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What Bitcoin Arbitrage Can Teach Us About the Crypto-Currency

Parabolic appreciation has thrown Bitcoin back into the spotlight, as Chinese demand for the crypto-currency sent it to an all-time high of $1,260 last Wednesday, up from $200 six weeks ago. A quick rise gave way to a steep dive after China announced a ban on financial institutions conducting Bitcoin transactions and Baidu (BIDU) stopped accepting Bitcoin payments at the end of last week. The digital currency crashed, dipping below $600 on some exchanges. Positive guidance from Bank of America (BAC), which said the currency could become a major form of transaction and gave it a $1,300 price target, and from Citigroup (NYSE:C) which suggested the currency could attract reserve managers as a complement to gold, didn't buffer the free fall at the time. Although over the weekend and into this week, Bitcoin prices have recovered and are now trading in the high $900s.

Volatility like that in markets that are regulated and not plagued by questions of legitimacy, sustainability, and safety, can be troubling. In barely-regulated, decentralized Bitcoin markets, the risk is incalculable. So how are Bitcoin traders -- yes, they do exist -- supposed to manage? The same way investors manage turbulent established markets: arbitrage.

It's a practice as old as markets themselves -- an academic paper published in the Oregon Law Review traces put-call parity back to ancient Israel; others have found evidence of arbitrage in Mesopotamia. Bitcoin has provided no exception.

Writing for ForexMagnates.com, Steve Hatzakis explains how nascent Bitcoin markets have provided ample opportunity for people to exploit price differences, in what's also known as "scalping." Disparity between prices on the different Bitcoin exchanges is significant, especially when compared to traditional equities and commodities markets:

Normally this pricing challenge isn't as pronounced (or even existent) with certain exchange traded securities or assets that are priced under any applicable best-execution regulations...Such opportunities in more developed markets are not only rarer and infrequent, but even more fleeting.

Incidentally, people have been taking advantage of inefficiencies in Bitcoin markets for some time now. Hank Stoever, a Seattle-based software engineer currently crowdfunding an open-source project to teach people how to create Bitcoin arbitrage programs, says he's seen arbitrage activity happening for years.

"The Internet is full of examples of Bitcoin arbitrage bots and discussions circa 2009," Stoever says. "So, there are definitely a lot of people out there doing it...in the past few months, my open-source project and blog posts have received continual boosts in traffic, likely due to the increased interest in Bitcoin."

Open-source algorithms like Stoever's are popular in the Bitcoin community. A quick search for algorithms across popular online Bitcoin forums, like bitcointalk.org or the "Bitcoinmarkets" subreddit, will return posts upon posts of novice Bitcion traders seeking an introduction to algorithmic arbitrage, and a slew of programmers, like Stoever, promoting their open-source bots.

On his blog, Stoever lays out a basic scenario where a trader could employ Bitcoin arbitrage. To paraphrase: Imagine the US government declares financial gains and deposits made through Bitcoin will remain untaxed forever. In turn, people rush to buy Bitcoin on the common exchanges, where liquidity may be higher and transactions are easier to conduct. Say that exchange is the Slovenia-based Bitstamp, at present one of the largest Bitcoin exchanges in the world. As people buy Bitcoins on Bitstamp, they drive the price of Bitcoins higher. Simultaneously, on a smaller exchange with lower volume like the Alpharetta, Georgia-based CampBx, prices are slower to react. For the next hour, the price of a Bitcoin on Bitstamp remains higher than on CampBx, allowing someone to buy a Bitcoin on CampBx at a lower price and sell it on Bitstamp at a higher price, locking in a risk-free profit.

This process is no different from basic currency arbitrage, where a currency is bought and sold from different brokers to exploit price disparity.

Braden Perry, a former senior trial attorney with the Commodity Futures Trading Commission (CFTC), which regulates Forex trading in the US, says he sees similarities between the early Forex market and Bitcoin markets.

"Forex essentially started the same way, and it has become automated to the point that its an extremely efficient system and people can do millions of transactions instantaneously to capture small spreads at a large scale. Right now on Forex it's efficient to do that."

Bitcoin is a different story. The large spreads between the leading US dollar Bitcoin exchanges (seen below) can seem like an attractive opportunity to squeeze a profit. But according to Félix Moreno, a portfolio manager at RF Trading in Madrid, Spain, who follows Bitcoin closely and practices Bitcoin arbitrage, taking advantage of these asynchronous markets can be problematic.

There are 84 Bitcoin exchanges currently operating. However, a mere four account for nearly all of the global trading volume: BTC China (35%), Mt.Gox (22%), Bitstamp (19%), and BTC-e (18%). Activity in the three US dollar exchanges (which exclude BTC China) is shown here. (Source:bitcoincharts.org.)

"There is a reason why there's such a large spread between exchanges. It's because there is a huge inefficiency in the way money goes in and out of them. It is extremely easy, for instance, to buy Bitcoins in Bitstamp where they are cheaper than Mt.Gox and send them to Mt.Gox where you can sell them for a higher price. But then, you can't actually get the money out of Mt.Gox to get a turnaround."

The Japan-based Mt.Gox exchange has arguably been the most high-profile example of how government regulations have crippled Bitcoin exchanges in the US. At one point, Mt.Gox was responsible for four-fifths of all global Bitcoin trading. Earlier this year, the Department of Homeland Security seized a total of $5 million from Mt.Gox after the exchange failed to register in the US as a money transmitting company. In June, Mt.Gox US temporarily suspended US dollar withdrawals claiming it did not have enough cash to convert Bitcoins. Transfers were markedly slower when withdrawals services resumed two weeks later, and they've been sluggish ever since. Trading activity on Mt.Gox has since plummeted by roughly 75%.

Mt. Gox isn't the only exchange that's been targeted by the US government. The Treasury Department''s Financial Crimes Enforcement Network (FinCen), forced the now-defunct exchange TradeHill, at one point the second largest Bitcoin exchange in the world, to shut down in 2012. Writing for The Guardian, Jerry Brito explains regulations that include " federal anti-money laundering and terrorist financing rules, as well as the cumbersome state-by-state licensing of money transmitters" have given government agencies reason to pursue Bitcoin businesses including exchanges.

Not surprisingly, this attention from local and federal government has slowed down Bitcoin trading in the US. Moreno explains that it can take weeks to get money out of Mt.Gox, as this forum titled "MtGox bitcoin withdrawal delay >:(" on the popular Bitcoin message board site bitcointalk.org confirms. The reason that Bitcoins are trading at such high premium on Mt.Gox is because money is "trapped" on the Mt.Gox exchange. The only way people can get their money out is in the form of Bitcoins, creating the demand which has inflated the price.

Liquidity factors into the issues that can deter Bitcoin arbitrageurs from scalping the markets. In addition, unpredictable volatility and the high fees for withdrawal can wipe out any profits made from Bitcoin-to-Bitcoin arbitrage.

"I've done arb myself with small amounts of money," Moreno explains. "But I've found there had to be at least a 15% difference between Bitstamp and Mt.Gox for it to be worth it. Really, even if it were 10%, you're taking too much risk. In the time it takes to move money from one [exchange] to the other, the price is going to move too much."

Instead of playing the price of Bitcoin across exchanges, Moreno favors another means of facilitating arbitrage: through open outcry.

Localbitcoins.com is a website where people looking to buy and sell Bitcoins organize in-person meet-ups with individuals or groups of people to conduct bid-ask exchanges. While technology has quieted 100-year-old open-outcry trading pits on the floors of equity, commodity, and futures exchanges around the world, ironically a currency born of technology has spurred a reemergence of the practice.

Source: Reddit.com

"It's much easier to get onto localbitcoins.com than to get onto an exchange," Moreno says of the barriers to entry. There are "know your customer" (KYC) and "anti-money laundering" (AML) compliance regulations one must submit to before joining many exchanges. Localbitcoins.com also offers an online store, where you can buy and sell Bitcoins over the Internet person to person.

"You have to send an copy of your ID, you're going to have to register, whereas with localbitcoins.com, you're just posting ads so all you need is an email address...you can call it a sort of craigslist for Bitcoin."

While using localbitcoins.comvprovides less friction than trading from exchange to exchange, it might not be where the best opportunities lie. Taariq Lewis, founder of Bitcoin Business, an advisory service that helps merchants set up Bitcoin payments, explains that as more and more people jump into and go long in Altcoins -- crypto-currencies that serve as alternatives to Bitcoin -- the more chances there are to conduct arbitrage on a single exchange rather than move between exchanges to trade Bitcoin.

Altcoin-to-Bitcoin arbitrage, and Altcoin-to-Altcoin arbitrage for that matter, look a lot less like the currency arbitrage that's been discussed so far, and a lot more like statistical arbitrage, or pair trading. Pair trading is the buying or selling of two stocks with a historical correlation, and taking advantage of that correlation to predict future movement between them and lock in profit.

As Bitcoin has grown in popularity, Altcoins like Peercoin, Securecoin, Quarkcoin, and Feathercoin have emerged in the margins, with a growing number beginning to trade on major exchanges like Bulgaria-based BTC-e alongside Bitcoin.

"Arbitrage trading really works when there are already Altcoins available to trade against, and there are price differences between them, Lewis says. "What we find is that BTC-e is currently the arbitrage king...because they are quick to offer trading in Altcoins that you might not be able to trade elsewhere, or newly launched coins that are increasing in popularity."

Imaginably, with this growing popularity of Altcoins, more and more opportunities will present themselves to Bitcoin arbitrage traders out there trying to squeeze a profit from crypto-currencies. Predicting their behavior is made a little harder, though, by the fact that the identity of Bitcoin users remains anonymous if they so choose.

So Who Are These Traders?

Before jumping into any arbitrage with Bitcoins, an investor might want to know who is on the other side of a trade. Who are the typical Bitcoin swappers? Are they traditional traders and investors? Or engineers and computer programmers?

The aforementioned Stoever, whose online, crowdfunded course on building Bitcoin arbitrage bots is currently half funded, is able to give us a clue:

It's a more technical crowd that attracts Bitcoin. Personally, I was an economics major that later shifted into a software career...I've been surveying the people who have preordered my course and the results are interesting. Seventy-seven percent of people have programming experience and 70% have finance experience. So it turns out that a lot of these people are very similar to myself in that they have a mixed bag of relevant skills, which is why Bitcoin is so attractive.

For those interested in a more more technical look at Bitcoin arbitrage, check out Stoever's blog post explaining math behind Bitcoin arbitrage yields.

See also: Can a Value Investor Buy a Bitcoin?

Twitter: @brokawbrokaw

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