Arbitrage is a practice where traders take advantage of inefficiencies in the market by rapidly buying and selling the same asset in two different markets (or exchanges).
Arbitrage traders take advantage of price differences between two markets for the same asset. They buy a considerably lower asset price from an exchange offering and sell on an exchange with a higher asset price offering, thereby making profits off the asset price imbalance.
Why Is Arbitrage Important?
The practice has been in existence in other financial markets (stocks, bonds, etc.) before the cryptocurrency space came to be. It helps correct these market inefficiencies and maintain a near-uniform price of assets across the board. The benefits of arbitrage cannot be overstated, which corrects price discrepancies of an asset between exchanges. This ensures that the differences in the price of various digital assets are constantly being looked out for by exchanges using automated trading tools, making the market attain near-perfect efficiency.
There are various arbitrage strategies used today, and the most common form of arbitrage is known as pure arbitrage, which we have discussed. Other popular types of arbitrage include cross-border arbitrage, statistical arbitrage, merger arbitrage, etc. The strategy employed for an arbitrage trade depends on the expertise and experience of the arbitrageur.
The execution risk associated with arbitrage trading is its most common downside, as trades are usually expected to be executed almost instantaneously. Automated trading tools employed by exchanges today, targeted at arbitrage trading, make it harder for arbitrage traders to make reasonable profits before the price difference is corrected.