What is Arbitrage?

Put simply, arbitrage is buying something at a low price and selling more or less immediately at a higher price through a different market. There are many kinds of arbitrage, but all of them boil more or less to the same goal: Capitalizing on a price difference for economic gain.

Arbitrage is everywhere in our global economy and lots of commercial transactions depend upon it and utilize it. Goods are produced at a reduced cost in one place and are sold at a higher cost someplace else. The important thing is that the differences in price allows us to recoup the costs of the transaction; i.e. packaging, transportation, management, etc. For our discussion we will be referring to the arbitrage between cryptocurrencies between exchanges and other markets.

Why does it happen?

The reasons for arbitrage are many and opportunities are created every day. Globally, it can be said that these profit windows open due to market inefficiencies and perhaps that’s the best way to put it since the work of many arbitrageurs decreases the profitability of arbitraging, benefiting the market as a whole.

Remember that Arbitrage depends on opportunities and these are not a plentiful resource; it is safe to say that arbitrageurs compete for these opportunities to capitalize on them when possible.

Is it hard?

Arbitrage requires both skill and strategic thought. While “simple” arbitrage situations, like buying goods at a farm to sell them at a market may not be the most shining examples, they still require some skill to manage them profitably. Also – remember that an arbitrageur’s worst enemy is another arbitrageur.

This is a game that begins with observation and measurement of the market as the arbitrageur must, at all times, be observant of the price difference in the goods he intends to acquire and sell. The markets move and what was an opportunity before can become quite the opposite in the future; an arbitrageur must hedge the risks he or she takes while doing their business.

Arbitrage in the Bitcoin Economy

Certainly there’s room for arbitrage with Bitcoin, but hold your enthusiasm; the golden age of bitcoin arbitrage has ended long ago. In 2014, there are no 30 percent ROI opportunities like in the MtGox days. The essence of current arbitrage remains the same, but the opportunities however are different.

A quick scan of currency arbitrage in the Cryptsy and Poloniex exchanges, as of September 17 2014 at 02:03 GMT yields three potential opportunities. Let’s analyze them.

Opportunity 1: Buy a Hunter Coin (HUC) at Cryptsy and sell it for BTC at Poloniex. Profit: 0.00000065 BTC. Margin: 3.96%.

Yes, that’s it – 65 satoshis. That’s 0.0003010475 of a dollar. At this rate you would need 3321 opportunities like this to earn a single dollar.

Opportunity 2: Buy a ProtoShare (PTS) on Poloniex and sell it for BTC at Cryptsy. Profit: 0.00000001 BTC

In this scenario you would need 215 thousand “opportunities” to make a single dollar.

Opportunity 3: Buy an Execoin (EXE) on Poloniex and sell it on Cryptsy. Profit: 0.02293949 BTC. Margin: 11.32%.

This is a fine opportunity indeed; at current exchange rates this is 10.64 USD of money earned in a supposedly risk-free transaction.

However, in the strict academic sense, there’s no arbitrage here. Why? Well, for one, there’s risk. You might not have the coins needed to trade in Poloniex and while you send them over the opportunity might disappear. Every cryptocoin movement between wallets takes time and good opportunities won’t last long. This is the first risk of cryptocurrency arbitrage.

Good arbitrageurs know this and use faster coins to move funds from exchange to exchange. The risk might be less, but it’s a risk nonetheless; while the world of Wall Street’s arbitrage happens in the miliseconds, in the world of cryptocurrencies it happens over minutes of waiting for transaction verification.

Now stop and think about how poor this is. Cryptsy is one of the exchanges with the most trading combinations – otherwise known as pairs – available, it has 298; placing it fifth overall. In addition it handles a very large transaction volume of 1117 BTC daily. This makes it one of the most attractive places to be conducting crypto-arbitrage, as there are hundreds of users trading the numerous alt-coins it supports. Still, there is over half a million dollars in trades going on, but only one true opportunity available – measuring in at just $10

Almost two hours later, at 05:45, the opportunity is still intact. What happened? Why not just go and take it? Now we come to the second risk of bitcoin arbitrage: Exchange withdrawal issues.

This is another layer of danger which inexperienced users usually overlook when thinking about arbitrage. Simply put, the exchanges withhold the right – at least Cryptsy does – of doing whatever they want with their withdrawal services. Let’s travel back in time to March 18 2014, where a young curious would-be arbitrageur scanned an opportunity and was willing to try it.

The scenario: Buy InfiniteCoin at Cryptsy, then sell it.

The wannabe did as the program said, and sent his precious bitcoin to the exchange; where he bought the InfiniteCoin he needed, with every fee already taken care of in his calculations. He wrote a destination address, then he clicked on “Withdraw”.

IFC had a block time of 30 seconds – that meant the transaction is supposed to take that amount of time to be confirmed. The amateur arbitrageur waited 30 seconds, and he began thinking that it must be some administrative issue.

60 seconds passed, and he kept thinking the same; two hours passed, and he emailed support.

“Oh, hello Cryptsy? InfiniteCoin withdrawals are taking infinite time. ”

Three hours later they replied saying the withdrawal was at last being processed.

By then though the arbitrage opportunity was lost. However, the story doesn’t end here. Twelve days later, and after several support tickets, the coins were at last transferred. Not only did the opportunity of profit pass, but the coins were more or less worthless by the time they were traded.

Experienced arbitrageurs already know this, in these cases the arbitrage opportunity is inexistent. How do they know? Well, to shed some light on it, sometimes the price is low not because the sellers are mis-pricing it, but because the exchange is broken, and they want their money out.

So how do you do bitcoin arbitrage?

There are many ways to do arbitrage with bitcoin, and other crypto-currencies, and they depend on several questions:

Will I have to move my currency between exchanges or are they already there?
Will I trade a single pair or several?
Which currency will I end up with? Dollars? Bitcoins? Something else?

Let’s take a look at the first question. While it is easy to imagine buying at a discount on one place and selling at a premium on another, it is not as intuitive to think about already having your funds there. This is our first arbitraging method.

Method 1: Waiting with coins

This method requires you to have the same amount of the coin you’re buying in the market you’re selling, and performing the trade as simultaneously as possible; back in the example above, it would’ve meant having enough Execoin ready to sell, while having enough Bitcoins to buy it too. Since it is difficult to reliably predict which currencies will have arbitrage opportunities in the often volatile markets, you would need to study the currencies for trends of potential arbitrage.

As it is, this method suffers no transaction risk whatsoever; your coins operate in the exchanges’ systems and are as instant as the exchange allows them to. The biggest drawback this method has is that the volatility risk might eliminate your gains from arbitrage. Requiring 2x the money involved in the transaction is not as big a disadvantage as it may seem, since current arbitrage opportunities are small.

Pros:

No transaction risk.
No transaction fees.

Cons:

The Volatility risk.
Requires much more money on hands.
Idle coins waiting for opportunity earn no return for you.

If you are keen on taking transaction risks, you might as well perform the second arbitraging method.

Method 2: Moving coins

This is what everybody thinks when they first learn about crypto currency arbitrage. You buy cheaply on Exchange A and then you sell it at a higher price on Exchange B. There’s not much more than that, and that is why the barrier of entry is so low for this method; which means more arbitrageurs, and less opportunities for everyone.

Transaction risk is the biggest here, as explained above there’s no guarantee that certain exchanges will allow you to make use of your funds as readily as you would like to. Also, this does not mitigate the volatility risk you will incur by holding cryptocurrencies. This may change though in the future with cryptocurrencies as they stabilize.

Pros:

It’s relatively easy to do.
No transaction fees.
No idle coins waiting for opportunity.

Cons:

It’s easy enough for everyone to do.
Transaction risk.
Volatility risk.
Transaction fees.

Method 3: Triple Arbitrage

Sometimes it is not a matter of buying apples at a low price and selling them at a premium elsewhere. Sometimes you buy apples to exchange for oranges and then exchange those oranges for bananas, which you then trade for apples again. Triple arbitrage takes advantage of price discrepancies amongst different trade-able objects. In this case it’s with the many currencies on major exchanges.

It is unlikely (and much riskier) that anyone performs triple arbitrage without automated means, the barrier of entry is also much higher than the two previous methods with a single trading pair.

Pros:

You can combine it with the two previous methods.
Less likely for common arbitrageurs to exploit these methods mean more opportunities.
If an exchange is particularly inefficient you might be able to do everything in one place.

Cons:

Unfeasible without automated means.
Doing this with the “moving coins” method increases transaction risks & fees.
Doing this with the “waiting coins” method requires more capital.
More trading fees.

While you might be able to use more than three pairs to trade, the possibilities of doing so diminish due to trading fees. We should carry on to the next question, which mitigates a risk that every method above has.

Method 4: Staying in stable currency

You might have read the term “going long”, which is trader jargon for staying in a currency or investment no matter the short-term performance. If you believe bitcoin will continue to acquire value in the future, you are thinking in this same mindset – your investment is its own holdings, rather than taking advantage of a market discrepancy.

But in the volatile world of crypto currency arbitrage, you might not necessarily want to go long with Bitcoin depending on your feelings of the market. The volatility for the five year old currency is high and any gains that you acquire from arbitrage are not stable. A mere ten percent gain or loss on the value of Bitcoin could double or destroy your gains from the arbitrage methods listed earlier in this article.

By staying in a stable, government-backed currency such as the US dollar, you can meanwhile get into an exchange, trade for your profit, and get out. Although you’ll be leaving the cryptocurrency market and entering charted, safer waters, there will be much more scrutiny on fees, waiting periods and other financial regulations

Pros:

You can incorporate this philosophy into every method.
Much more stable than playing the market.

Cons:

No opportunity for short selling and gains.
Fees from exchanges to and from fiat currencies

There surely are variations and increasingly complex ways of conducting arbitrage, for instance instead of triple-arbitrage, quadruple and quintuple-arbitrage. These ways exposed here, and their resulting combinations, should be enough to describe what’s accessible to most bitcoin traders worldwide.

Conclusions

These methods listed above are, at a glance, how to approach arbitrage with Bitcoin and other cryptocurrencies on the market. In my opinion, the landscape for arbitraging is not easy – Take it from someone who thought it would be profitable and went through the effort of developing software exactly for arbitrage. I could be proven wrong, but I would need to see data to believe it; just as I needed data to conclude the great risk of arbitrage at this time.