What is arbitrage?

Traders have many tools in their toolbox—some are more familiar to retail traders than others. They may buy and sell stocks, bonds, commodities, fiat currencies, or cryptocurrencies. Some use derivatives like options or futures to apply leverage and increase their ability to profit. They may also use analysis of charts to trade based on patterns. However, a popular strategy used by hedge funds, wealthy investors, and other high-volume traders is arbitrage—a way to take advantage of small differences in prices of assets across markets.

Let’s explore the concept of arbitrage using cryptocurrencies.

Beginning in 2016, Bitcoin was selling for a higher price on Korean exchanges than it was on US exchanges. This was due to a number of reasons, including higher demand for the asset in that region. For most, this was an interesting quirk of the system.

However, arbitrageurs saw opportunity. These traders could buy Bitcoin for $10,000 in the US and then sell it for $11,000 in South Korea. They could make a 10% profit by simply buying Bitcoin in one place and selling it in another. Dubbed the “kimchi premium,” this difference in price reached over 50% in 2018, and plenty of traders took advantage of it. In fact, one was embattled FTX founder Sam Bankman-Fried—which is how he made enough money to jumpstart the empire that later fell in 2022.

The kimchi premium is a unique case in the pure size of its price disparity, but this is how arbitrage works in other markets as well. Yet, even arbitrage of assets with small differences in price can be quite profitable when trading in large volumes.

How does arbitrage work?

If markets were entirely “efficient,” prices would be the same everywhere. In other words, there would be no differences in valuations of assets from one market to another. Arbitrage relies on market inefficiencies to provide profitable opportunities to traders. Importantly, sometimes these traders are not even humans. High-frequency trading (HFT) is a form of arbitrage that often uses computers to trade in very short time frames using algorithms.

Despite its relative strategic simplicity, arbitrage comes in many forms. This is because the price of an asset may vary based on geography, time, type of markets, and what other assets trade in the same markets. Some of the most common strategies are explored below.

Main types of arbitrage: beyond market differences

Spatial arbitrage is the classic example of arbitrage trading. It involves buying an asset in one market and selling it for a higher price in another market. Example: A trader buys a stock on the New York Stock Exchange for $100.00 and immediately sells it on the Tokyo Stock Exchange for $100.10, earning a profit of 10 cents because of the price discrepancy.

Statistical arbitrage, or “stat arb,” is the practice of simultaneously buying and selling assets that are historically—but not currently—correlated. This is a type of arbitrage that is commonly performed using HFT. Example: The shares of two microchip companies which typically track each other break their correlation on a given trading day. An HFT algorithm facilitates a trade in which it shorts (sells) the higher-than-expected stock and longs (buys) the lower-than-expected stock, predicting that the usual correlation will soon normalize. This prediction presumes a tendency called mean reversion, and it is critical for statistical arbitrage.

Triangular arbitrage is a strategy with that relies on using three different assets whose individual trading pairs present an opportunity. It is most traditionally performed with foreign currencies, but it can also be used for cryptocurrencies. Even though there are a few steps, by the end of a triangular arbitrage the trader ends up with more of the first asset than they had at the beginning. Example: The exchange rates for the USD, JPY, and GBP currencies are unbalanced. A trader sells USD to buy JPY, then sells their new JPY for GBP, and subsequently buys USD with the GBP. Because of incremental differences in the exchange rates of USD/JPY, JPY/GBP, and GBP/USD, they generate a small profit.

Merger arbitrage is a unique type of arbitrage in which one company is planned to be bought by another. Because the buyout price is usually higher than the current stock price of a company, arbitrageurs can buy shares of the target company and expect to make a profit if the deal goes through. Example: Shares of a company are trading for $20.00, but a larger competitor offers to buy the company for $28.00 per share. A trader buys stock for $20.00 and holds those shares until the merger is completed, ultimately being paid out the $8.00 difference in profit.

Cryptocurrency arbitrage

Traditional forms of arbitrage are possible with cryptocurrencies, just as they are with foreign currencies, stocks, and other assets.

Differences in the price of BTC or ETH on centralized exchanges present opportunity for arbitrageurs—a form of spatial arbitrage. Similarly, the prices of certain crypto assets tend to (DeFi protocol tokens, layer 1 coins, etc.) correlate with each other, and so when this correlation is broken it may be a chance to perform statistical arbitrage. Automated bots that perform HFT may also perform stat arb using any number of cryptocurrencies.

However, there are some unique types of arbitrage that can be used in cryptocurrency markets. Decentralized finance (DeFi) platforms can be treated like traditional markets, as their quoted prices for asset pairs (e.g. BTC/USDC) vary based on supply, demand, and oracles. Differences in these prices can be leveraged just like those centralized exchanges or stocks on the New York Stock Exchange. However, some argue that yield farming represents another type of arbitrage, as savvy DeFi users know that converting one asset for another might mean they can generate a higher yield from liquidity pools or rewards programs.

Smart contract technology has also made flash loans possible. Flash loans are forms of uncollateralized loans that are processed extremely quickly and within one block of a chain like Ethereum. A trader can use a flash loan to borrow a large amount of crypto and apply it to an arbitrage trade—taking advantage of differences in prices of two decentralized exchanges, for example—before returning the loaned funds and keeping the profit from the arbitrage. This is a highly technical process and requires computer code to accomplish successfully.

Risks of arbitrage

Arbitrage is considered to be a low-risk strategy. Some even refer to it as risk-free profit. However, there are some considerations that can create issues with arbitrage trades.

• Trading costs – Arbitrageurs must be careful to account for the fees associated with trading on their chosen platform(s), which can significantly eat into their profits or even make their trades unprofitable.

• Slippage – Because arbitrage often involves trading in large volumes, it relies heavily on liquidity—the ability for assets to be traded without causing large movements in their prices. When it comes to cryptocurrencies, this is especially important in decentralized exchanges that use liquidity pools. If there are not enough assets in a pool, an arbitrageur’s large trade may unexpectedly shift the price of an asset—a phenomenon called slippage.

Arbitrage essentials

• Arbitrage is a trading strategy that relies on leveraging different markets’ prices of an asset.

• The simplest form of arbitrage is called spatial arbitrage, which involves trading an asset in two (or more) markets that quote disparate prices for that asset. Other types include statistical arbitrage, triangular arbitrage, and merger arbitrage.

• Blockchain technology and cryptocurrencies create the opportunity for unique types of arbitrage using decentralized finance (DeFi)

• Arbitrageurs must consider certain quirks of this strategy before executing their trades, including trading costs/fees and slippage