Bitcoin Arbitrage: Can you profit?

At Quora, I occasionally play, “Ask the expert”. Several hundred of my Quora answers are linked at the top right. Today, I was asked if the difference between quotes at various Bitcoin exchanges presents a profit opportunity.

In addition to my answer, one other cryptocurrency enthusiast offered pithy, one-line response: He said “Buy local, sell internationally and pocket the difference!” I tend to believe the opposite is more likely to generate profit: Buy internationally and sell locally. But, I am getting ahead of myself. Here is my answer [co-published at Quora]…


Question:
A Bitcoin exchange in my country quotes a different rate than
international markets. Can I profit from the price difference?

Answer:
Buying and selling a commodity with the intention of profiting from the difference in price in various markets, regions or exchanges is called arbitrage. Typically, the item must be widely traded and fungible. Although it can be a tangible item (one that must be delivered or stored, like gold, oil, frozen orange juice or soy beans), arbitrage is more practical when applied to an ‘item of account’, such as foreign currency, equity shares, stock futures, or Bitcoin.

With this in mind, Bitcoin qualifies as a fungible item of account. If you see a different price at various exchanges (or if you believe that you can source personal sales at a higher price than the market spot price), then you have found an opportunity for arbitrage. But hold on! It is not so easy…

  1. The arbitrage opportunity is often illusory. For example, the cost difference that you observe in market quotes may be overshadowed by the bid/ask spread or by fees, which can be both fixed and a percentage.
  2. The arbitrage opportunity is transient. It is there for a few seconds and then it vanishes in the next quote. For this reason, successful arbitrage players must be very adept at day-trade techniques. To avoid massive risks, you need up-to-the-second quotes, fast trading tools, and the ability to simultaneously freeze your purchase and sale price.
  3. Trust is never golden! Even with these tools and promises, when a commodity begins to move in either direction, you will find that a buyer or seller often finds a way to renege on the agreed price. These are not random events…When a trading partner abandons a transaction, it always work against you.
  4. Some exchanges (and even some national regulatory agencies) prohibit rapid and repeated trading. This may be to discourage speculation or it may be designed as a circuit-breaker (a mechanism to avert the cascade effect that sometimes results from pre-programmed trades). These halts on quick trades can wipe out your gains, or worse. They can turn your investment into a horrible mess.
  5. Some big exchanges have built-in arbitrage mechanisms that quickly adjust prices and even buy and sell on their own account to keep their limit order books in sync. They are on the front lines and you aren’t! This fact, alone, should give you pause. Opportunity for an outsider is severely limited by these ‘inside’, self-adjusting trades.
  6. Other legal risks: If the transaction is later deemed to be illegal in the jurisdiction of any party, your exchange accounts may be frozen, fined, or your privileges revoked. Unlike p2p Bitcoin transactions, exchange transactions can be reversed. Again, these legal snafus will always work against you. In fact, sometimes, they were pre-planned scams from the start!
  7. Finally , there are sometimes good reasons for different prices in different markets. For example, national and local regulations may burden the consumer cost for an item, or the seller may be required to pay a fee or tax to some authority or regulatory agency. If you dodge these costs, you may be violating laws and subject to penalties or punishment. You may even put your customer at risk.

What about arbitrage pools or affiliate programs? Don’t be a sucker! If Gladiacoin could double your Bitcoin every 90 days, they wouldn’t need to set up a multi-level marketing scheme. They would simply start with a few hundred dollars and become billionaires by endlessly doubling their money.

I am neither an arbitrage player nor a day trader. These are just a few warning bells that come to mind when I think about such activity. You can be sure that this list of risks only scratches the surface. Bitcoin is remarkably fluid and many people flaunt regulations. For this reason, I am confident that opportunities for profitable arbitrage are rare and very tiny (small gain for a big risk).

Have I scared you away from Bitcoin arbitrage? If not, proceed with extreme caution and don’t bet the family ranch! Once you have some experience, come back and post feedback below. I have dabbled in options arbitrage, but never with Bitcoin or any currency. Since I don’t have first-hand experience, your feedback will be appreciated.

Ellery Davies is a frequent contributor to Quora. He is also co-chair of Cryptocurrency
Standards Association, host of The Bitcoin Event (New York), and editor at A Wild Duck.

3 thoughts on “Bitcoin Arbitrage: Can you profit?

  1. Hello Ellery, pls what advivs would you give me in terms of trading on the exchanges as new coins everyday keep flowing?
    Thanks

    • This is a very long answer. I am revealing my personal investment strategy, but I am speaking informally and off-the-cuff.

      I will not characterize this opinion as advice. But, I have arrived a philosophy, principles and a strategy that guide my own interest and aversion to various cryptocurrencies.

      In general, I am believe these things:

      1. Bitcoin is king. Although it is slow to adapt, ultimately, it is likely to incorporate every good idea from the altcoins, and it has already achieved a robust 2-sided network. If it can get its act together (regarding faster settlement, lower transaction cost, reducing energy use, and transaction replay issues), then it will remain king forever.

      This is *not* a situation like VHS and Beta. With the exception of Ripple, Cryptocurrencies are p2p, open source and permissionless. This makes it very unlikely that the leader will be unseated.

      2. But there is a risk. Bitcoin can fail. If if fails, it will be because of the messy governance issue. It is so completely decentralized, that consensus is incredibly difficult. More importantly, miners, users, vendors and developers do not have the same goals. There is a solution for this: Make everyone a miner and base voting on something other than proof of work. But, we cannot yet fortell if the fractured parties will get their act together before consumer faith is shattered.

      So, while I would not bet against Bitcoin (even as it floats near $20,000/coin), I might hedge my risk by investing in a few other coins. But, here’s the problem: How can you be long on Bitcoin while also preparing for it to be replaced by something else. I’ll get to that, below!

      Two forks, Bitcoin Cash and Dash (formerly “Darkcoin) appear to have the makings of a functional coin. They have mechanisms to address the issues with speed, the governance quagmire, and a few issues that I cannot disclose in this informal reply.

      3. ICOs are almost all BS. (I will receive angry letters because of this statement, but I have never been shy about expressing an opinion). If I review a random sampling of popular ICO offerings, 80~90% of would fail an endorsement by me or by CRYPSA (my employer). That’s because they fall into one of these categories…

      • Veiled securities offerings, designed to duck under securities regulators)
      • Created for the express purpose of pump & dump (without clearly disclosing caps, reserves or pre-mined stakeholders)
      • A non-functioning coin that can only gain value through MLM (not necessarily criminal, but outside our mandate).

      In practice, I might not dismiss such a high fraction of ICOs presented to me, because the wackier ones won’t approach my organization in the first place. If we begin accreditinmg ICOs, we will publish clear criteria and suggest compliancy characteristics before any relationship. This should reduce the fraction of non-starters.

      Incidentally, I am not bundling every altcoin with ICOs. But, watch out for the ICO coins coming onto the market. If it is a genuine altcoin, it will be open source, permissionless and the corpus will be based on the original Bitcoin stake. At the very least, you will know the supply cap, identity and stake of every founder, the pre-mined coins will be less than 0.5% of the theoretical total. To be clear, I consider any mining prior to 50 miners (who don’t know each other) to be “pre-mining”. Anything less, and it is a scam.

      So, how can you avoid risk as you bet for and against Bitcoin? It’s not that hard. You implement a revenue neutral strategy in which you hedge your risk as I am doing:

      a) I am long on Bitcoin. This is not likely to change.

      b) I plan to invest long and short (for example, puts and calls)* on certain coins that are likely to perform better than other coins. This reduces risk, by leaving me without a loss, if the entire market rises or falls. The only way I might lose is if I get it exactly wrong! That is, if the coins that I believe are scams do better than the ones that I feel are well-designed and with a solid adoption trend. (Remember: The strategy is to invest on the difference between an overvalued dog and an under-performing beauty).

      To avoid the downside scenario (i.e. getting it exactly wrong), focus on fundamentals and not the cost of a unit, short term trends, or other technical issues. Don’t follow the crowd! Bet on value and bet against hype.

      * Of course, a market for puts and calls does not exist on alt-coins, but with a little research, you can create an equivalent options instrument.

    • I have seen very few ICOs that rise above the level of scam or pyramid scheme. In fact, CRYPSA has scrapped its recent plan to offer ICO certification. Fewer than 1% of new coins serve a valid function or have a reasonable chance of surviving in the altcoin world.

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