Exchange Arbitrage

In this article, we explain what exchange arbitrage is and delve into its features on cryptocurrency exchanges and stock markets.

What is Exchange Arbitrage?

Arbitrage trading is a strategy that profits from price differences of the same asset on different exchanges or within the same platform. Simply put, exchange arbitrage involves buying an asset in one market and selling it in another at a higher price.

In the “classic” arbitrage trading formula, a trader purchases an asset at a lower price and transfers it to a higher-priced exchange. Securities can be transferred between stock exchanges. However, arbitrage is more straightforward in the cryptocurrency market due to the ease of transferring digital assets.

Arbitrage trading is possible across various markets, including stocks, cryptocurrencies, precious metals, and foreign currencies. The core principle of this strategy is market inefficiencies: the same trading instrument may have different prices across platforms. This price discrepancy can arise from exchange fees, liquidity, trading volume, technical infrastructure, trade recording methods, quote currency, order processing speed, etc.

Specific factors can also influence price differences. For instance, futures arbitrage takes into account contract delivery dates, liquidation fees, and settlement terms. Bond market arbitrage accounts for coupon payments, duration, issuer ratings, base rates, and tax advantages (common in government securities trading).

Nearly all exchanges permit arbitrage trades, benefit markets by stabilizing prices between platforms, increasing trading volume, and enhancing liquidity.

Key Characteristics of Arbitrage Trading

Higher Transaction Costs: Arbitrageurs incur higher fees than regular traders, such as charges for securities deposits, cryptocurrency transfers, or contract settlements. Arbitrage becomes profitable only when the trade’s revenue covers these costs.
Relatively Low Risk: One significant advantage of arbitrage trading is its comparatively low risk. In most cases, traders do not need to predict future market movements. Arbitrage logic relies on visible data, such as current price differences between two exchanges. However, arbitrage is still a complex trading type, requiring traders to monitor price movements across multiple platforms and accurately calculate transaction costs and timing.
Arbitrage opportunities exist in various markets and offer a unique, lower-risk trading approach. However, successful execution requires advanced tools, analytical skills, and a thorough understanding of the market.

Exchange Arbitrage Strategies

Inter-Exchange (Pure, Spatial) Arbitrage

Inter-exchange arbitrage, or pure or spatial arbitrage, involves exploiting price differences for the same instrument on two different exchanges. Sometimes referred to as geographic arbitrage (when assets are transferred between exchanges in different countries), this strategy capitalises on price discrepancies. For example, Apple shares may be quoted in EUR on the Milan and Frankfurt stock exchanges, but their prices may not always match. A trader with access to both platforms can buy shares in Milan and immediately sell them in Frankfurt at a higher price.

Cryptocurrency Exchange Arbitrage

The cryptocurrency market is a prime environment for arbitrage traders due to its 24/7 availability, accessibility, and the absence of intermediaries like brokers.

On stock exchanges, assets are typically quoted in the local currency, while on cryptocurrency exchanges, USD, BTC, or stablecoins are the standard. This reduces currency risks as trades and withdrawals are usually conducted in the same currency. Additionally, cryptocurrency trading is more standardized, simplifying cost calculations for arbitrage transactions.

A typical crypto arbitrage trade mirrors stock market practices. For instance, if ETH/EUR is trading at €3633.62 on Kraken and €3633.72 on Binance, you can buy ETH/EUR on Kraken, transfer it to Binance, and sell it at the higher price, earning a €0.10 profit per unit (3633.72 - 3633.62). However, this calculation excludes transaction and transfer fees.

P2P Arbitrage

P2P arbitrage is a trading strategy that leverages peer-to-peer transactions. In this strategy, buyers and sellers directly trade without placing orders on the exchange. Prices in P2P markets are determined by participants and often vary significantly, creating arbitrage opportunities.

For example, in the P2P section on Binance, the “Buy” tab might show a trader selling 1 BTC for $103,517, while the “Sell” tab lists another trader buying at $103,607. An arbitrageur can buy BTC at $103,517 and immediately sell it for $103,607, earning a $90 profit (excluding platform and payment system fees).

Retail Arbitrage

Retail arbitrage involves physical goods. A trader buys items locally at lower prices and resells them in another city or country at a higher price.

Consumers benefit from avoiding the travel costs of acquiring the product themselves. Since the resale occurs after the initial purchase, the trader takes on risks, such as:

Demand Risk: Will buyers be interested in the product?
Price Risk: Will the product sell at the desired price?

The profit in retail arbitrage compensates for these risks.

Merger Arbitrage

This strategy arises during mergers and acquisitions when one public company acquires another. The acquiring company typically offers to buy the target company’s shares at a price above the current market value, creating an opportunity for profit.

When a deal is announced, arbitrageurs purchase shares of the target company, anticipating their price will rise to the acquisition price. Once the target price is reached, the counterparty becomes the acquiring company. However, risks include regulatory intervention or unforeseen circumstances that might block the deal, preventing the arbitrageur from selling at the intended price.

The more significant the difference between the current price and the target price, the higher the potential profit.

An alternative approach is to short the target company’s shares. If the deal fails, the price may plummet, yielding profits. However, this strategy isn’t pure merger arbitrage as it lacks predictability and calculable potential.

Convertible Arbitrage

Convertible arbitrage involves convertible bonds, which companies issue to attract investment. Unlike traditional bonds, these can be converted into the issuer’s shares at a predetermined price. Interest rates on convertible bonds are typically lower, but they provide the advantage of share conversion at favourable rates.

Arbitrage opportunities arise because the current share price often exceeds the bond’s conversion price. A typical trade involves simultaneously buying the bond and shorting the underlying stock.

If the stock price rises after the trade, losses are offset by interest payments from holding the bond.

However, risks include:

Delayed Conversion: Some bonds have a lock-in period before conversion, exposing traders to market volatility.
Credit Risk: If the issuer’s credit rating falls, the stock price may decline faster than the bond price, leading to potential losses.

In cases where a bond is “overbought,” the arbitrage strategy reverses: buying the stock and shorting the convertible bond.

Pros and Cons of Arbitrage Trading

The primary criterion for successful arbitrage trading is speed. The faster a trader identifies arbitrage opportunities and executes trades, the higher the profit potential. Consequently, arbitrage is not suitable for manual trading enthusiasts, as they are inevitably outpaced by algorithmic trading programs.

At Quantum Rise, we invest heavily in hardware and software development. Our communication channels and trading systems execute trades 1,500 times faster than a human trader, turning this speed advantage into consistent profitability. We continually invest in infrastructure and trading software enhancements. High-frequency arbitrage is not an easily replicated business. Major players, such as Citadel, RenTech, and XTX, have built their own infrastructure, while others lack experience and rely on external teams for joint product development.

Pros of Arbitrage Trading

Clarity

Unlike traditional trading, where one trader might see a “head and shoulders” pattern, and another might focus on horizontal levels, arbitrage has a clear objective: to exploit price discrepancies. The target is unequivocal and measurable.

Reduced Uncertainty

In classic trading, every trade involves a mix of potential outcomes, and success cannot be predicted with certainty. In arbitrage, the outcome is primarily determined by execution speed.

Cons of Arbitrage Trading

High Costs

Profitable arbitrage requires significant investment in advanced software to automate trades or substantial time and effort for manual trading. Unlike traditional trading, arbitrage doesn’t allow you to set an “alert” and wait for the right conditions. Execution must be instantaneous.

Execution Risks

As a form of short-term trading with small profit margins but large volumes, arbitrage is sensitive to issues such as:

Slippage: Delays in order execution that cause worse-than-expected prices.
Requotes: Changes in available prices during trade execution.
Connectivity Issues: Internet interruptions that can disrupt trade.

What Are the Opportunities for Arbitrage Strategies in the Stock Market?

At the current stage of stock market development, five primary types of arbitrage are utilized:

Inter-Exchange (Pure) Arbitrage

This involves tracking price differences for the same asset across multiple exchanges. The key characteristics of this type have been discussed earlier. When calculating profitability, traders must account for:

Currency Conversion Costs: Assets may be traded in different currencies on different exchanges, incurring conversion fees.
Transfer Fees: Moving securities between depositories can also add to expenses.

Intra-Industry Arbitrage

This strategy identifies price discrepancies between highly correlated assets, such as shares of companies within the same industry. It assumes that the prices of these securities will move in tandem with the industry’s current performance.

Equivalent Arbitrage

This involves tracking price differences between a base asset and its derivative financial instruments, such as a stock and its futures contract. The underlying principle is that as a futures contract approaches expiration, its price converges to the base asset’s price and eventually equals it on the expiration date.

Calendar Arbitrage

This strategy tracks price differences between futures contracts with different expiration dates for the same asset. When there is a significant price divergence:

The more expensive contract is sold, and the cheaper one is bought, in anticipation of convergence.
Conversely, if the spread is narrow, the strategy reverses: buying the more expensive contract and selling the cheaper one, expecting price divergence.

Statistical Arbitrage

Based on the principle of mean reversion, this strategy involves:

Shorting “overbought” stocks.
Taking long positions in “undervalued” stocks.

The idea is that asset prices will eventually revert to their historical averages, allowing traders to profit from temporary imbalances.

Conclusion on Arbitrage Trading

The fundamental dilemma in arbitrage trading lies in choosing between investments in infrastructure and skill development:

Automated Trading: Requires a larger deposit or a higher frequency of trades to achieve profitability.
Manual Arbitrage: For strategies that are less reliant on speed, the required deposit can be comparable to that for standard trading.

High-frequency arbitrage trading involves a blend of team expertise, technological solutions, trading equipment, and algorithms. It involves routine, meticulous work, such as identifying inefficiencies, configuring equipment and trading logic, managing positions, enhancing strategy performance, and reconciling tens of thousands of trades.

At Quantum Rise, we understand every nuance and challenge of this business. Our team offers a proven portfolio of investment strategies that have withstood the test of time, crises, sanctions, and market halts. We possess expertise in algorithm development, building trading and clearing systems, brokerage operations, and advanced risk management methodologies.