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Direct arbitrage

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Crypto arbitrage trading is a type of trading strategy where investors capitalize on slight price discrepancies of cryptoassets across multiple markets or exchanges. In its simplest form, Crypto Arbitrage focuses on buying a cryptoassets on one exchange and selling it (just about) simultaneously on another where the price is higher. Doing so means making profits through a process that involves little or no risks. 

 

What is arbitrage trading?

Arbitrage has been a mainstay of traditional financial markets long before the emergence of the crypto market. And yet, there seems to be more hype surrounding the potential of arbitrage opportunities in the crypto scene.

This is most likely because the crypto market is renowned for being highly volatile compared to other financial markets. This means crypto asset prices tend to deviate significantly over a certain time period. Because crypto assets are traded globally across hundreds of exchanges 24/7, there are far more opportunities for arbitrage traders to find profitable price discrepancies.

All a trader would need to do is spot a difference in the pricing of a cryptoasset across two or more exchanges and execute a series of transactions to take advantage of the difference.

 

Why are crypto exchange prices different?

Centralized exchanges

The first thing you need to be know is the pricing of assets on centralized exchanges depends on the most recent bid-ask matched order on the exchange order book. In other words, the most recent price at which a trader buys or sells a digital asset on an exchange is considered the real-time price of that asset on the exchange.

 

For instance, if the order to buy bitcoin for $60,000 is the most recently matched order on an exchange, this price becomes the latest price of bitcoin on the platform. The next matched order after this will also determine the next price of the digital asset. Therefore, price discovery on exchanges is a continuous process of stipulating the market price of a digital asset based on its most recent selling price.

Note that the price also tends to vary because investor demand for an asset is slightly different on each exchange.

Decentralized exchanges

Decentralized crypto exchanges, however, use a different method for pricing crypto assets. Known as an “automated market maker” system, this directly relies on crypto arbitrage traders to keep prices in line with those shown across other exchanges.

Here, instead of an order book system where buyers and sellers are matched together to trade crypto assets at a certain price and amount, decentralized exchanges rely on liquidity pools. For every crypto trading pair, a separate pool must be created. For example, if someone wished to trade ether (ETH) for link (LINK) they would need to locate an ETH/LINK liquidity pool on the exchange.

Each pool is funded by voluntary contributors who deposit their own crypto assets to provide liquidity that others trade against in exchange for a proportionate share of the pool’s transaction fees. The main benefit of this system is that traders don’t have to wait for a counterparty (an opposite trader) to buy or sell assets at a certain price. Trading can be executed at any time.

 

Across most popular decentralized exchanges, the prices of both assets in the pool (A and B) are maintained by a mathematical formula. This formula keeps the ratio of assets in the pool balanced.

What this means is, when a trader wishes to buy ether from the ETH/LINK pool, he would have to add LINK tokens to the pool in order to remove ETH tokens from it. When this happens, it causes the ratio of assets to change (more LINK tokens in the pool and less ETH.) In order to restore balance, the protocol automatically lowers the price of LINK and increases the price of ETH. This encourages traders to remove the cheaper LINK and add ETH until the prices realign with the rest of the market.

In circumstances where a trader changes the ratio significantly in a pool (executes a large trade), it can create big differences in the prices of the assets in the pool compared to their market value (the average price reflected across all other exchanges).

Read more: What Is an Automated Market Maker?

Types of crypto arbitrage strategies

There are several ways crypto arbitrageurs can profit off of market inefficiencies. Some of them are:

  • Cross-exchange arbitrage: This is the basic form of arbitrage trading where a trader tries to generate profit by buying crypto on one exchange and selling it on another exchange.
     
     

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