Cryptocurrency funds mainly carry out two types of operations, risk-free arbitrage, and trend arbitrage. Whereas it may be hard for ordinary traders to replicate such strategies - they tend to be designed by talented and experienced operators and implemented by computer programs - the theory underpinning them is worth understanding for everyone.
What is arbitrage?
To understand arbitrage, one must first take into account the so-called Law of One Price, according to which in a perfectly competitive market, the price of identical assets will be the same anywhere.
However, as crypto markets are often not fully competitive, reality often begs to differ from theory, with different prices being quoted on various exchanges. And it is precisely in such cases, when prices are not aligned across platforms, that arbitrageurs can benefit by buying low on one and selling high on another. (Which, incidentally, will also contribute to aligning asset prices.)
As the trading environment in crypto markets is different from that of the traditional financial market - and financial derivatives are less developed - only some arbitrage strategies can be implemented.
Here are a few.
1. Cross-market arbitrage
Cross-market arbitrage - also known as "brick-moving" - is the earliest arbitrage strategy used in crypto. The idea behind it is generating profits by buying the same currency low and selling it high on different markets.
Arbitrage opportunities for the same currency are plentiful. However, due to the serious liquidity problems of most small market capitalization currencies and small crypto exchanges, most of the current cross-market arbitrage is concentrated in the mainstream currencies of large exchanges.
At its simplest, the original brick-moving strategy entails depositing and withdrawing coins to transfer funds. After buying at a low-priced exchange, coins are deposited into a high-priced exchange and sold, carving out a profit.
The main risks attached to cross-market arbitrage relate to liquidity and price volatility, as slow on-chain transactions, and the exchanges' deposit and withdrawal policies can lead to arbitrage opportunities disappearing if the price changes during the withdrawal process.
2. Futures arbitrage
Discrepancies between prices on futures and spot markets are common, and this in urn creates arbitrage opportunities.
For example, let us suppose that the price of BTC on the futures market is $6900, whereas the price of BTC on the spot market is $6500, resulting in a spread of $400.
A trader could short $6900 on the futures market while buying $6500 worth of contracts on the spot. As the spread narrows, with the BTC price sinking to 6000 USD on the futures markets and to $5800 spot, our trader will stand a chance to pocket a profit of $200. This is because the futures profit will be $900 (6900-6000) whereas the spot loss only $700 (5800-6500).
3. Triangular Arbitrage
Triangular arbitrage is an arbitrage method mainly used in the foreign exchange market. It generates income opportunities from cross-exchange rate pricing errors. Although there are also many types of currencies in crypto, arbitrageurs usually resort to mainstream assets with good liquidity for triangular or even multi-angle arbitrage.
4. Rate Arbitrage
Rate arbitrage refers to the arbitrage of perpetual contracts' funding rates on a futures exchange.
In order to understand how this strategy works, one must first recall that the price of perpetual contracts traded on exchanges is anchored to the underlying asset's spot price through the funding rate. Funding fees need to be paid every eight hours depending on the position a trader holds. Longs pay shorts when the funding rate is positive, and shorts pay longs when the funding rate is negative.
Since the main function of the fund rate is to stabilize the perpetual contract's price and keep it linked to the spot index, the size of the fund rate is also related to the discount or premium of the contract. In a market with an obvious upward trend, for instance, the large number of long positions will generate contract premiums, turning the funding rate positive. This, in turn, will mean that longs will have to pay funding to the shorts.
Arbitrageurs can benefit by opening short hedging positions, or vice versa, cashing in on the fees.