Crypto Market Arbitrage: Profitability and Risk Management

How to Identify Arbitrage Opportunities in Crypto and Manage Risks

Author

Nam Nguyen
March 23, 2025 • Estimated Reading Time: 9 minutes

I just got back from an investment conference in NYC. Our panel had an in-depth discussion on crypto, but aside from us, only two other panels touched on it briefly. From my interactions and the feedback I received, it’s evident that the audience is interested in crypto, but it still doesn’t get enough attention. In this issue, I feature some strategies for trading and managing risks in cryptocurrencies.

In this issue:

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  • Volatility Risk Premium: The Growing Importance of Overnight and Intraday Dynamics (12 min)

  • Exploring Credit Risk: Its Influence on Equity Strategies and Risk Management (9 min)

Conference Recap

Columbia Mathematics of Finance (MAFN) Future of Portfolio Management Conference is a gathering of top quantitative portfolio managers, data scientists, and AI/ML specialists. This year, the theme is centered largely on data and AI, with some discussion on passive vs. active investing, macro environment, and alternative assets like crypto.

The conference provided a great opportunity to engage and explore new trends in systematic trading and risk management with an AI focus.

For a summary of the conference, check out Md Amir Khan post on LinkedIn.

For more details about our panel, check out Ken Chapman's post.

Arbitrage Trading in the Cryptocurrency Market

Arbitrage trading takes advantage of price differences in different markets and/or instruments. Reference [1] examined some common and unique arbitrage trading opportunities in cryptocurrency exchanges that are not discussed often in the literature. They are,

  • Exchange futures contract funding rate arbitrage

  • Exchange futures contract intertemporal arbitrage

  • Triangular arbitrage

  • Pairs trading

  • Order book spread prediction arbitrage

I provide details about the funding rate arbitrage below. Other arbitrage strategies are described in the paper.

Cryptocurrency exchanges use the funding rate to ensure perpetual futures prices align with spot prices, improving liquidity and narrowing bid-ask spreads. This mechanism periodically compensates long or short traders based on price differences. For example, Binance settles funding payments every 8 hours to balance demand between buyers and sellers.

When the perpetual contract trades above the spot price, longs pay shorts, discouraging further price increases and encouraging shorts to push it back down. An arbitrage strategy involves shorting Bitcoin in the perpetual market while holding an equal amount in the spot market, earning funding payments with minimal exposure to price fluctuations, excluding exchange and market risks.

When the perpetual contract trades below the spot price, shorts pay longs, so we buy the futures and short the spot.

Findings

  • Research on cryptocurrency price prediction focuses on both time-series and cross-sectional analysis. 

  • This paper explores arbitrage opportunities in cryptocurrency exchanges that are often overlooked in academic literature. 

  • These arbitrage strategies can generate high returns with minimal risk. 

  • However, real market conditions and exchange constraints can reduce their effectiveness in live trading compared to backtesting. 

  • Incorporating these arbitrage strategies into a portfolio can improve the Sharpe ratio compared to simply holding cryptocurrencies.

In short, arbitrage trading is possible and profitable in the crypto market. However, we note that,

  • These trading strategies are not riskless. Drawdown can happen

  • Diversification helps smooth out the equity curves greatly

Reference

[1] Tianyu Zhou, Semi Risk-free Arbitrages with Cryptocurrency, 2022 5th International Conference on Financial Management, Education and Social Science (FMESS 2022)

The Hurst exponent is a statistical measure used to assess the long-term memory and persistence of a time series. It quantifies the tendency of a system to revert to the mean, follow a random walk, or exhibit a trending behavior. A Hurst exponent (H) value between 0 and 0.5 indicates mean-reverting behavior, H = 0.5 suggests a purely random process, and H between 0.5 and 1 signals persistent, trending behavior.

Reference [2] utilized the Detrended Fluctuation Analysis technique to study the Hurst exponent of the five major cryptocurrencies. Its main novelty is the calculation of a weekly time series of the Hurst exponent and its usage.

Findings

  • This study examines long-range correlations in the cryptocurrency market using Hurst exponents across multiple time scales. It analyzes the log-returns of the top five cryptocurrencies, covering over 70% of market capitalization from 2017 to 2023.

  • Four out of five cryptocurrencies exhibit persistent long-range correlations, while XRP follows a random walk.

  • Trend Monitoring: The Hurst exponent (H) can help detect trend continuation or reversal. Cryptocurrencies like XRP showed transitions from short-term persistence to long-term anti-persistence, which could signal trend changes.

  • Dynamic Strategy Adjustments: Rolling-window DFA estimates can track shifts in market behavior, aiding in strategy adjustments by identifying when a market moves from trend-following (H>0.5) to mean-reverting (H<0.5).

  • Asset-Specific Behavior: Different cryptocurrencies exhibit unique behavioral patterns, suggesting that H-based analysis can inform tailored trading strategies.

  • Systemic Risk Monitoring: Synchronization of H values across multiple cryptocurrencies during extreme market events may indicate rising volatility or instability, helping traders implement defensive measures like diversification.

In short, the findings suggest opportunities for using Hurst exponents as tools to monitor trend continuation or reversal, develop asset-specific strategies, and detect systemic risks during extreme market conditions, offering valuable insights for traders and policymakers navigating the cryptocurrency market’s inherent volatility.

Reference

[2] Huy Quoc Bui, Christophe Schinckus and Hamdan Amer Ali Al-Jaifi, Long-Range Correlations in Cryptocurrency Markets: A Multi-Scale DFA Approach, Physica A: Statistical Mechanics and its Applications, (2025), j.physa.2025.130417

Closing Thoughts

We have shown that arbitrage strategies in the crypto market are both possible and profitable. Additionally, risk management, trend detection, and reversal identification can be improved using the Hurst exponent, offering traders a valuable tool to navigate market volatility more effectively.

Educational Video

Stable coins and DeFi

In this talk, A. Lipton explores recent developments in the cryptocurrency ecosystem. Specifically, he reviews stable coins, their classification, potential applications, and related topics. He also addresses the emerging field of decentralized finance (DeFi), including Automated Market Makers (AMMs), yield farming, and other unique concepts. The discussion covers the mathematics, economics, and technology behind these developments, highlighting their advantages and limitations.

Volatility Weekly Recap

The figure below shows the term structures for the VIX futures (in colour) and the spot VIX (in grey).

There was a lot of volatility in the stock market this week, with significant price swings. Stocks edged higher in the final minutes of Friday's trading session after a week of sharp moves. All three major indexes ended the week in positive territory. The Dow Jones Industrial Average led the way, gaining 1.2%, while the S&P 500 rose 0.5%, and the Nasdaq Composite added 0.2%. Meanwhile, the VIX term structure shifted from steep backwardation last week to contango by the end of this week. This resulted in returns of -6.66% and -2.86% for VXX and VIXM respectively.

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Disclaimer

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