What is crypto arbitrage trading?

• Crypto arbitrage is a trading strategy that exploits price inefficiencies between markets and trading platforms in a variety of ways.

• While generally considered a low-risk strategy, its efficacy depends on being able to identify and capitalize on price mismatches before they disappear.

• The use of algorithms and other tools such as scanners may improve the overall implementation of this strategy.

Crypto arbitrage is a trading strategy that exploits temporary inefficiencies in crypto asset prices, across different markets and platforms. 

Arbitrage is defined as “...the simultaneous buying and selling of securities, currency, or commodities in different markets…in order to take advantage of differing prices for the same asset.”

Because demand for cryptocurrency often varies significantly across the globe, price discrepancies are relatively common. The simplest example of crypto arbitrage would be buying Bitcoin (BTC) at say, $50,000, then selling it shortly thereafter at a different trading platform for $50,500, realizing a near-instant $500 gain.

It sounds straightforward, but—as you will discover below—it is not without risk.

The Kimchi premium

The kimchi premium refers to price mismatches between South Korean trading platforms and other international equivalents. Kimchi is a South Korean fermented cabbage dish.

Historically, owing to its popularity in this part of the world, Bitcoin has frequently traded at much higher prices in South Korea, creating multiple opportunities for arbitrage. However, because of various restrictions, taking advantage of this premium has been notoriously difficult. 

Founder of the now-defunct FTX trading platform, Sam Bankman Fried, famously did find a way to exploit the kimchi premium for Bitcoin between 2017-2020, on one occasion scalping a 50% price differential between US and South Korean platforms. He managed to pull off the same feat in Japan, though for a smaller gain.

The BAYC flash loan

In 2022, with the help of a flash loan, someone was able to claim $1.1M worth of Apecoin (APE). 

This is a slightly more complex and obscure form of arbitrage (or “attack,” depending on how you interpret it). The trader in question profited from a lightning-fast purchase and resale of 5 BAYC NFTs, in order to redeem the APE airdrop. 

By owning these NFTs at the precise moment of snapshot, the individual was able to claim the tokens before immediately returning the NFTs. The whole process was completed within one transaction block.

For more information, check out our Kraken Learn Center article on, What is a flash loan?

There are several different crypto arbitrage strategies, each with their own characteristics:

Cross-platform arbitrage

Cross-platform arbitrage involves buying and selling assets between two trading platforms, profiting from any price differences. There are three different types of cross-platform arbitrage:

• Standard arbitrage

This basic strategy involves scalping temporary price mismatches between two centralized trading platforms. Such mismatches do not last long, so a trader must be quick enough to take advantage of any inefficiency before the market adjusts. 

Example: After speaking with some other traders, you hear that someone is selling large clips of Litecoin (LTC) at a smaller, unknown centralized trading platform, which is not tracked by any scanners. As a result, the price is frequently offering a 10% discount compared to other platforms. 

Accounting for the increased counterparty risk of sending funds to this platform, you send $10.000 USDT to buy some Litecoin before the seller has unloaded all his assets, and the price corrects. After a brief wait for the funds to confirm, you are able to trade.

However, the seller appears to have finished, and the discount has reduced slightly as other traders were quick to take advantage. You can now only buy Litecoin at a 2.5% discount. You complete the trade, make a successful withdrawal request back to your preferred platform, then convert the Litecoin back to USDT, yielding a 2% return after all fees. 

• Spatial arbitrage

The kimchi premium described above is an example of spatial arbitrage, and results from prices being different in certain regions of the world.

Because some trading platforms only operate in one region, this can drive up demand for assets in these discrete locations. If you are able to safely move capital in and out - taking into account any restrictions or barriers beforehand - then you may be able to benefit from the premiums therein. 

Example: A new trading platform has just opened its doors in a part of the world that, up until recently, had extremely draconian restrictions on trading cryptocurrency. Assets are trading 10%-50% higher than at other larger, more established platforms in other regions.

Anyone can open an account with the platform, but all withdrawals are subject to a long list of conditions. Without taking the time to confirm these restrictions, you send a small amount of Solana (SOL) to be converted into USDT.

The funds land and you convert the Solana into USDT at 40% premium. However, when you try to withdraw the funds, you realize that you will need to prove that you are a citizen of the country in question and that all withdrawals are subject to intense scrutiny.

Seeing this, you realize it’s likely you will never retrieve your funds, and you decide to write it off and move on. 

• Decentralized arbitrage

Prices on decentralized trading platforms (DEX) can sometimes differ significantly from prices offered on centralized platforms. This is likely a function of how DEXs work. Because they are driven by automated market makers and are isolated from the activities of their centralized counterparts, arbitrage opportunities can frequently emerge between the two.

Uniswap is a frequently used example of a DEX. To learn more about Uniswap, take a look at this Kraken Learn Center article. 

Example: After monitoring various DEXs, you notice a thinly-traded crypto asset is trading at a 50% premium compared to several centralized platforms. To execute the arbitrage, you buy this asset from a highly liquid market and transfer it to a Web3 wallet that you control, also supported by the DEX in question. Once the funds arrive in your wallet, you prepare to make the trade.

The pool in question has low liquidity, meaning you will experience significant slippage on the trade.

However, after careful consideration, you decide to proceed with a smaller position. Although you are unable to realize the full 50% premium, you succeed in netting a 20% gain.

The above examples capture the essence of crypto arbitrage, but there are some other, arguably more advanced types that you can explore:

• Triangular arbitrage: This type of arbitrage uses three assets as part of a 3-step “triangle” to exploit price differentials between the three pairs. 

• Derivative/Spot price arbitrage: The spot price of an asset often deviates from that of the corresponding derivative instrument. When this occurs, traders are incentivized to try and capture the perpetual funding rate fee (which helps bring the price back to parity), by entering a delta neutral position on the same asset.

• P2P arbitrage: Some platforms enable you to trade directly with other traders. Because of the way these markets operate, they can sometimes lead to large inefficiencies. By playing both sides of the market - where you set the price - you can ensure that you get value on either side of the trade. 

For example, if Bitcoin is trading at $50.000 and you offer to buy it at $49.500 while simultaneously offering to sell at $50.500, both offers would likely net a gain if taken.

Step 1: Prepare your capital

For anyone interested in arbitraging crypto markets, consider leaving capital on trading platforms that frequently offer the best opportunities, while remaining mindful of counterparty risk. Capital left on any centralized platform may be at risk of loss due to hacks, insolvency, or other issues.

If you are trading on decentralized platforms, ensure your Web3 wallets are funded with the appropriate amount of capital before proceeding so that it’s ready to be deployed when an opportunity arises.

Step 2: Find arbitrage opportunities

Some traders use scanners to track prices across multiple trading platforms. Here is one example you can explore:

• Arbitrage Scanner: Arbitrage Scanner between CEXs and DEXs

Most large, highly liquid trading platforms are unlikely to produce significant arbitrage opportunities. However, the cryptocurrency market is highly diverse, with hundreds of different assets traded on a wide variety of platforms. If you look hard enough, you may discover opportunities that others have missed.

Step 3: Execute the trade

While some arbitrage trades can be executed manually, traders may find it beneficial to automate the process with a trading bot. Some services combine a scanner and execution software in one package:

• Cryptohopper: Arbitrage between exchanges without sending funds from one exchange to another.

Using an API, these bots can interact directly with trading platforms to execute bespoke trades much more quickly. 

Without a scanner or bot, traders are at a significant disadvantage unless they have a unique edge that conventional tools cannot track. Anything you can do to expedite the process of finding and exploiting arbitrages can increase your edge over other traders.

In the past, there have been instances where hackers have exploited third party software, resulting in considerable losses.

The services shared above are not endorsed by Kraken.

Pros

• Aspiring arbitrage traders have many tools at their disposal that can help them to identify and take advantage of arbitrage opportunities, meaning that even the novice trader can start to experiment with this strategy relatively quickly.

• Cryptocurrency assets are traded across a wide array of centralized and decentralized platforms, offering a lot of potential inefficiencies to be exploited.

• Crypto arbitrage can offer a very high strike rate, which may be suitable for traders who cannot endure large swings in their equity curve. Some traders may find this psychologically more palatable, as a higher variance approach can be more stressful.

Cons

• Unless the price mismatches are noteworthy, generating sizable returns can be difficult unless you have a lot of capital to trade.

• Crypto arbitrage is not without risk - there are many challenges faced by traders seeking to take advantage of crypto markets in this way.

• As with any strategy, you will be competing with other traders for a piece of the same pie. The degree to which you are successful will be a function of your own research, experience and expertise.

This type of crypto trading strategy is certainly not risk free. While it may be lower risk than several other strategies—depending on how it is executed—there are several challenges that an arbitrage trader faces.

Common pitfalls of crypto arbitrage

• Local restrictions: As identified in one of the examples above, it may be easy to deposit funds but much more difficult to get the funds out. If you can’t withdraw your funds for any reason, then you have effectively lost that capital. Pay close attention to the KYC requirements attached to any platform before depositing any capital. You may find that other traders have detailed their experience on Reddit or other forums, which may save you from losing your funds. 

• Wallet maintenance: In some cases, there may be an arbitrage, but you are simply not able to take advantage of it. An asset may be trading at a significant premium, but after depositing your funds you may realize that it will not be credited for several hours, which explains why the discrepancy still exists. In this scenario, you may be unable to access or withdraw your capital for some time while the issue is resolved. 

• Limited liquidity: Be very careful trading on DEXs and always check what the projected slippage will be before proceeding. If there is not sufficient liquidity for you to make the trade, the slippage may entirely negate the value of the arbitrage. See our Kraken Learn Center guide, How to stay safe in DeFi.

• Speed of execution: price inefficiencies often evaporate very quickly. Every arbitrage opportunity will attract some competition from other traders seeking to gain from the same trade. Naturally, not every trader can and will profit from every price mismatch. Every trade has some costs attached (such as trading or withdrawal fees) but no guarantee of success. If a trader is simply not quick enough to capture an arbitrage before a market adjusts, this strategy will not be a fruitful endeavor. 

1. If you are manually moving funds to a new and non-whitelisted address, double/triple check everything before confirming the transaction. Many traders in the cryptocurrency space permanently lose funds due to mistakenly sending assets to the wrong address, or being tricked by an attack known as ‘address poisoning’. 

2. Always do the necessary due diligence on any opportunity before proceeding. This could amount to searching online for the most up-to-date information or with other traders. A five minute search may spare you from losing a large chunk of your capital. 

3. Test out the different tooling on offer to see which enables you to execute the trades most efficiently. 

4. Do several trial runs with a very small amount of capital before sizing up. If you are using some software - test it extensively before risking a larger portion of your funds. 

5. Talk with other traders who engage in the same activities to determine where to look for unique opportunities and what tools to use. Traders are not likely to share their own edges with you, but they may be able to share useful resources, or give you some idea of what to look for and where you might find it. 

6. Think outside the box - some of the best arbitrage opportunities likely exist in some of the most obscure, unknown places.

7. Finally, never risk all of your capital on one trade, and always manage your risk so that any losses are acceptable losses, and won’t cripple your ability to participate going forward. Arbitrage trading has its own unique risks (such as counterparty risk), which are not always easy to spot. 

In summary, crypto arbitrage is a tried-and-tested trading strategy often employed by high profile traders that can yield a positive expectation.

While some may consider it to be "low risk," it carries its own unique challenges that traders should be mindful of.

Now that you understand how arbitrage trading works, why not sign up for your free Kraken account and access over 210+ cryptocurrencies.

Start your crypto journey today!