Arbitrage in cryptomarkets (part one)

Cryptomarkets are not a good example of efficiency. Empirical evidence shows that market-efficiency in the five largest cryptocurrencies is highly time-varying. In particular, cryptocurrency-markets were mostly inefficient before 2017 and they become more efficient over time in the period 2017-2019. On average, Litecoin is the most efficient cryptocurrency, and Ripple being the least efficient one. This is what empirical data suggest.

As we know, finance theory says that unefficient markets pave the way to arbitrage strategies, where, in forex markets, arbitrage can be defined as the simultaneous purchase and sale of a currency to profit from an imbalance in its price. It is a strategy that profits by exploiting the price differences of the same currency (cryptocurrency) on different markets or different exchange platforms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.

In cryptomarkets, arbitrage software look for market inefficiencies within one exchange or among exchanges. Many of them attempt to increase the amount of the coin(s) a trader has selected as base coin (e.g Bitcoin), by taking advantage of price discrepancies between cryptocurrencies traded on cryptoexchanges. In order to perform an arbitrage strategy, a trader needs to perform three different trades, to obtain an increase in the chosen base coin at the end of the process. Furthermore, the lower trading volumes, the higher the possibilities to gain from this strategy.

For example, suppose a trader selects BTC as base coin. The arbitrage software detects a market arbitrage opportunity that includes the cryptocurrencies Ethereum and Litecoin. First, it will buy Ethereum (suppose 45 ETH) with a single unit of Bitcoin on the exchange (sell Bitcoin). Secondly, the Ethereum (45 ETH) the software has just bought is used to buy Litecoin (suppose 156 LTC). The final step is to buy back Bitcoin (suppose 1.007 units), completing the triangle and increasing the initial amount of Bitcoin.

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