETH and then you can execute the second half of your supposedly risk-free trade.

By this point, the buyers in Chicago at the $250 price level may have gone away or reduced the price they’re willing to pay. Maybe it’s because demand in all markets has dropped. The price could be down to $220 and you could at least break even (except for all the fees). The price might also be lower. After all that effort, you’d now be losing money.

There is a way to get around this risk of price changing. You just need some Ether in Chicago before you even buy it in New York. This would mean that you have to already own or be able to borrow some of the asset and deposit it in places where you potentially want to sell later. This might double the amount of capital you need to do these trades as well as exposing you to any drop in value of your HODLing in ETH. If you bought or borrowed 10 ETH when it was $250/ETH and now the price of ETH is $200 then you’re down $500 whether you’re using the coins or not.

I forgot to mention that just to be able to buy the ETH on the exchange you would need to have already deposited trading capital in dollars or BTC and if it wasn’t there at the time the arbitrage opportunity was available, you would likely not get it in time. Bitcoin deposits often require six 10-minute block confirmations after you’re able to get your transaction accepted by miners. And banks transfer money on the order of days, not minutes. So you’ll need to come up with or borrow Bitcoins or fiat but if you’re calculating your profit in BTC or fiat then you at least don’t need to be concerned with the value of that capital dropping on you.

Let’s stop for a minute and ask ourselves how we feel about leaving dollars at the bank. Bank deposits are insured (in the US, the FDIC insures bank accounts up to at least $250,000). Cryptocurrency exchanges, generally, are not. Of course, banks have a lot of their own problems when we in the crypto industry try to use them. And this can include problems affecting funds in bank accounts, insured or not. You don’t think twice about leaving money in a US bank, but this sense of security should not carry over to deposits on crypto exchanges. And so our arbitrageur is faced with the risks inherent in holding assets with a counterparty, both the capital to buy ETH with and the ETH to sell.

There are plenty of crypto traders who are long on crypto and plan to own Bitcoin and perhaps some altcoins long term. These alts may include ETH or EOS or Bitcoin Cash — digital assets that are not only investments but can be used as capital to purchase other digital assets.

By keeping your crypto assets on two different crypto exchanges you are ready to start arbitraging. Let’s get this bread.