Last month the owner of Bitcoin arbitrage service Bitcoin Trader, John Carley, suddenly announced the service would be closed down, after which he disappeared into the ether. The service was likely set up as a Ponzi scheme rather than a real arbitrage service, but managed to operate for months despite consistently posting totally unrealistic trading results.
With the trading results at about 15 to 20 percent per month, a $10,000 investment would grow to nearly half a million in just two years’ time at this rate, and this does not even include the mining income. The consistency of the returns was the first red flag, as even the performance of the most stable asset fluctuates. Overly consistent returns are typical for Ponzi schemes and a sign of possible investment scams in general.
The reason the service got away with the previous is that it claimed to earn its income via a strategy called arbitrage, which was portrayed as a safe way of generating income by taking advantage of price differences of a single cryptocurrency at two exchanges. But even though prices will indeed differ across various exchanges, and even though real arbitrage is indeed a relatively safe strategy, the second red flag should have been the height of the returns in relation to the applied strategy.
The general principle is that risk and reward are related, and high returns do not come without high risk. At the same time, “pure” arbitrage is completely risk free in theory. So how does this mix with the results reported by Bitcoin Trader? The short answer is: it does not. To get a better understanding, consider the definition of arbitrage:
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.
For example, it could refer to buying one Bitcoin at exchange OKCoin for $323.81 while simultaneously selling one Bitcoin at exchange Bitfinex for $324.51, resulting in a profit of 70 cents or 0.22 percent. After the trade is done, the bought Bitcoin is send from OKCoin to Bitfinex to cover the short position, after which the USD is sent back to OKCoin to repeat this cycle. In reality this cycle would result in a loss as the trade fees on both exchanges are between 0.10 and 0.20 percent, while the costs of taking a short position (borrowing money) and sending USD are not included.
Most exchanges do not allow for short selling to begin with, leaving only a few exchanges and limited currency pairs on which trades can be simultaneously executed. If the trade is not simultaneous, then it is not really arbitrage. This would be the case if a coin is bought on one exchange and simply sold on another exchange, without having a short position there. Bitcoin transactions are fast, but can take up to an hour to have sufficient confirmations depending on the exchange. While waiting for the Bitcoin to become available for trading again, it is an open long position that carries price risk like any other. Cryptocurrencies are well known for their price volatility, and significant price fluctuations may occur even on very short periods of time. This could easily erase potential gains or worse.
But even if this additional risk is ignored, it can be very hard to come up with a theoretically profitable trade. Consider another example where three Bitcoins are bought at exchange Coinbase for $326.49. This time, the coins are transferred to CampBX to be sold for $338.29 per coin (note CampBX currently does not allow short selling but will make this available soon). This would leave a theoretic profit of $35.40 in total or 3.61 percent. The trade fees of 1 percent at Coinbase and 0.55 percent at CampBX should be subtracted, leaving $20.02 or 2.04 percent.
Coinbase and CampBX were chosen because they both based in the USA. The withdrawal fee at CampBX is $15, further reducing the theoretic profit to $5.02 or 0.51 percent. With a profit this small, there is a pretty big chance of losing it due to price movements, while waiting for the coin to be transferred. Even worse is that a check by mail transfer takes several days or even weeks to be processed, so it would not be possible to repeat this cycle more than once per week. Looking at CampBX’ order book only $20 worth of Bitcoin can be sold at a price above $334.02. A full coin can be sold at the latter price. Including this in the example would already the trade unprofitable unless it is allowed to execute slowly. In this scenario, the coins would carry price risk for a longer period of time.
Lastly, arbitrage actually causes prices to move closer together. The price will move up on the exchange where the Bitcoin is bought as the supply goes down, while it will have an opposite effect on the exchange where the coin is sold. This limits the ability to generate a profit on large sums of money by nature.
Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.
Altogether, it should be clear that arbitrage is not a magical strategy that allows large profits to be made without carrying any risk. Any fund that claims otherwise is either a scam, or at least taking a lot more risk than advertised.