What is Triangular Arbitrage?

With a majority of the population now owning a smartphone, people use it to help themselves make the best of this technological resource–including generating profit through their investments. Triangular Arbitrage is one such investment. Although, it may sound complex and exclusive to sophisticated traders, this blog post sheds light on the potential of this rewarding opportunity, and how you can easily earn short-term benefits, too. But first, let’s understand Arbitrage.

What is Arbitrage?

Various assets are traded in high volume across different exchanges in India. However, due to market inefficiencies and differential demand-supply, the price of the asset classes may vary across platforms. For example, you may have noticed that the shares of a particular company have a different prices on the National Stock Exchange and the Bombay Stock Exchange. Investors see this as a potentially profitable opportunity.

Arbitrage is the simultaneous buying and selling of any of the securities, such as stocks, commodities, bonds, currencies, etc., in different markets to profit from the price difference. These investors, called arbitrageurs, research the price difference and buy the security from one market at a lower price and sell it in another market at a higher price.

What is Triangular Arbitrage?

As per the definition, when there is a possible advantage in arbitrage in the foreign currency exchange, this arbitrage opportunity between three currencies is known as triangular arbitrage. Such a price difference is often a result of one overvalued market and another undervalued one.

The trader makes three simultaneous deals, purchasing one currency and selling another, with the base currency being the third one. Why? When there are differences between the rate of exchange and the quoted cross-currency rate, it develops an arbitrage opportunity. This scenario may arise when a currency is overvalued against one currency but undervalued against another.

In triangular arbitrage, an investor would trade at minimum transactional costs by converting an amount at one rate (EUR/USD), thereafter converting at another rate (EUR/GBP), and lastly to the original (USD/GBP)

How does Triangular Arbitrage Work?

Assume a trader spots an arbitrage opportunity between the US dollar, Euro, and British pound. With the EUR/USD exchange rate at 1.2, the trader buys €0.83 with $1. The Euro is then used to purchase the pound at the cost of 0.90 EUR/GBP. The trader now has £0.75, which they use to purchase back the US dollar at the cost of 0.72 USD/GBP. The trader finally receives $1.04 in this manner. Now, a trader who invests only $100 will generate a profit of only $4. Similarly, if the investment is $10,000, the profit is $400. However, if the deal does not completed successfully, the trader may lose all of their money.

Automated Triangular Arbitrage

By establishing an algorithm that automatically performs a deal if certain criteria are met, automated trading platforms have streamlined the transaction execution. A trader can specify rules for entering and terminating a transaction on an automated trading platform, and the computer will execute the trade accordingly.

When considering automated triangular arbitrage, there are many advantages, such as the ability to assess historical data before any significant decision. Triangular arbitrage works with full potential when governed automatedly. Because the market is fundamentally a self-correcting system, deals occur quickly when an arbitrage opportunity emerges and then fades seconds later.

The speed of marketplaces as well as algorithmic trading platforms, on the other hand, might work against traders. The triangular arbitrage, like any other arbitrage, is a risk-free profit in principle. On the other hand, a trader can also lose money if they take a long time to complete the deal and the rate of exchange changes. If traders cannot lock in a successful price before it passes in seconds, it poses an execution risk.

Another aspect to keep in mind is that pricing variations across exchange rates (if any exist) are quite minor in triangular arbitrage. Due to the way foreign currency exchanges work in markets, price disparities between currencies are restricted to a very small margin. As a result, a large amount of money is needed during the triangular arbitrage exchange opportunity.

The Basics of Triangular Arbitrage

As described earlier, triangular arbitrage is the act of taking advantage of a foreign exchange market arbitrage opportunity arising from a price difference between three different currencies. When the market is implicit, and both the cross-exchange rates do not match, i.e., they are slightly different, then there is a chance to profit from the arbitrage by locking it.

An Arbitrageur locks in a risk-free profit from the gap that occurs during the second trade when the market crosses both exchange rates, as well as the implicit cross exchange rate, does not match. Only if there are market flaws can a lucrative agreement be made. When profitable triangular arbitrage chances occur, traders make transactions that take most benefits out of the flaws, and prices fluctuate until the opportunity vanishes. However, in the real world, triangular arbitrage possibilities are rare.

There is vast competition between forex marketers, institutional traders, and other players. Market competition is continually correcting market inefficiencies. Therefore, arbitrage possibilities are short-lived. Furthermore, cryptocurrency trading leverages the triangular arbitrage method as well. Cryptocurrency markets and exchanges are still in the early stages of development, but they provide more arbitrage opportunities than traditional currency markets. With a good triangular arbitrage strategy, one can generate good profit in a fraction of a second. Let's understand how this works.

1. Identify a triangular arbitrage opportunity. Only when the stated rate of exchange differs from the cross-exchange rate implicit market, then the triangular arbitrage possibilities arise. The following equation calculates the rate of exchange, which is the rate at which one would anticipate within the market based on the ratio of two currencies different from the currency chosen as the base.

   A/B x B/C x C/A = 1

   The currency considered as the base is A, while the other two currencies for the exchange are B and C in this equation. If the equation does not equate to unity, an arbitrage opportunity may occur.
2. Once an arbitrage opportunity has been confirmed, the trader must determine the difference between the quoted and cross-rate.
3. The trader should then execute the first leg if the differential (between quoted and cross-rate) is sufficient to generate a profit on the deal after additional expenses and charges. It is like exchanging one money for another.
4. Now, the trader must swiftly exchange the second coin for the third. This is the second leg of the bargaining process.
5. The trader changes the third currency back into the base currency in the last step (and third leg).

By reducing the bid-ask spread more than the implied rate of the cross-exchange bid-ask spread, certain multinational banks act as market makers across currencies. Market makers are naturally disciplined by the implicit cross exchange rate's bid and ask prices. When the banks' rate of stated currency diverges from cross-exchange prices, a trader who notices the difference can use a triangular arbitrage technique to benefit from the difference.

Is Triangular Arbitrage always risk-free?

The mere presence of triangular arbitrage opportunities does not imply that a currency mispricing-based strategy for trading will be consistently profitable. Using the electronic trading platform, the constituent transactions of a triangular arbitrage transaction can be submitted extremely fast.

At the same time, there is a time lag between finding such an option, starting transactions, and trades arriving at the trader stating the mispricing. Even if the delays are only for fractions of seconds, they are considered important. In case a banker or a trader sets the triangular transaction, it will not be finished if each trade is a limit order to be filled at the arbitrage price only and the price shifts due to activity in the market or a different price are given by a third party. In this instance, the trader will be charged the same amount to close down the trade as the price move that destroyed the arbitrage condition.

Many market players compete for each arbitrage opportunity in the market of foreign exchange; for arbitrage to be lucrative, a trader must discover each opportunity quicker and more efficiently than competitors. The arbitrageurs in the competition are likely to keep trying to improve their transaction speed of execution in an "electronic trading 'arms race,' according to some researchers. The expenses of staying ahead in such a rivalry make it challenging to outperform other arbitrageurs over time continuously.

Conclusion

Arbitrage is a short-term profit opportunity created by market inefficiencies. Arbitrage possibilities should not exist in an ideal environment where prices are discoverable. Even yet, triangular arbitrage opportunities are rare. You'll need powerful automated trading tools to spot a triangular arbitrage opportunity. When certain requirements are satisfied, the program will start a transaction. When market circumstances allow, triangular arbitraging is an effective technique to generate a profit with practically no risk.