Crypto Arbitrage: Strong Stablecoin Pegs, and Trading Gains

It has never been so easy to trade cryptocurrency. There are hundreds of crypto exchanges, DEXs, and DeFi dApps available. Every platform has different liquidity, trading volume, and centralization.

Despite these differences, cryptocurrencies have about the same prices wherever you trade. How is that possible? Crypto arbitrage is the answer.

Crypto arbitrage traders help balance prices among platforms, helping liquidity providers and making profits in the process. Sometimes, more than you could earn from holding or yield farming. Crypto arbitragers also perform the vital task of ensuring that certain stablecoins hold their peg.

What is Crypto Arbitrage?

The goal of crypto arbitrage is to solve market inefficiencies that cause price differences. Arbitrage traders essentially get paid to stabilize prices, buying low and selling high somewhere else. Some reasons for these price differences are:

• Different fees and spreads on every exchange
• Price volatility on low-liquidity platforms
• Uneven trading volume

Almost every market has some inefficiencies, including Forex, real estate, ecommerce, and even service-based businesses. In blockchain technology, these differences are greater because most cryptocurrencies are decentralized. And the rise of decentralized finance has created even more arbitrage opportunities.

Arbitrage traders follow a different approach from value investors and cryptocurrency traders. It’s not about project fundamentals but liquidity and volatility:

• Two illiquid exchanges are more likely to have price differences
• Two volatile coins are more likely to create arbitrage opportunities

“Opportunities” mean something different for every trader:

• Value investors will look for tokens that have high long-term price potential, ideally undervalued.
• Crypto lenders profit from interest when tokens either go up or have price stability.
• Liquidity providers benefit when token pairs stay the same or move together.
• Arbitrage traders profit from any price direction as long as the difference offsets trading expenses.

The most favorable situation for arbitrage might be the opposite of liquidity providing, lending, and crypto staking. Assuming prices rebalance, arbitrage can help prevent everyone else’s losses.

What is a Crypto Arbitrage Bot?

Arbitrage isn’t as easy as it sounds because it includes volatility risk. But when done right, it’s very profitable short-term. This model attracts several traders, to the point where market inefficiencies disappear within seconds.

The only way to earn consistently is by using trading bots. A crypto arbitrage bot is the fastest way to explore all price feeds, calculate returns, and trade. They repeat the same operation until it’s no longer profitable, causing platform prices to rebalance with the largest ones.

An efficient bot trades hundreds of times per day, achieving a reasonable 0.5% to 2.5% daily profit.

But don’t take these for money printing machines. The bot needs high calibration and precision. A volatile market could turn your algorithm ineffective overnight, and it might take weeks of testing before it’s reliable again.

In fact, most arbitrage platforms that once offered 1% daily returns have fallen to 0% for this reason. Not only do returns decrease because of market trends, but because of increasing liquidity and more competitors using arbitrage bots. Large-volume arbitrage traders can profit from tiny inefficiencies, which often means these price gaps don’t get big enough for small traders to break even.

Arbitrage and Stablecoin Pegs

Not only is stablecoin arbitrage possible, but necessary to peg prices. In the case of algorithmic stablecoins like USDL, smart contracts regulate prices along with arbitrage incentives. Arbitrage also works for USDT and USDC, but deviations are so tiny that only institutional investors trade them (with exceptions)

While arbitrage seems beneficial for stablecoin stability, it only is as long as incentives remain. If a stablecoin isn’t over-collateralized, arbitrage can lead to its ruin. The moment these coins lose their fiat peg, trading bots will suck dry all liquidity until the token price falls to zero.

Liquid Loans is an over-collateralized lending protocol that prevents the inherent risks of stablecoins and DeFi.

How Does Arbitrage Affect Bridges

Just like decentralized exchanges (DEXs), bridges have fees and spreads that make token prices different from other platforms. Bridges are essentially cross-chain exchanges for popular currencies like ETH, BTC, or BNB. Bridge arbitrage is similar to crypto arbitrage, except it also includes differences in network fees and speeds.

When arbitrage traders add liquidity to these dApps, bridges can “bridge” tokens faster with lower spreads. This means you can transfer tokens to any blockchain like PulseChain and benefit from the unique protocols of that ecosystem. Because PulseChain increases Ethereum speed and cost-efficiency four times, it will likely create great arbitrage opportunities after its launch.

What are the Risks of Arbitrage?

It’s not hard to profit with crypto arbitrage. To consistently win is not, and it’s for the same reason yield farming isn’t. Once you find a winning system, it becomes less effective over time.

You’ll need to either update the system or find a different market. Otherwise, you expose to several risks:

Cost Risk

For arbitrage to be profitable, the market price difference must be great enough to offset fees. Costs are a problem because:

• Platform rates change quickly, especially on DEX liquidity pools
• If you’re trading low-capitalization tokens (e.g., <$10M market cap), the spread might be as high as 10%+
• High-frequency trader makes fees unviable for smaller traders

It’s neither wise to trade low-frequency because then you expose yourself to price-volatility risk. When traders lack the funds to overcome fees, they compensate with leverage and crypto borrowing.

Defaulting Risk

Whether you have a small account or want to maximize profits, leverage is common in arbitrage trading. For example, let’s assume you’ve found an opportunity to trade 1 USDC for 1.1 USDT, but you only have $40K:

• Borrow $200K with $40K collateral
• Trade 200K USDC for 200K USDT ($220K)
• Repay the loan to make 15K – 20K profit (after fees)

If for whatever reason you miss out on the 1:1.1 trade, you’re stuck with $220K, plus potential interest and fees. Any minor price move against you could liquidate the whole amount. While stablecoins are safer, arbitrage is no exception to network risks.

Network Risk

Most DeFi platforms are on the Ethereum Mainnet. In the past year, the fees of this blockchain have ranged from $10 to $200+. Not all arbitrage bots consider network-level costs.

This means your bot might find a $100 price gap and pay $200 to trade it, over and over again. At the same time, there might be network congestion. If you don’t want to miss the trade, you’d pay extra fees to speed up the transaction.

Sometimes it inevitably fails.

However, your risk exposure can change based on the different types of arbitrage trading.

What Are the Different Types of Arbitrage?

Crypto arbitrage can be confusing for beginners because the sources might be referring to different types of arbitrage. There are contradictory facts about the risk, frequency, or trading volume required. Let’s review them from least to most complex:

Spatial Arbitrage

The most straightforward type is what we know as “markets arbitrage. Spatial arbitrage traders profit from price differences by changing the “space” or platform. It doesn’t matter if it’s higher or lower as long as:

• The margin is wide enough to offset expenses (spreads, dApp fees, network fees)
• Your trading amount is big enough to minimize the impact of those fees
• You have enough time and network availability to trade before the gap closes

Spatial arbitrage has never been easier with decentralized finance. Traditionally, you’d need to create an account for every exchange, approve KYC verification, and wait minutes (if lucky) to transfer. But DeFi apps use ubiquitous Web3 wallets, so you can use the same balance for 100s of dApps.

Because it’s the easiest strategy, it’s also competitive and highly optimized. This means you might trade against high-latency trading bots from institutional investors. Using the exact same algorithm, they would complete the order first because they have faster devices and larger funds.

The smaller the difference, the more likely you are to trade it successfully. One trick to magnify profits from tiny deviations is triangular arbitrage.

Triangular Arbitrage

Triangular arbitrage applies a proven trading principle. “If you compound modest profits, your account will grow faster than if you risk it on one big win.” Triangular arbitrage is about compounding three or more price deviations (essentially a “chain” of spatial arbitrages).

Let’s suppose we trade on a network with low fees and high transaction speed. You realize that one token has an upward deviation on three small DEXs. But there’s another DEX with more liquidity, so the token price hasn’t increased yet.

Assuming you buy from this DEX, the next steps are:

• Connect your wallet to overpriced DEX 1 and sell.
• Buy back from the underpriced DEX.
• If DEX 1 is still overpriced, repeat. If it no longer is, sell on overpriced DEX 2 instead.
• Repeat until they’re all balanced

Triangular isn’t necessarily about platform switching. Sometimes, the same exchange might have three or more tokens in unbalanced liquidity pools. In that case, you can profit by trading Token1 for Token2 for Token3 for Token1.

Convergence Arbitrage

Similar to spatial, convergence arbitrage involves buying and selling. It involves long and short positions for both tokens of a liquidity pool. When a pool with 50/50 proportions deviates to, say, 40/60, eventually Token1 will go up and Token2 down (AKA convergence).

By longing and shorting at once, you can almost double your returns for being right. It’s unlikely to go wrong because all pools are designed to regain balance. The problem is that they might not rebalance quickly enough, which leads to shorting complications:

• Short/margin trades charge you daily interest to keep the position.
• A volatile liquidity pool can liquidate your Short/Sell. If it unbalances to say, 30/70 for a few seconds, smart contracts could close your Short, even if it returns to 50/50.
• While you wait for equilibrium, cryptocurrency prices keep changing. Market volatility often follows arbitrage opportunities.

Not every DEX allows shorting, and not many traders know how it works. Convergence arbitrage is high-frequency, low-competition, and complex.

Examples Of Arbitrage

Let’s use numbers to compare the three types of arbitrage. Initial conditions will be $10,000 (USDT), near-instant transactions, minimal fees, and decentralized platforms only. Here’s what spatial arbitrage would look like:

1. You find the same token priced differently on two exchanges. Let’s say it’s a 2%+ deviation.
2. Connect Metamask (any Web3 wallet) to buy from the cheapest platform.
3. Connect to the pricier platform to sell.
4. After you buy 10K tokens for $10,000 and sell them for $10,200, you profit $200.
5. Suppose prices are the same after your trade. You repeat the process and earn $204, $208, $212, and so on until deviations are ~0%

e.g. If you only had time for four rotations, your $10K would have earned $800 – $824 in four trades at a 2% profit.

For a triangular arbitrage example, let’s say your DEX has three stablecoin pairs. 1 USDT = 1.01 USDC, 1 USDC = 0.99 USDL, 1 USDL = 1.01 USDT. You can:

1. Buy 10K USDL and sell it for 10100 USDT
2. Sell 10100 USDT for 10201 USDC
3. Sell 10201 USDC at $201 profit

As long as the 2nd token relation is higher than 1, you can repeat and make $201+ per rotation. Since buying USDL would lose money, we can instead:

1. Convert 10201 USDC to 10201+ USDL on another exchange
2. Go back to exchange 1 and repeat

Assuming it’s four iterations, you made ~$804 – $828. Spatial is simpler, but because 1% deviations happen more often than 2%s, you earn more long-term.

What about convergence arbitrage? Suppose a 50/50 liquidity pool has 100K USDT and 100K USDL. 1 USDT = 1 USDL, and the pool constant value is $200,000.

However, traders have overbought USDL. There are now ~57K USDL priced at $1.50 and ~172K USDT priced at $0.50. The pool has unbalanced to 66/33 where 3 USDT = 1 USDL.

Spatial arbitrage traders will profit by selling USDL for USDT. You can complement with convergence arbitrage by:

1. Buying $5,000 in USDT with take-profits at $1
2. Shorting $5,000 in USDL and cover-buy at $1
3. When both reach $1, you profit $5,000 ($2,500 each).

Is Crypto Arbitrage Sustainable?

While crypto arbitrage helps sustain liquidity pools and stablecoins, it’s not a sustainable trading model. It’s an active investment style that requires updating the trading bot while constantly looking for market differences. Once you find a profitable trade you can repeat, it’s expected to become unprofitable due to competition and pool rebalance.

Crypto arbitrage traditionally favors the largest investors, as they won’t need high deviations to offset trading expenses. Thankfully, today’s DeFi apps make it more accessible to retail investors. On high-performance networks like Pulsechain, trading fees are negligible. If you want to start trading, all you need is a Web3 wallet, a reliable blockchain, and some crypto.