Arbitrage Trading in the Cryptocurrency Market

Cryptocurrency is a digital or virtual asset that uses cryptography to secure its transactions. Cryptocurrencies are decentralized, meaning they are not subject to government or financial institution control. Bitcoin, the first and most well-known cryptocurrency, was created in 2009. Cryptocurrencies are often traded on decentralized exchanges and can also be used to purchase goods and services.

There are four main strategies for trading cryptocurrencies:

  • Mean reversion
  • Momentum trading
  • Trend following
  • Arbitrage trading

The first 3 trading strategies are based mostly on time-series and cross-section price prediction. Relatively little attention is paid to the last one, i.e. arbitrage trading strategy.

Arbitrage trading takes advantage of price differences in different markets.  Here’s an overly simplistic example: if Bitcoin is selling for $11,000 on one exchange and $11,100 on another, a trader can buy Bitcoin on the first exchange and immediately sell it on the second exchange for a $100 profit. In order to be successful, an arbitrage trader must have access to capital, be able to move capital quickly, and have a low overhead.

Reference [1] examined some common and unique arbitrage trading opportunities in cryptocurrency exchanges that are not discussed often in the literature. They are,

  • Exchange futures contract funding rate arbitrage
  • Exchange futures contract intertemporal arbitrage
  • Triangular arbitrage
  • Pairs trading
  • Order book spread prediction arbitrage

The author found that,

Many pieces of research are done on cryptocurrency time-series and cross-section price prediction. This paper examines some common and unique arbitrage opportunities in cryptocurrency exchanges that are not widely mentioned in academic journals. It is shown that these semi-risk free arbitrage can provide a great return with minimal risk, despite constraints of actual market conditions and exchanges conditions that make them perform worse in live trading than backtesting. By mixing these strategies into portfolios, we could achieve a higher Sharpe ratio than simply holding cryptos.

In short, arbitrage trading is possible and profitable in the crypto market.

Our observations are as follows,

  • These trading strategies are not riskless. Drawdown can happen
  • Diversification helps smooth out the equity curves greatly

Last and not least, since the crypto market is still in its early days, we don’t know whether other risks such as liquidity, counterparty credit risk, etc. were factored in the price discrepancies.

Let us know what you think in the comments below.

References

[1] Tianyu Zhou, Semi Risk-free Arbitrages with Cryptocurrency, 2022 5th International Conference on Financial Management, Education and Social Science (FMESS 2022)

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