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Academy Beginners Tutorial Article
Bitcoin OKEx Trading

Bitcoin and cryptocurrency arbitrage explained

2021.05.22 Hunain Naseer

An introduction to crypto arbitrage as a trading strategy that capitalizes on price differences between markets

As the cryptocurrency market grows and innovates, it presents ample opportunities for profit, ranging from volatile price action to constantly changing correlations and adoption drives across niches like DeFi and NFTs.

That being said, trading crypto assets remains the core activity for market participants, all of whom have the same goal: buy low, sell high. However, trading strategies need to be changed according to market conditions. When you are day trading or swing trading crypto, for example, you need the market to move in a specific direction so you can profit from the volatility. 

What happens when volatility is low and the market is largely directionless? That is when traders can make use of neutral or directionless strategies, one of the most popular of which is arbitrage.

What is arbitrage and how does it work?

Arbitrage is a strategy that aims to profit from price differences across various markets. To understand how it works, one needs to understand how markets function. The price quote for any asset, such as BTC, is shown in a pair, such as the BTC/USDT pair on OKEx — people trading this pair are directly buying and selling BTC for USDT, a stablecoin worth approximately $1. 

The pair's price quote, or the price of BTC in USDT, changes in real-time based on market bids (buy offers) and asks (sell offers), and represents the market's supply and demand dynamic at any given moment. This market activity is reflected in the screenshot below, taken from the BTC/USDT spot market on OKEx.

BTC/USDT trading pair on OKEx. Source: OKEx.com

This is an organic pricing mechanism, where buyers and sellers are essentially in a state of constant negotiation and agreement, as opposed to the hard, flat pricing we typically see in the retail sector. As a result, the price of any asset is not guaranteed to be uniform across all markets.

A simpler example of this is how the same exact products, especially luxury and consumer electronics — like gaming consoles, for instance — are often priced differently in different regions of the world. In the same manner, the BTC/USDT quote, or a quote for any other asset, is unlikely to be the same on all exchanges at all times. This pricing difference, or inefficiency, presents an opportunity for traders to buy an asset from an exchange at a lower price and sell it on another exchange at a higher price.

In reality, however, crypto arbitrage opportunities are not limited to exchanges or specific markets like spot and futures. In fact, arbitrage is one of the main activities that ensure some level of price uniformity across markets around the world. Were it not for arbitrageurs, there would be significant price discrepancies for any asset — from market to market, exchange to exchange and region to region.

Since arbitrage does not require the market to be either bullish or bearish, it is considered a neutral, or directionless, trading strategy.

Examples of Bitcoin and crypto arbitrage opportunities

While there are numerous arbitrage opportunities available for BTC and other crypto assets, we will discuss the most popular ones in this article, starting with arbitrage via futures contracts.

Futures premium arbitrage

Given the massive growth seen in the crypto derivatives market, BTC futures now represent a significant share of the trading volume on OKEx and other exchanges. The popularity of these instruments, coupled with the recent bullish market sentiment, meant that most futures contracts have been trading at a premium over the spot price — that is, the price of BTC when you trade it directly.

The BTC basis shows the BTC quarterly futures premium over spot price. Source: OKEx

This means when BTC was trading around 50,000 USDT on the spot market in April, the quarterly futures contract for BTC was trading higher than 50,000 USDT. This variance meant arbitrageurs could buy "cheaper" BTC from the spot market and then short (i.e., sell) the more expensive futures contract (which sells at a price higher than spot BTC) to capture the price difference.

"Kimchi" premium arbitrage

Another example of Bitcoin arbitrage opportunities is the so-called "kimchi" premium seen in South Korean markets. Due to strict control over cross-border capital flows, it is challenging for South Koreans to purchase BTC from international exchanges. Because demand is more restricted domestically, the price of BTC sold on local exchanges in South Korea is often higher than their global counterparts.

This price difference presents an arbitrage opportunity for traders with access to both international and South Korean markets. They can buy cheaper BTC from outside the region and sell it at a higher price locally. 

Stablecoin premium arbitrage

The majority of cryptocurrency trading volume is fueled by stablecoins, meaning that many global exchanges, such as OKEx, use a dollar-pegged stablecoin (most frequently, USDT) as the main trading pair for all crypto assets — rather than using a fiat currency like USD. Though fiat-pegged stablecoins like USDT are designed to always keep their price stable (1 USDT = $1), there are times when stablecoins trade slightly above or below their projected stable price, presenting arbitrage opportunities.

For example, during the March 2020 crash, demand for stablecoins was high — which resulted in USDT briefly trading slightly higher than $1.

Similarly, in regions where it's difficult or illegal to buy cryptocurrency with fiat currency, we often witness stablecoins selling for a premium. Arbitrageurs with easy access to fiat–crypto exchanges can purchase stablecoins with fiat and sell them for a profit in more restricted regions or markets, generally using peer-to-peer or over-the-counter marketplaces during times of high demand.

The USDT premium surged on May 19, 2021, as BTC and the crypto market fell sharply. Source: OKEx

Grayscale premium arbitrage

The Grayscale Bitcoin Trust is an OTC investment fund registered with the United States Securities and Exchange Commission. The fund holds BTC directly and issues what it calls "GBTC shares" that track its BTC holdings in order to facilitate institutional exposure to the leading digital currency.

Given the growing demand for crypto assets from institutional investors — and a combination of the perceived and real regulatory and custodial risks of buying and storing BTC directly — GBTC had, for years, traded at a premium (until recently). This premium, which is currently in the negative due to a variety of reasons outside the scope of this article, meant that contributors (i.e., entities adding assets to the fund's holdings in return for GBTC shares) could purchase spot BTC, exchange it for GBTC shares, and then sell those shares on the secondary market for a profit.

The GBTC premium has historically been positive but turned negative this year. Source: bybt

However, Grayscale's redemption restrictions (namely that GBTC shareholders cannot redeem shares for actual BTC) mean that the current negative premium does not offer as attractive an arbitrage opportunity as when the premium is positive.

Risks in crypto arbitrage

While arbitrage is a relatively safe trading strategy given that it does not rely on market momentum or direction, it has its own set of unique risks. 

Firstly, arbitrage trades have very brief windows of time for execution due to intense competition and the increasing use of automation and algorithms. This means there is a very high chance that each arbitrage opportunity is being competed for by a number of traders, not all of whom will succeed.

Secondly, arbitrage requires the movement of funds and assets across exchanges. This entails that traders need to pay fees and take on liquidity risks — not knowing whether they will be able to sell all their holdings in time, and without significant deviation from the target price.

Thirdly, some arbitrage opportunities arise due to challenges in capital movement or intrinsic risks, like regional instability and so on. Arbitrage traders should be mindful of these factors when identifying price differences across regional and global markets.

The future of arbitrage 

Due to its nature and the technological advancements in trading, arbitrage trading is a great fit for automated setups. Today, most arbitrage traders use bots and scripts to remain competitive in the market and to capitalize on any opportunities as soon as they arise.

Moreover, with the advent of decentralized finance protocols, we're witnessing a faster shift toward automated services, such as decentralized exchanges and lending protocols. Given the pricing dynamics involved in these complicated protocols, arbitrage has become one of the most prominent strategies to capture gains. For example, decentralized exchanges like Uniswap largely rely on arbitrageurs to maintain price parity with other exchanges and platforms.

While there is no doubt that arbitrage will become increasingly competitive with time, the fact that it is one of the cornerstones of all efficient markets means that there will be gains on offer for traders prepared to exploit new opportunities.

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Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

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