Arbitrage

Arbitrage means, that price differences at different but similar markets are used to make a profit out of it. Arbitrage is something that is used in the world of finance but it is not limited to finance people. Maybe you heard of the business model of Droppshipping, where products are bought cheaply from Chinese manufacturers for example on Alibaba.com, and are sold expensively in Europe or other parts of the world. This is an arbitrage business where the price differences of two markets (the Chinese market and the European market) are used, to make a profit. Maybe the living room lamp costs only 10$ in China but 100$ in Germany. Arbitrageurs will then use this price difference to make of profit by buying the lamps cheaply in China and selling them expensive in Germany. By the way, as you might already have guessed, arbitrageurs are the people called, that make an arbitrage business. Now if you think further, arbitrage is widely used in finance. Arbitrage is making use of the inefficiency of markets and arbitrageurs make them efficient.

Key takeaways

Arbitrage is a method to capitalize on inefficient markets
The more capital an arbitrageur is willing to invest, the more he can capitalize on an opportunity
Trading fees should be considered carefully because they can eat all the profit
Arbitrageurs make the overall market more efficient

How do arbitrageurs work

Imagine Johnny collects baseball cards and he finds out, that his classmate Paul likes them too and is willing to pay 110$ for a special baseball card. Johnny knows, that his neighbor Josefine sells that baseball card for 100$. Johnny has no money at the moment, that's why he asks his dad for 100$ and promises to give it back the next day. What Johnny does is, he takes the 100$ and trades it with Josefine for the baseball card. The next day he sells the baseball card for 110$ to Paul. Now Johnny has 110$ from which he has to give 100$ back to his dad. Johnny made a net profit of 10$ from which he normally had to pay interest rates for borrowing money. As long as the profit is bigger than the interest rates Johnny has to pay for borrowing the money, he still makes a profit.

Paul

Johnny

Josefine

Johnnys dad

The arbitrage business happens in all kinds of markets. If one ounce of gold is cheaper in London than in New York, arbitrageurs will buy it cheaply in London and sell it more expensive in New York. The same happens for Stocks, Commodities... Nearly every market that you can imagine has arbitrageurs that look for price differences in different markets and make use of them. As you can imagine, this business was more lucrative when the information flow was slower than it is today. Today it is only one mouse click away from finding out how much one ounce of gold is sold in Moscow, London, New York, or Berlin. One of the biggest markets for arbitrage business if not the biggest market is the Foreign Exchange market (FX). Foreign Exchange is the market for currencies like the USD, EUR, JPY, and so on... One reason why the USD has the same value almost all over the world is, that arbitrageurs look for price differences on different exchanges and then buy and sell the currencies until the price differences disappear. Let's make an example with four exchanges with four exchange rates:

I live in Germany and I want to sell EUR to buy USD. I know that my bank 'Deutsche Bank' will sell me 1,07 USD for 1 EUR. Now I found out, that Deutsche Bank will also sell me 0,86 GBP for 1 EUR. The problem is that I want Dollars and not Pounds so if I had 0,86 GBP I would need to go to a bank that sells me USD for my 0,86 GBP. If I would now be able to find a bank that sells me more USD for 0,86 GBP than 1,07 USD, I could make use of these price differences. All I'd need to do is buy USD 'cheap' with my EUR and sell it 'high' for GBP and then change back my GBP to EUR.

Deutsche Bank: EUR/USD 1,07

Deutsche Bank: EUR/GBP 0,86

JP Morgan: USD/GBP 0,81

Barkleys GBP/USD: 1,24

Santander GBP/EUR: 1,16

To spot an arbitrage business opportunity I need to find out if I can get the same amount of USD if I trade EUR for USD or if I first trade EUR for GBP and then trade GBP for USD. There shouldn't be a price difference. If there is a price difference and all the other exchanges have correct exchange rates, it means, that there is an opportunity for arbitrage business.

If EUR/GBP : USD/GBP = EUR/USD it means that there are no price differences between those markets and no arbitrary business is possible.

If EUR/GBP : USD/GBP ≠ EUR/USD it means that there are price differences between those markets and arbitrary business is possible.

EUR/GBP 0,86 : USD/GBP 0,81 = 1,0617284 ≠ EUR/USD 1,07

Now we found out, that there are price differences between markets and that arbitrage business is possible. To not overcomplicate things, we assume, that I already have 100 EUR and that I keep my profits in GBP and don't change them back to EUR. The trade would look as follows:

Borrow 86 GBP at Deutsche Bank and deposit 100 EUR
Sell 86 GBP to Barkleys and buy 106,64 at a rate of GBP/USD 1,24
Trade back 106,64 USD to 86,3784 GBP at JP Morgan
Payback 86 GBP to Deutsche Bank and keep 0,3784 GBP
Sell 0,3784 GBP for 0,199844 EUR at Santander

To make a profit 0,199844 EUR, 100 EUR where initially invested. To make bigger profits, a higher initial investment is required.

How does arbitrage work in DeFi?

There are three types of arbitrage in the world of DeFi:

Cross-Exchange Arbitrage
Spatial Arbitrage
Triangular Arbitrage

Cross-Exchanges Arbitrages try to identify price differences in one Cryptocurrency on two exchanges. After price differences are identified, the arbitrageur buys the coin at the exchange where it is cheaper and sells it at the exchange where it is sold more expensive. A very important factor here is the trading costs that should be considered. High trading costs can eat up all of the arbitrage profits so the calculation should always include the trading fees. Spatial Arbitrage is pretty much the same as the Cross-Exchange Arbitrage, with the difference, that Spatial Arbitrage makes use of exchanges that are regionally separated. Like when you buy Bitcoin on a London-based exchange and sell it on a Berlin-based exchange. Both of the methods are comparable to the first example of Johnny, trying to sell a baseball card with a profit. Triangular Arbitrage uses price discrepancies between currency pairs on one exchange and makes a profit on them by trading them in a loop. This can include three or more funds like in the above example on FX. Flash loans and arbitrage bots can help to capitalize on arbitrage opportunities.