It is not difficult to observe that cryptocurrency prices can trade at different prices across multiple exchanges.
Price discrepancies in LTC/BTC
In this blog post, we will provide a primer on why such price discrepancies exist, and briefly address how one can potentially take advantage of them through arbitrage strategies.
What is arbitrage?
First, let’s start with understanding arbitrage. Arbitrage in markets refers to riskless profit that can be made by trading on price discrepancies. The underlying concept behind arbitrage follows the fundamental trading logic of buying low and selling high.
The two common types of price discrepancies that exist in the cryptocurrency markets are: between exchanges and cross currency (i.e. the price discrepancies that happen between different cryptocurrency pairs traded on the same exchange).
Let’s look at both of these in turn.
Price discrepancies between exchanges
Price discrepancies between exchanges occur because of differences in liquidity present on each exchange. Put simply, the price of a cryptocurrency pair is determined by the demand and supply for that cryptocurrency on that exchange. Let’s take a look at the trading price of BTC/USD across the major exchanges on 20 August 2019:
Note that the largest difference in price, $47.77, occurs between P2PB2B and Bitfinex. We will be using this price difference of $47.77 between P2PB2B and Bitfinex exchanges to illustrate arbitrage opportunities.
To take advantage of this price difference, one might conceivably buy BTC from P2PB2B at $10,792.28 and sell it on Bitfinex at $10,840.05. Doing so will seemingly give you an immediate profit of $47.77.
You might then think: Why not repeat this process until the price difference disappears, and make easy returns? Why isn’t everyone using this strategy?
A deeper answer to that is that there are often hidden costs and risks involved, which need to be factored into your arbitrage strategy. While the approach above may seemingly earn you $47.77 per round in theory, we have yet to consider and account for the transaction fees and the risks involved.
The diagram below details the constraints that we start with:
P2PB2B Trading Fees – 0.2%
P2PB2B BTC Withdrawal Fees – 0.001BTC
Bitfinex Trading Fees – 0.200%
Bitfinex USD Withdrawal Fees – 0.100%
Amount you start with – US$10,000
As per the assumptions above, you have US$10,000 which you wish to use for this trade. With it, you can get $10,000 110,792.28 BTC/USD = 0.92658826BTC on P2PB2B.
However, you have to pay a 0.2% transaction fee so you end up with 0.0.92658826BTC – (0.92658826BTC 0.200%) = 0.92473509BTC.
Now, to transfer your BTC from P2PB2B to Bitfinex, you will incur a withdrawal fee of 0.001BTC on P2PB2B so you will have 0.92473509BTC – 0.001BTC = 0.92373509BTC on Bitfinex.
Trading this BTC to USD on Bitfinex, you will get (0.92373509BTC $10,840.05) (100% – 0.200%) = $9,993.31 after adjusting for the 0.200% trading fees.
Finally, to close the entire strategy, withdrawing this amount from Bitfinex will leave you with $9,993.31 ($9,993.31 0.100%) = US$9,983.31. You have made a loss of US$9,983.31 – US$10,000 = -US$16.69.
Moreover, this logic assumes that your transactions are processed immediately and the price differential remains constant which are unlikely to be the case in real life as transaction verification and transferring to another exchange takes time. This delay in transaction times may mean that the price differences across the exchanges may be eroded and you may end up making greater losses as prices do not stay constant over time. Thus, such an arbitrage strategy is difficult to implement in real life and it is the reason why price discrepancies between exchanges persist.
Yet, this does not mean that inter-exchange arbitrage strategies are entirely unprofitable. There is an alternative way to potentially profit from these price differences while reducing the costs and risks involved. You can hold some amount of BTC and USD on both exchanges simultaneously. Let’s look at how this strategy will work:
Suppose you allocate your initial investment of US$10,000 equally between P2PB2B and Bitfinex with US$5,000 and US$5,000 in each. Of this amount you hold half or US$2,500 as fiat and remaining half as BTC on both exchanges. When you notice a significant price difference between these two exchanges as in our scenario above, you can buy more BTC using USD on P2PB2B where BTC/USD is cheaper and sell BTC for USD on Bitfinex where USD is more expensive.
($2,500 110,792.28) (100% – 0.2%) = 0.23118377BTC
(0.23118377BTC $10,840.05) (100% – 0.2%) = $2,501.03
This will translate to earning $2,501.03 – $2,500 = $1.03 on your portfolio even after all the necessary fees. This method also eliminates the risk that time delays will erode any price difference.
However, do note that even with a significant principal investment of $2,500, the above approach only provides a US$1.03 or 0.0412% return. Therefore, it may be said that such inter-exchange arbitrage strategies may not be worthwhile for some to pursue. In the next section, we will explore a further type of price discrepancy.
Cross currency: price discrepancies within an exchange
The second type of price discrepancies that exist in the crypto market is between cross rates. Difference in cross rates refers to the price discrepancies that happen between different cryptocurrency pairs traded on the same exchange. The arbitrage opportunity here is similar to a triangular arbitrage that happens in trading forex. We will be looking at the USD-BTC-ETH triangular arbitrage opportunity on 18 July 2019 on Bitfinex.
Consider the illustration below:
As in the diagram, theoretically, following the arrows to exchange any amount of USD to BTC (step 1) then to ETH (step 2) and back to USD again (step 3) should return the exact amount of USD you started with. However, the price of pairs at each step are different and constantly changing hence the above triangle may not hold true in reality. This creates another type of arbitrage opportunity known as triangular arbitrage.
Suppose you have US$10,000 on Bitfinex (after deposit fees). With this amount you can buy US$10,000 (19870)BTC/USD = 1.013171226BTC.
After 0.180% transaction fees (refer to https://www.bitfinex.com/fees for Bitfinex transaction fees), you get 1.013171226BTC (100% – 0.180%) = 1.011347518BTC.
Converting this BTC to ETH, you will receive 1.011347518BTC 0.02086100ETH/BTC = 48.48029901ETH. After accounting for 0.200% transaction fees, 48.48029901ETH (100% – 0.200%) = 48.38333842ETH will remain.
To take profit, we now trade ETH for USD. This will give us (48.38333842ETH 218.230000000ETH/USD) (100% – 0.180%) = 10,539.70USD after transaction fees.
With this arbitrage strategy, the potential profit is $10,539.70 – $10,000 = $539.70.
However, as with any arbitrage strategies, time is of essence. Do note that prices are constantly changing and the arbitrage opportunity (if any) might be eroded before you can execute your strategy fully.
Arbitrage opportunities can exist due to inherent market inefficiencies in the crypto markets. However, price discrepancies between exchanges or in cross rates within an exchange are often temporary in nature, and coupled with the possible transaction fees involved, it would be prudent to first do all necessary research, checks and calculations before embarking on any arbitrage strategy.
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Disclaimer: This blog post does not constitute advice (legal, financial or otherwise) on any matter discussed and, accordingly, should not be relied upon as such. Hydra X does not make any representation or warranty as to the accuracy, completeness or correctness of the information or opinions set out in this blog post. Opinions expressed are subject to change without notice. This blog post does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee, and Hydra X accepts no liability whatsoever for any direct, indirect and/or consequential loss (including any claims for loss of profit) arising from any use of and/or reliance upon this blog post.