Bitcoin & Exchange Arbitrage

First, some caveats. I spot checked exchange websites to verify these prices. It appeared like I could trade the Bitcoin/USD pair on each of these exchanges. How the exchanges adjust their local currency into USD could cause the price differences. For example, the Chinese exchange might use a delayed quote to adjust their price from Yuan to USD for advertising purposes. Then, when you try to trade you’ll see a different quote. What follows below is just a thought  exercise – do not take it as anything more.

Want to make ~10% of your money instantly?

Buy bitcoin on Poloniex and sell on LakeBTC. Poloniex lists themselves as a Wilmington, DE company whereas LakeBTC is Chinese. So if that geographical difference bothers you, then flip to GDAX or Gemini vs Poloniex where the arbitrage is closer to 5%.

The USD Bitcoin Price Spread by Exchange

Why is the Price Difference Between Bitcoin Exchanges so Big?

There is no real linkage between various Bitcoin Exchanges. Historically stock exchanges didn’t have linkages either and it was market participants who made their living arbitraging between exchanges. As more arbitrage players step in the price spread between exchanges shrinks. More players, more competition, smaller (aka “tighter”) spreads.

Why haven’t arbitrage players/market makers jumped into Bitcoin?

Well, many have. There are players in the arb game already but there are some challenging barriers to entry.

Exchanges often have API’s which allow you to connect and with a bit of code you could be on your way. Now the fun part.

Bitcoin wallets are local to the exchange.

There is no “central” wallet (that I’m currently aware of) which all the exchanges connect to. If you are trading on OKCoin you have to have a bunch of funds on that exchange. If you want to arbitrage against Gemini you need funds there, too. What happens if you buy a bunch Bitcoin on OKC and then need to sell a bunch on Gemini? Suddenly you’d be out of cash on OKC and flush with cash on Gemini. You then need to either transfer cash or Bitcoin to OKC so you can buy more on that exchange.

Great, lets transfer more cash to OKC:

This can be time consuming – will the exchange take in the funds instantly? When arb’ing time is of the essence. Additionally, many exchanges won’t take US customers. Some find ways around this of opening local companies and local bank accounts. Enter in the issue of currency.

If you’re  primarily in USD’s you might have to account for the currency conversion to the local exchnages currency. OKC is in China, so you have to get USD into Yuan and factor that into your arbitrage. When the price spread is $200 between exchanges this might not matter much – but when that spread gets tighter it may become a problem.

Option two: send Bitcoins from Gemini to OKC: Generally this is cheap and efficient. BUT, Bitcoin has been known to have some network issues that slow down the transfer of Bitcoin from one wallet to another. Particularly when the prices are really moving fast. As an arbitrager its when markets are moving fast that you’re most likely to have to move Bitcoin between wallets. Lets say you need funds at OKC immediately because you sold some at Gemini – a 5 minute delay in sending coins could wipe out your arbitrage.

Keep in mind – most arbitrage players want to trade on many exchanges simultaneously not just two. You can see how this could get confusing quite quickly.

These problems are solvable, but far from trivial.

Enter Bitcoin Exchange “counterparty” risk.

Alright, you need to keep a bunch of funds distributed to all the various exchanges on which you trade. As any long time Bitcoiner will tell you, keeping funds on an exchange brings a lot of risk. You’re exposed to everything from hackers hitting the exchange (see Poloniex) to the people that own the exchange just deciding your funds are theirs (see Mt. Gox). Certainly exchanges are getting better and more secure as they evolve. Buy lets say the Konim exchange messed up your wire transfer. They’re Turkish – do you speak Turkish? There are also plenty of stories involving US Banks which aren’t wild about your evil cryptocurrency related money transfers. So they hold up your funds.

These and others are all risk that you have to consider.

All that aside, it appears there is money to be made. Its also a safe bet that more players are going to pile in, technology will improve and the price difference between exchanges will close up. For most of us normal “buy and hodlrs” that means more efficient markets.

Whats Wall Street Waiting For?

Why Is Wall Street Slow to Move into Crypto?

  1. Regulation
  2. Clearing

Not the sexiest topics, so we’ll keep it short.

Hedge funds and Wall Street firms have been slow moving into trading and investing in cryptocurrencies such as Ethereum and Bitcoin. There are some

Enterprise Ethereum Alliance
Enterprise Ethereum Alliance

indicators that sentiment is shifting such as JP Morgan (and others) joining the Enterprise Ethereum Alliance and Goldman Sachs initiating research coverage of Bitcoin.

Assume for a second that sentiment is suddenly 100% positive and that all the “scam” and “crime” stigma has left the building. So, whats the problem?

Regulation of Bitcoin, Ethereum

Party of the beauty and attraction of crypto is the decentralization and lack of regulation. There are many reasons why this is beneficial. But if you’re a big bank or managing billions of dollars, regulation matters. First, Bitcoin is not “legal” in all countries. Just look at what China did a few months ago when they started “regulating” Bitcoin. As per wikipedia: “While private parties can hold and trade bitcoins in China, regulation prohibits financial firms like banks from doing the same.” Not only is there  (outside) risk of the US doing this, but if you’re a fund thats has Chinese investors or does business with China this clouds the water.

Most assets are also considered collateral. If I have $10 million in gold I can bet that the bank I deal with would consider that an asset against which I can borrow. Does every bank see Bitcoin in that same light?

What about tax treatment – the IRS has made some comments but I’d say nothing is set in stone. Just this month the IRS is talking to Congress about strategy.

A lower risk, but still foreseeable is the risks of regulators such as the SEC or FINRA coming after you for engaging in (for example) an investment used to launder money. Maybe you buy Monero and build up a large position and

Bitcoin SEC Regulation - image courtesy
Bitcoin SEC Regulation – image courtesy

those assets are seized because the FBI thinks they were used in some hacking blackmail scheme. Probable? Probably not. Possible? Sure.

The facts are that until a regulator “green lights” Bitcoin and/or Ethereum its going to be tough for large institutions to trade or invest.

When Might Regulators Weigh In?

I’ve been watching the SEC’s ruling on the Winklevoss Bitcoin ETF launch. Its taken years for a ruling, and earlier this year it was initially rejected. However in April the SEC decided to take another look. I think its a bit underestimated the impact that approval would have to the price of Bitcoin. This would give not only a regulatory stamp of approval, but paves the way towards clearing and settlement of Bitcoin at an institutional level.

Clearing and Settlement is a Major Problem

Take stock or ETF trading as an example. When funds (or anyone as a generalization) trade publicly listed stock that stock clears through a central clearing house called the DTC. If I am a hedge fund and have my assets at say, Goldman Sachs (your “prime broker”), I can trade stock with JP Morgan. JPM sends the stock to my account at Goldman through the DTC. Its a pretty seamless process and universal to US stock trading.

Now, lets say I’m a hedge fund and I want to buy $1 million Bitcoin. Buying is easy enough – you go to one of the exchanges, wire money and buy your Bitcoin. The problem is there is no way to get your Bitcoin back to your prime broker. No, a wallet even with vaulted cold storage wouldn’t work. The risks associated with that are high, but the mechanics of trading in and out are a huge hindrance. If the fund needs to immediately raise assets by selling Bitcoin they need to have immediate access to those coins. While yes, you can work out the mechanics if you are a small fund or “crypto” is your dedicated business. But for large institutions who want to simply invest in crypto this is a major hindrance.

How Could Clearing Change?

One possible way is for clearing houses/prime brokers like Goldman or Morgan Stanley to have some type of central clearing wallet. Linked to that wallet would be “sub-wallets” for each fund that owns Bitcoin. Therefore if I go to Gemini Exchange and buy 1000 Bitcoin, I tell Gemini to send that Bitcoin to Morgan Stanley on my behalf. Morgan Stanley then has custody and can allocate the Bitcoin to my funds sub-wallet. This “sub-wallet” concept seems to peripherally exist and I’d imagine banks could pay someone to hash it out rather quickly.

If the Bitcoin ETF launched this would circumvent all of this, because you could just buy the ETF and it would clear via the DTC like all other stocks and ETFs. (Yes, I am aware the GBTC exists, but the premium on that product is absurd). To this point I think this clearing/custodial aspect is probably one of the problems the SEC is having with the product.

In the End

I’m confident these issues will be worked out. The fact that they haven’t yet makes (in my opinion) Bitcoin and Ethereum such an interesting investment at the moment. The door is currently cracked open to big investors, but eventually we could see a real flood of assets.