Buy Low Sell High: The Science Behind Crypto-Arbitrage
Tags: Blockchain Development, Startup Ideas, Arbitrage, Bitcoin, Blockchain Technology

The following is a write-up of the speech that I did for bitfwd on Friday 20th at UNSW on arbitrage. It has been edited for conciseness and formatting. The corresponding slides can be found here.

It is aimed at those with relatively little exposure to finance and cryptocurrency and want to get started with trading. I talk generally about one type of trading strategy — arbitrage — and how you can get started here. Apologies if I oversimplify some concepts — I aim for clarity and a stepping stone, rather than technical depth.

Feel free to email me at stefan@virgilcap.com if you have any questions. Thanks!

What is Arbitrage?

Arbitrage is when you buy and sell an asset at pretty much the same time to make a profit from the price difference. Essentially, buy low, sell high, but simultaneously.

Let’s take Taobao and Alibaba, for example: I see an air filter, and it’s listed on Taobao for 700 yuan. Now I go on Alibaba and see the same brand of air filter is being sold for an average of 1000 yuan. What I can do is this: I buy the air filter on Taobao for 700 yuan, and then instantly sell the air filter on Alibaba for 1000 yuan. I now have 1000 yuan, which is 300 more than I started with. I’ve made 300 yuan in an essentially riskless transaction.

Another example, using bitcoin: in Australia, the price of bitcoin is 900 AUD. In the US, the price of bitcoin is 1000 USD. Let’s say 1 USD is equal to 1 AUD. So, I buy bitcoin is Australia for 900 AUD, sell it in the US for 1000 USD, and then exchange my USD back to AUD. I now have 1000 AUD, which is 100 AUD more than I started with. Obviously this is a simplified example not including transaction fees and transfer delays but we will ignore them for now for the sake of explanation.

Why Does It Happen?

In the real world, markets are inefficient. Assume that the price of an asset reflects all the known information behind that asset. As we know, information doesn’t transfer from one location to the other instantly.

Take the example of China and Australia. Let’s say that in Australia, the government releases news saying that they’ve banned bitcoin completely. As a result, everyone starts panicking and selling. The price of bitcoin crashes. Now, most people in Australia are awake at this time — but in China, it’s 3am and everyone is asleep. There is no one panicking, or even thinking about bitcoin. The bitcoin price has not moved one bit.

What does this mean? It means that while everyone else in Australia is panicking and going crazy about their bitcoins, you can smile to yourself and celebrate. There is an arbitrage opportunity. You buy bitcoin in Australia and quickly sell in China, for a profit. A few hours later, people in China wake up and read the news about Australian bitcoin. They start panicking as well, since it could mean bad news for Chinese bitcoin. The price drops, until it matches the price in Australia. There is no more arbitrage opportunity. However, you’re already long gone — and you drive away in your new Tesla with your earnings.

Why Arbitrage Cryptocurrencies?

The market is not mature. The first bitcoin exchange opened in 2010; the first stock exchange opened in 1642. Information transfers much slower, and there are less traders and therefore less competition. By arbitraging crypto-currencies, you are a first-mover. There is a high barrier of entry to trade. For example, some exchanges only allow deposits and withdrawals if you have banks accounts in their country. If you have these connections, this is a huge advantage. Cryptocurrencies are really, really volatile. If you ask the average person on the street, this is a bad thing. As an arbitrage trader, the more volatile an asset is, the bigger the price differences, and therefore the more profit you can make. Arbitrage turns crypto-currency trading, a traditionally risky investment, into a low-risk venture that generates consistent profit.

Examples of Spreads

So, what are some of the spreads I’ve seen? There was a 2.92% price difference between the exchange Kraken and the exchange theRockTrading company. In particular, you could buy 853 US dollars worth of bitcoin and sell it in Canadian dollars for a 25 dollar profit. Obviously, this isn’t much — but consider that this is just one trade, and you might be making hundreds or even thousands of these trades a day. The profits add up.

The largest spread I’ve seen was between the US and Korea, which was something ridiculous like a 40% spread. That’s one trade. Meaning if I put in $100 000 dollars, I make $40 000 instantly.

Types of Arbitrage

Obviously, it can’t be this easy. Traders have come up with more and more sophisticated strategies to beat the competition. Some examples are:

Simple arbitrage : this is buying and selling the same asset simultaneously. Like our taobao-alibaba example. Triangular arbitrage : this is taking advantage of a price difference between three different currencies. Buy bitcoin in China, sell the bitcoin in the US, and then exchange the US dollar back into yuan for a profit. Convergence arbitrage is where things get interesting. Take the following example: the price of bitcoin in BTCC is 5500 yuan, and the price of bitcoin in Huobi is 5000 yuan. The price in huobi is undervalued and the price in BTCC is overvalued. So, let’s buy the bitcoin in Huobi and short sell the bitcoin in BTCC. At some point in the future, the prices will become more equal, meeting somewhere in the middle — your profit is equal to the amount of convergence. Future Index Arbitrage : Some exchanges, such as bitmex, allow you to buy bitcoin on a futures contract. This is a more sophisticated arbitrage strategy which I won’t go into depth here. It’s related to examining the interest rate on futures contracts and taking advantage of any mispricings.

A Deeper Look: Triangular Arbitrage

Benefits of triangular arb: it’s very easy to get started. Triangular arbitrage is also one of the least risky arbitrage strategies — there’s no need for you to perform price predictions or wait for a price to converge.

However, because it’s so simple there are some consequences. You’re definitely not going to be making as much money as other strategies. Consider the withdrawal fees of bitfinex — that’s a minimum $20 withdrawal. If you exchange $2 000 dollars, that implies you’ll need to be making more than 1% per trade to be profitable. And that’s not even taking into account other associated fees.

This isn’t the only problem. You’ll need a way to exchange your money back. Let’s say you find an arbitrage opportunity to buy in the US and sell in China. You’re now stuck with Chinese yuan which you need to exchange back to US dollar. This is obviously difficult, due to capital control or the high fees if you go through the bank. Some money transfer services you might want to check out are Transferwise or OFX.

Arbitrage Risks (General)

Below are some of the major risks related to arbitrage strategies.

Competition risk. One of the key reasons why arbitraging crypto-currencies is so, so profitable is because there’s not much competition. As more and more people see the opportunities in arbitrage trading this is going to decrease. Heck, even by writing this up I’m decreasing my own profits since some of you might go back home and try it out. Slippage risk. What do we mean by slippage? This is the difference between the expected price and the price the trade is actually executed at. This can be due to a number of reasons. These include things such as internet delays — such as through the great wall, long block confirmation times or even sending incorrect data. As a result, you could lose money from making an incorrect trade. Volatility risk. As arbitrage traders, we want the price to go crazy! If bitcoin becomes stable, then our profit margins decrease. Concentration risk. Let’s say we find a bunch of our opportunities coming from a single source. Then we end up concentrating most of our assets in a single currency, or a single exchange. If you guys have been following the news, this is really really bad. Just look at the DAO hack, or the BitFinex hack. Always diversify — this is one of the number one rules of investing. Liquidity risk. It’s important that you can actually execute on the opportunity — if the market isn’t liquid, there’s no way you can actually make the trade and therefore make a profit.

How to Manage Risks: “H-O-D-L”

So how do we actually manage these risks. In the bitcoin community, we have a meme — always remember to HODL. What does this mean?

The ‘H’ stands for Hedge.

There is an opportunity between China and Australia. You buy bitcoin in China, and you want to sell it in the Australia. So you transfer the bitcoin to the Australia exchange. That takes a while — maybe something like an hour to transfer. In that hour, the bitcoin price crashes.

We really want to avoid this, so we hedge against bitcoin, meaning that while we are waiting for our bitcoin to transfer, we also short the bitcoin. Then, if the bitcoin price crashes we lose money from our bitcoin, but we make money from our short position, so it balances out.

This is one example of a hedging strategy. I’m not going to go into hedging here, but the different hedging strategies that traders use actually determine who makes the most money. I would heavily recommend reading up more on hedging strategies before you start arbitraging large volumes. The ‘O’ stands for Optimising your Algorithm.

You want to avoid delays in your trading as much as possible. When you press buy, or sell, you want that to be instant and not slow because of your clumsy fingers or network speed.

Why does everyone want to move to New York? If your answer is “Trump Tower”, you can leave right now. The closer you are to the NASDAQ, the faster your trade is executed. Similarly, by trading on servers closer to the exchanges, or using a trading program to help you trade allow you to avoid slippage risk. The ‘D’ stands for Diversify.

One of the principles of investing is to diversify! This is the same for crypto-currencies. Don’t only invest in one exchange, or one crypto-currency — invest in many! Remember decentralization? This is essentially the investment version. And lastly, the ‘L’ stands for Limit Exposure.

Never arbitrage more than you can afford to lose. Sometimes things go wrong, and sometimes things get hacked. Have a hard limit on the amount you can lose in a single trade. Wear a safety hat.

Conclusion

Arbitrage over the cryptocurrency markets is a very, very profitable way to trade, if you know what you’re doing. Remember, these markets are still relatively young. Get in early, before the opportunities dry up.