If you want to get past a first-round interview for a finance job, you need to be ready to answer this question: “Is arbitrage possible?”

Why is this question so common? The standard economic theories taught in schools start out with the assumption that markets are efficient — and, in an efficient market, arbitrage opportunities don’t arise.

But the real world isn’t quite like textbook economics: markets aren’t efficient, which is why institutional investors and savvy traders are able to use strategies like arbitrage to make outsized profits.

One look at the Bitcoin market will tell you that arbitrage is possible. But, like economic theory, your chances of successfully mastering arbitrage are best when you have a solid understanding of why arbitrage opportunities come about in the Bitcoin market and where you can find these opportunities.

Sharpen your pencils and grab a fresh notebook: class is in session.

Why Bitcoin Arbitrage Happens

There’s a constellation of market factors that can generate Bitcoin arbitrage opportunities. Here are some of the biggest causes to keep on your mind as you embark on your arbitrage quest.

Liquidity varies across exchanges

Different exchanges keep different order books, and those order books can vary widely with regard to how much liquidity they provide Bitcoin — that is, how easy it is to convert BTC into cash on an exchange without incurring a loss in the process.

If you’re trying to buy Bitcoin on an exchange with a sparse order book, you might end up paying a higher price than you would if you’d bought it on an exchange with a more filled-out order book: while both order books might show the same price for BTC, people might only have very small orders of BTC at that top-of-the-book price. As soon as you buy up those smaller orders, you’ll have to move deeper into the order book to fill the rest of your order — and that’s when a sparse order book will drive up your costs.

There may be a large trade on one exchange, but not on another

A single large trade can totally skew an order book.

Have you ever seen a depth chart that looks like this?

The vertical line at ~$6000 USD is a sell wall, a large sell order (or group of sell orders) at a certain price point that drives down the price of BTC on a particular exchange. When this much selling pressure is exerted on an order book, there’s not enough demand to buy up all the BTC in the sell wall. This means that anyone else who wants to sell BTC on that exchange will have to accept a price less than that of the sell wall, which drives the price of BTC down.

But while a large order can quickly and directly influence the pricing of BTC on its own exchange, it’s unlikely to have as direct an effect on order exchanges, which creates a discrepancy in BTC pricing across exchanges with and without large orders.

Exchanges cater to different clients

Exchanges are built with different kinds of traders in mind, and that can lead to arbitrage opportunities.

On exchanges that cater to many institutional clients, for example, you may find gaps in the order books between large limit orders that these clients have left open. You might not find such substantial gaps on exchanges with a broader, more retail-investor-heavy user base. As such, these gaps create arbitrage opportunities: you can buy BTC on a retail-oriented exchange, then place a sell order in a gap deep in the institutional exchange’s order book to try to turn a profit right away.

People view the quality of exchanges differently

If everyone viewed all cryptocurrency exchanges as equal, there’d probably be far fewer arbitrage opportunities: order books would look a lot more homogeneous, and the price of BTC would be more consistent.

In reality, though, people don’t view exchanges as equal: individuals view exchanges as more or less reliable, with better or worse fee structures, faster or slower transaction times, more or less liquidity, and better or worse security. These sentiments can be influenced by a wide range of factors, including (but not limited to):

personal experience with an exchange (“This exchange took forever to fill my support ticket”)

with an exchange (“This exchange took forever to fill my support ticket”) testimony about an exchange (“This exchange’s subreddit is full of people complaining about it freezing their assets”)

about an exchange (“This exchange’s subreddit is full of people complaining about it freezing their assets”) public issues with an exchange (“This exchange was just hacked last week”)

These perceptions can make one exchange’s order book vastly different from another’s — for instance, an exchange might have a very sparse order book following a hack. If you’re willing to trade across these exchanges and pay attention to popular sentiment without getting too caught up in it, you might find arbitrage opportunities to be exploited.

Market demand varies by country

Cryptocurrencies range in popularity all over the world, and the fairly insular nature of many countries’ exchanges means that supply and demand of BTC can be fairly constrained by national borders.

If Korea is especially bullish on BTC while the US has lukewarm sentiment, for example, you might easily see a higher price point for Bitcoin on Korean exchanges than you do on US exchanges. That could be an arbitrage opportunity, assuming that one could buy BTC in the US and sell it in Korea quickly with minimal fees — but that can be a lot harder than you might imagine.

Foreign currency rates can influence prices

When you’re considering global Bitcoin markets, national demand isn’t the only factor that can lead to arbitrage: currency exchange rates can also skew BTC’s price across exchanges.

Imagine a situation in which the USD gains against the KRW, while the price of BTC remains fairly stable on US and Korean exchanges. Again, assuming that you’re able to trade across US and Korean exchanges quickly and with minimal fees, this could be an opportunity to convert USD into KRW, buy BTC on a Korean exchange, and sell BTC on a US exchange.

Exchanges have different deposit and withdrawal times

If you could instantaneously move your fiat and crypto holdings to and from all exchanges, there would be far fewer arbitrage opportunities: the easy and immediate flow of cash would correct price discrepancies that arise between exchanges.

As it stands, though, exchanges vary in how long it takes to move fiat and crypto in and out. For example:

Some exchanges let you send and exchange fiat in a matter of minutes, whereas others take days.

Exchanges vary in their policies regarding when and how they process BTC withdrawals.

These market inefficiencies mean that it can take longer for exchanges with slower withdrawal and deposit times to “catch up” to market sentiment than it does for exchanges with faster withdrawal and deposit times, creating discrepancies in pricing. Of course, longer withdrawal times can also make it hard to capitalize on these arbitrage opportunities: unless you’re already keeping fiat on these exchanges, discrepancies due to mere withdrawal time wouldn’t be actionable since you would be at the mercy of that very withdrawal time as you were moving your funds into position to capture the arbitrage!

Where to find Bitcoin arbitrage opportunities

Now that you’ve learned why arbitrage happens, it’s time for a class field trip: let’s take a look at how you can find Bitcoin arbitrage opportunities in the wild.

Watch multiple exchanges

If you’re looking for price differences in BTC between different exchanges, it’s only natural that you need to be paying attention to multiple exchanges at once. If you’re using SFOX, you can do this by in a single place using our order book, which aggregates the order books of the many different exchanges we allow you to trade on.

Beyond just watching the order books, consider following recent news about exchanges, both internally (e.g., on their company blogs) and externally (e.g., on public forums). We’ve seen that factors like an exchange’s clientelle and public perception of an exchange can generate arbitrage opportunities, and those opportunities are easiest to act on when you see them right away — for instance, through a blog post announcing that an exchange intends to add institutional trading support, or through breaking news about a large hack on an exchange.

Watch multiple countries

Similarly to watching multiple exchanges, you may want to consider separately tracking the markets in different countries since so much arbitrage opportunity arises between different nations. Think strategically about when to check in on other countries — for example, price differences might be especially stark when trading has already started in Korea on Monday morning while it’s still Sunday in the U.S. (Even though you can technically trade Bitcoin on weekends, trading often slows down dramatically on weekends.)

Be sure to also keep up-to-date on the functionality of foreign exchanges if you’re trying to actively exploit foreign arbitrage. Price discrepancies between US and Korean markets can look tantalizing, but some Korean exchanges are also notorious for freezing user accounts — so you could end up opening and funding a Korean account only to lose access to your funds.

Look deep in order books

While you can and will find arbitrage opportunities at the top of order books, you can find even more if you look deeper in exchange’s order books. That’s where you can find opportunities like gaps in between large, open orders placed by institutional investors, or sell walls that are pushing down the price on a single exchange.

If you’re trading on SFOX, you can use our proprietary algorithms to exploit the depth of exchange order books and get the largest possible arbitrage spread. For instance, you could set a limit order to buy Bitcoin using the Hare algorithm or the Tortoise algorithm, which work to find the best price at which to execute your order across multiple exchanges. Then, once that order executes at your desired price, you can use the Polar Bear algorithm to turn around and sell the Bitcoin you just purchased as a hidden order on the top of the best available order book, quickly closing your position at a profit.

Get literate in Bitcoin arbitrage

Arbitrage is out there in the crypto world, and just understanding why it’s there can be enlightening. Even if you don’t try to turn a profit through arbitrage opportunities, a firm grasp of its causes can illuminate the key inefficiencies facing the crypto market today.

But if you do want to profit off of Bitcoin arbitrage, knowing where to find it is only half the battle: you also need to know when and how you can act on arbitrage opportunities, and when it’s better to stay away. If you want to take that next step, check out our article on the best strategies for capturing Bitcoin arbitrage.

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