You’ve probably read about the wide range in prices bitcoin is trading at among the numerous exchanges around the world. For a digital currency, where transactions are supposed to be frictionless, and allow for near free transfers of money around the world, the existence of diverse pricing is enigmatic. In addition, while such inefficiencies would have thought to have decreased as the currency has become more mainstream and widely used, the reverse has actually taken place. While in the past spreads of $20 between exchanges were considered high, now we are routinely seeing differences of over $200 between major trading venues. It is also important to keep in mind that the situations we are seeing aren’t just for smaller exchanges with low trading volumes, but among the largest, most liquid venues.
For example, let’s look at current prices at 10:00 BST on December 3rd
MtGox: $1139
Bitstamp: $1050
BTC China: $1072
BTC-e: $985
Bitfinex: $1050
Why are their different prices?
Before understanding how to take advantage of the disparity in pricing, let’s first understand why this is taking place.
While bitcoins are in essence, a commodity, with no individual bitcoin being different than another, buying and selling of them is still restricted to the locations of each exchange. For example, while a barrel of oil trades around $100, it still requires physical delivery and refining to be used around the world. Depending on supply and demand, plus delivery costs, the actual amount for that barrel of oil will vary around the world.
Similarly, supply and demand, as well as delivery affects the prices of bitcoins on each exchange. For example, dollar denominated trading of bitcoins composes the lion’s share of volume at the MtGox exchange. As such, one can imagine that efficient methods for account holders to deposit and withdraw dollars is a big deal for MtGox clients. However, with their banking partners, partly regulatory problems, and partly sheer numbers of transactions, dollar based payments are vulnerable to massive delays; with clients reporting month long plus wait times. Alternatively, customers can buy bitcoins with their dollars, transfer them to another exchange, and sell them there for dollars. As a result of all the delays, a dollar at MtGox is worth less than at more efficient exchanges. This comes from the opportunity cost that customers pay to wait for their withdrawals to take place.
Another example is BTC China where trades are denominated in Chinese yuan. As a result, only customers with yuan can transact trades on the exchange. This creates a situation where supply and demand is based mainly on one country. After Baidu announced it would accept bitcoins as payment for some of its web-services, it triggered , which led prices higher. With, few destinations accepting yuan, Chinese customers were limited in their alternatives to buy bitcoins; thus creating a seller’s market. The effect was that prices of one bitcoin on BTC China began to trade at a premium to other exchanges, such as Bitstamp and BTC-e. This contrasted pre-Baidu trading, where BTC China prices were more or less in line with other exchanges.
In addition, affecting prices is also how long it takes an exchange to process a bitcoin withdrawal. When buying on an exchange, bitcoins are held in a shared wallet that is controlled by the company. Therefore, when an account holder wants to send his/her bitcoins to their own personal wallet, the exchange needs to identify the amount, make a credit/debit in their books, and process the transfer. Most exchanges process digital currency orders in 24 hours. Firms with long wait times to receive transfers or process withdrawals leads to higher opportunity costs for customers; thereby increasing bitcoin premiums.
Why arbitrage is difficult?
Based on the above, it is easier to understand why bitcoin arbitrage is difficult.
In a standard arbitrage scenario, traders find inefficiencies where they can buy low on one exchange and sell at another for a higher price. Ideally this is all done in fractions of a second. But what if they don’t know the price at that second exchange, or they have to wait a few days to make the sell, at which time prices may have dropped.
This is what occurs with bitcoins. In a perfect world, I’ll just buy one bitcoin from BTC-e at $985 and transfer it to MtGox and sell it there minutes later for over $1100. But, while I can make that purchase at $985, by the time my bitcoin arrives at MtGox, it may be a few days by the time both BTC-e and MtGox processed my transfer.
Similarly, if I have a bitcoin at MtGox and sell it at $1135, by the time my dollars can be withdrawn to my bank and redeposited at BTC-e, who knows where prices will be and whether I can buy another bitcoin for less than $1135.
As a result, we have a market where physical delivery (in the digital sense of putting those bitcoins in my personal wallet) is highly fragmented and inefficient.
This is how you do it – Concentrate on spreads
Partially to blame is that while bitcoins and other digital currencies are aiming to disrupt traditional fiat money, they are still closely tied to the existing financial infrastructure. It’s easy to send bitcoins around the world, but if you want to buy them from someone on the other side of the globe, you need to send them fiat, which isn’t always easy. As a result, traditional arbitrage just doesn’t work. If it did, the market would be efficient and those crazy spreads we are seeing wouldn’t exist., or least be much smaller.
But that doesn’t mean we are out of arbitrage luck.
Rather than focusing on buying and selling the same bitcoin at different exchanges, we can look at trading the spreads by simultaneously buying and selling at different exchanges. What if at the same time you bought from BTC-e, you also sold at Mt-Gox at the same time? Then you could make a trade out of it.
But, you can answer that this is impossible since MtGox doesn’t allow for short trades. This is true and why we first identify where to trade.
Before we do that, I want to introduce CFDs. Standing for ‘Contracts for Difference’, CFDs are synthetic products that mimic the price of an underlying security. For example, a CFD of gold tracks the price of gold and rises and falls as prices of gold go up and down. The difference between actually buying gold and a CFD, is that with the CFD there is no actual ownership of gold, but simply a contract with your broker. Popular in Europe and the UK (although illegal in the US), there are CFDs available for nearly every stock, commodity, or equity index. And yes, there are bitcoin CFDs that can be bought and shorted.
Now back to that list of where to trade:
Bitfinex: Bitcoin exchange that provides its own market book as well as liquidity from Bitstamp. As a result, prices tend to track Bitstamp very closely. Bitfinex allows for margin trading (you can buy/short 2X the balance of your account) as well as short trades.
Forex brokers that offer bitcoin CFD: has a CFD that tracks pricing at MtGox with the ability to both buy and short using 5X leverage. (alternatively, offers CFD trading, but they have recently made changes to their trading conditions that are disruptive for arbitrage)
BTC-e: One of the largest exchanges by volume, trading accounts. Using the MetaTrader platform, traders can access BTC-e liquidity with leverage and short trades.
Using products from these exchanges we can build an arbitrage strategy. The goal is to buy from one destination and short on another. But, you can’t just buy at BTC-e and short at AvaTrade, since who knows if prices at the two exchanges will ever become equal.
Alternatively, the opportunity is to monitor spreads between multiple exchanges. If spreads between MtGox and Bitfinex are averaging $100, an arbitrage opportunity occurs if prices among the two exchanges widens or contracts. For example, if spreads go to $175, one could short on AvaTrade one bitcoin, while buying one bitcoin at Bitfinex. After creating this trade, whether prices of bitcoin skyrocket or tank, it doesn’t matter. What does matter is if the spreads between the two exchanges changes. In our trade, the trader would profit $75 if spreads between MtGox and Bitfinex drop back to $100.
Risks
Like any arbitrage trade, there are risks. Firstly, there is no guarantee that spreads will return to norms. If MtGox would announce tomorrow that they have reached an agreement with US banks to expidite dollar transactions, spreads could crater quickly. Secondly, by simultaneously trading on two venues, if there is a technical failure at either of the companies it could harm execution and the success of the trade. Last, working with multiple counterparties also increases risks that one of the firms will go out of business. The last risk exists anytime one trades with multiple financial parties.
Overall, when it comes to bitcoin arbitrage, it seems like a slam dunk, but is in reality very difficult. This is due to the inefficiencies prevalent among processing of deposits and withdrawals at exchanges, as well as regional supply/demand. However, what does exist are oppurtunities to take advantage of spikes in spreads between major exchanges through the use of leveraged trading and CFDs.
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