What is Triangular Arbitrage?

Triangular arbitrage is a trading strategy that involves swapping between three different currencies and their pairs due to the price discrepancies among them. The goal of executing triangular arbitrage is to make a profit almost instantly. Typically, an arbitrage involves identifying price discrepancies on two different platforms or marketplaces and making profits from this difference.

With triangular arbitrage, the profit-making process involves three currencies and their respective pairs. In this case, three coins are used when a price loop cannot be found on just two pairs.

How does Arbitrage Trading Work?

To understand triangular arbitrage clearly, let us first explain what arbitrage is. Arbitrage is a strategy used in the cryptocurrency, stock, and commodity markets to take advantage of price differences among different assets and make a profit.

A profit opportunity exists when a cryptocurrency sells for a different price on two exchanges, in other countries, or against different pairs. There are many types of arbitrages. These include simple arbitrage, cross-border arbitrage, and triangular arbitrage. For triangular arbitrage, the profit opportunity is usually spotted within one trading platform and across three trading pairs. The swap then occurs in a triangular pattern, hence the name.

Triangular Arbitrage in the Cryptocurrency Market

Triangular arbitrage opportunities have been existing for hundreds of years. In the Financial markets, it is not uncommon for slight price discrepancies to occur. Price fluctuations happen every second, and some marketplaces may need to catch up with price appreciation or depreciation. This is also a function of trading volume on the market or demand and supply levels.

With Triangular arbitrage, the profit comes from swapping across three different pairs. Utilizing two pairs may not lead to profitability, hence, the need for a third pair.

Example of Triangular Arbitrage in the Crypto Market

Let’s assume the price of Bitcoin is $28,500 while Ether’s is $1850. Hence, we have the following:

BTC/USDT = $28,500
ETH/USDT = $1,850

With the values above, we expect the ETH/BTC pair to be 0.0649. That is, if Bitcoin is worth $28,500 when Ether is worth $1,850, we can buy 1 ETH with 0.0649 BTC. If the trading platform has any value other than 0.0649 for the ETH/BTC pair, it means an opportunity for triangular arbitrage exists.

With the values above, let’s assume the price for the ETH/BTC pair on the exchange is 0.0645 rather than the expected 0.0649; then, a profit-making opportunity exists.

Since the actual market price is slightly lower than the expected market price, traders can profit by buying BTC, using the BTC to buy ETH, and then selling the ETH for USDT.

Here’s the step-by-step process:

• Buy Bitcoin using USDT (Buy BTC/USDT): Using $1850 USDT, you can buy 0.0649 BTC.
• Use Bitcoin to buy Ethereum (Buy ETH/BTC): Using the 0.0649 BTC, buy ETH. Since the ETH/BTC pair on the exchange has a lower price of 0.0645, you can buy a little more than 1 ETH with the 0.0649 BTC you have. Hence, using 0.0649 BTC to buy ETH, you will have 1.0062 ETH.
• Convert the ETH back to USDT to make a profit (Sell ETH/USDT): Selling your 1.0062 ETH for $1850 per ETH will give you $1861.47.
• Your profit would be the Final Value – Initial Value = $1861.47 - $1850 = $11.47

Factors to Consider Before Executing Triangular Arbitrage

Note that the calculation above did not consider some factors that could limit profitability. Two significant factors that could limit profitability are price fluctuations and swap fees on the platform. Other factors must be considered before embarking on triangular arbitrage. These factors could reduce the profit margin of traders.

Price Fluctuations

In the cryptocurrency market, prices of assets fluctuate every second. In the process of swapping from Bitcoin to Ether to USDT, price margins may get sealed up within the twinkling of an eye. Hence, if done manually, triangular arbitrage must be executed speedily. However, the best way to perform triangular arbitrage involves using an automated trading system.

Using automated trading platforms, traders can instruct a computer or software to execute a trade once specific criteria are met. The software could be programmed to instantly buy a pair, buy another pair, and sell the final pair once a significant price gap appears. This often happens within split seconds.

Swap Fees on the Trading Platform

Some crypto exchanges have very high transaction fees. As such, the expected profit may not be enough to cover up for swapping across three pairs. When trying to execute triangular arbitrage, a trader must consider the swap fees on the platform.

Trading Volume

Arbitrage opportunities may exist on a platform, but with low trading volume, traders would be unable to profit from the price difference. The best platforms for executing triangular arbitrage are those with high transaction volume. One of the best trading platforms to perform triangular arbitrage is the Gate.io exchange. Daily, Gate.io boasts a multi-million-dollar transaction volume, even up to a billion-dollar volume or more on some days. The high transaction volume on Gate.io also helps to keep swap fees low. When using an order book to trade, transactions can be executed swiftly.

Market Volatility

The more volatile a market is, the higher the chances of catching arbitrage opportunities. When the market ranges for a long time, there may be no opportunities for price discrepancies.

Benefits of Triangular Arbitrage

• Low Risk: Traders do not need to hold an asset long when executing triangular arbitrage. Thus, the possibility of making losses because of a price crash is lower.
• Quick Profit: Executing triangular arbitrage is one of the fastest ways to profit from the crypto market. Unlike crypto investors, who typically wait for days, months, or years to profit, triangular arbitrage traders can make profits within a few minutes or hours.
• Improved Market Efficiency: When traders exploit arbitrage opportunities, it balances demand and supply in the market. When a price discrepancy between three trading pairs exists, and traders spot it, the buy and sell action leads to a market balance. Eventually, the price loophole will be sealed, and market prices become more accurate.

Limitations of Triangular Arbitrage

• Huge Capital Needed: Traders usually need a vast amount of money to make significant profits from triangular arbitrage. This is because price differences between trading pairs are typically minor.
• Price Fluctuation: The price loophole spotted between pairs can change within split seconds. If swapping is not done speedily, a trader may end up breaking even or even losing rather than making profits.
• Complexity: Triangular arbitrage is more complicated than simple arbitrage and cross-border arbitrage. It involves almost twice the effort.

Triangular Arbitrage vs. Other Types of Arbitrage

Some other famous types of arbitrage are simple arbitrage, cross-border arbitrage, and peer-to-peer arbitrage. How does triangular arbitrage compare to these?

Triangular Arbitrage vs. Simple Arbitrage

Triangular arbitrage involves three pairs and three price paths. On the other hand, simple arbitrage involves two pairs and two price paths. Triangular arbitrage can be executed on one exchange, but simple arbitrage is executed across two exchanges or trading platforms. Simple arbitrage involves buying a cryptocurrency or an asset where the price is lower and selling it where the price is higher.

For instance, if ETH/USDT is worth $1,850 on the Gate.io exchange and $1851.5 on Uniswap, traders can buy on Gate.io and sell on Uniswap. Of course, the profit margin would also depend on transaction fees on both platforms and how much capital the trader uses. Simple arbitrage is more straightforward than triangular arbitrage, but there are usually more opportunities for triangular arbitrage than simple arbitrage.

Triangular Arbitrage vs. Cross-Border Arbitrage

Cross-border arbitrage is similar to simple arbitrage. Cross-border arbitrage is executed across different countries. Because of varying laws across jurisdictions, the price of Bitcoin or Ether in one country can significantly differ from that in another. The most famous example of this is the Kimchi Premium.

In South Korea, citizens are exposed to fewer digital investment opportunities than in the Western world. Because of this, Bitcoin and Ethereum usually trade at a premium or a higher price. Thus, arbitrage traders often take advantage of this by buying crypto on regular exchanges and selling on South Korean exchanges. At certain times though, the price on South Korean exchanges could be lower when retail interest in South Korea declines. Compared to triangular arbitrage, cross-border arbitrage gives more significant profit margins.

Peer-to-Peer Arbitrage vs. Triangular Arbitrage

Peer-to-peer trading involves buying cryptocurrency directly from an individual. Many trading platforms have P2P marketplaces that support direct trading aided by an escrow. P2P traders fix their buy and sell prices and can deal with anyone who meets their terms.

Hence, P2P traders buy crypto at a lower rate and sell at a higher rate. For example, a trader may buy Bitcoin from the P2P market at $28,400 per BTC and list the BTC at $28,500. The profit is made once the Bitcoin has been sold. P2P arbitrage traders do not need to utilize bots. Trades can be executed slower, and profit would still be made. Also, peer-to-peer traders can control their profit margins compared to triangular arbitrage.

Conclusion

Triangular arbitrage involves less risk than trading cryptocurrencies or investing in them. Triangular arbitrageurs aim to profit from price differences between three pairs. Although the buy and sell trajectory for triangular arbitrage is more complex than that of simple arbitrage, it can be worth the effort. Triangular arbitrage opportunities can exist when simple arbitrage opportunities do not exist. Despite the benefits of this money-making technique, traders should consider the possible risks before embarking on triangular arbitrage.