What is Triangular Arbitrage in crypto and how to use it?

A triangular arbitrageur identifies market inefficiencies and executes simultaneous trades across three asset pairs while skillfully managing risk. This trading strategy, originally used in stock markets and forex, is now effectively employed by cryptocurrency traders. It allows them to profit from price differences of digital assets across various platforms.

Although complex and requiring advanced skills, the process can be simplified with the use of bots.

This article covers the basics of arbitrage and triangular arbitrage, the role of bots, benefits and risks of triangular arbitrage, and its potential future in the digital realm.

What is Arbitrage?

Arbitrage is a financial strategy where traders simultaneously buy and sell the same digital asset on different platforms to profit from price discrepancies. These price differences arise due to market inefficiencies and varying supply-demand dynamics. For example, the price of Polygon’s MATIC might slightly differ between Uniswap and PancakeSwap.

Arbitrageurs meticulously analyze these price differences, buying low in one market and selling high in another to generate profits, presenting a lucrative opportunity for investors.

What is Triangular Arbitrage?

In cryptocurrency trading, triangular arbitrage involves exploiting price discrepancies between three different cryptocurrencies. The process requires trading one asset for another as long as price differences exist between the cryptocurrency assets on different exchanges. To execute this strategy efficiently, traders must spot market irregularities, perform concurrent trades across several asset pairs, and manage risk effectively. Rapid price fluctuations in the cryptocurrency market necessitate quick responses to capitalize on these opportunities. Depending on the prices of the three cryptocurrencies, traders might use strategies like buy-buy-sell, buy-sell-buy, or sell-sell-buy to make a profit. Identifying arbitrage opportunities and employing the right method requires a sophisticated skill set. Often, traders need to complete several cycles to earn a substantial profit due to the small price differences between cryptocurrencies.

A common question among new traders is whether triangular arbitrage is illegal. It is not prohibited in most jurisdictions. It involves profiting from short-term price differences in exchange rates. However, using funds from illegal activities for trading, such as money laundering, is illegal, even though triangular arbitrage itself is legal.

Example of Triangular Arbitrage in Crypto

Suppose a crypto trader notices a triangular arbitrage opportunity with MATIC, Bitcoin, and Tether on Binance. Here’s how it works:

Step 1: Identifying the Exchange Rate Discrepancy

Assume the hypothetical exchange rates at the time of trade execution are:

• MATIC/BTC = 0.000018 BTC
• BTC/USDT = 29,500 USDT
• MATIC/USDT = 0.531 USDT (buy)
• MATIC/USDT = 0.535 USDT (sell)

Step 2: Finding an Arbitrage Opportunity

Calculate the implied cross-rate of MATIC/USDT:

(MATIC/BTC)×(BTC/USDT)=0.000018BTC×29,500USDT=0.531USDT(MATIC/BTC) \times (BTC/USDT) = 0.000018 , BTC \times 29,500 , USDT = 0.531 , USDT(MATIC/BTC)×(BTC/USDT)=0.000018BTC×29,500USDT=0.531USDT

Compare the actual MATIC/USDT rates:

• Buy rate: 0.531 USDT
• Sell rate: 0.535 USDT

Since the implied rate is lower than the sell rate, this presents an arbitrage opportunity.

Step 3: Execute Trades

The trader executes a series of trades:

1. Buy MATIC with USDT: Use 10,000 USDT to purchase MATIC at 0.531 USDT/MATIC, acquiring 18,832.61 MATIC.
2. Sell MATIC for BTC: Sell 18,832.61 MATIC for BTC at 0.000018 BTC/MATIC, resulting in 0.338987 BTC.
3. Sell BTC for USDT: Convert 0.338987 BTC into USDT at 29,500 USDT/BTC, obtaining 10,053.95 USDT.

Step 4: Calculate the Profit

• Gross profit: Final USDT amount (10,053.95 USDT) - Initial USDT amount (10,000 USDT) = 53.95 USDT

• Trading fees (assuming 0.1% per trade): 10,000USDT×0.001+10,053.95USDT×0.001=20.05USDT10,000 , USDT \times 0.001 + 10,053.95 , USDT \times 0.001 = 20.05 , USDT10,000USDT×0.001+10,053.95USDT×0.001=20.05USDT

• Net profit: Gross profit (53.95 USDT) - total fees (20.05 USDT) = 33.90 USDT

In this scenario, the trader started with 10,000 USDT and executed three trades, resulting in a net profit of 33.90 USDT by capitalizing on cryptocurrency price differences.

Algorithmic Trading Using Triangular Arbitrage

Executing triangular arbitrage manually multiple times a day is beyond human capacity, making the use of trading bots essential. These bots can analyze multiple cryptocurrency pairs simultaneously and execute arbitrage opportunities in real-time, enabling profitability from even tiny price variations across various pairs. This approach supports steady earnings and overall portfolio growth.

Triangular Arbitrage vs. Statistical Arbitrage

Triangular arbitrage and statistical arbitrage both exploit market inefficiencies. Triangular arbitrage capitalizes on pricing discrepancies among three currency pairs, often involving less leverage and quick transactions to limit exposure. Statistical arbitrage, on the other hand, involves analyzing historical pricing data and using statistical models to find trading opportunities, often requiring greater leverage and longer holding periods, increasing risk.

Triangular arbitrage vs. statistical arbitrage

	Triangular arbitrage	Statistical arbitrage
Strategy	Exploit the price difference between three cryptocurrency pairs	Exploit statistical relationships and mispricings
Risk	Relatively low if executed quickly	Differs depending on the model and securities
Time horizon	Short-term (seconds or minutes)	Short-to medium-term
Data requirements	Real-time exchange rates	Historical price data and statistical models
Profit potential	Small but frequent profits	Can be substantial but also riskier

Benefits of Triangular Arbitrage

• Transparency: Increases market liquidity and depth, facilitating significant trades without substantial price fluctuations.

• Market Capability: Helps identify and correct pricing imbalances, enhancing market efficiency and stabilizing prices.

• Profit Opportunities: Offers more profit opportunities by exploiting price disparities across multiple currency pairs.

• Risk Mitigation: Diversifies risk among several assets, reducing exposure to the volatility of a single currency.

Risks of Triangular Arbitrage

• Liquidity Risk: Insufficient market liquidity can hinder the execution of necessary trades, risking losses.

• Market Inefficiencies: Factors like execution delays and market volatility can disrupt trade timing and impact profitability.

• Slippage Risk: The time-sensitive nature of triangular arbitrage makes it susceptible to slippage, where the intended trade price differs from the actual execution price, affecting profits.

Future Evolution of Triangular Arbitrage

Rapid technological advancements and developments in financial markets may transform the triangular arbitrage landscape. As this strategy becomes more popular, increased competition might reduce profitability. Additionally, changes in regulatory policies across different countries could influence arbitrage profits. Traders need to stay flexible and adaptive to capitalize on opportunities in the evolving cryptocurrency markets.