The simplest arbitrageur definition is that of a trader in the financial markets who practices arbitrage trading.
What Does Arbitrage Mean?
Arbitrage is the practice of buying and selling the same asset on two or more different markets to profit from the price difference.
The word arbitrageur – someone who engages in arbitrage trading – comes from the Latin arbitrary, meaning “to judge.”
The judgment in question relates to the way arbitrage traders (i.e., arbitrageurs) need to assess market conditions, manage risk, and carefully weigh the probability of profiting from any given arbitrage opportunity.
Roles and Functions of Arbitrageurs
Arbitrageurs act as a “corrective force” in the markets, looking for price discrepancies and forcing price convergence. In this way, they contribute to a more stable and predictable market. This price convergence ensures all markets accurately reflect the fair market value of traded assets.
Arbitrage plays a critical role in the analysis of securities markets because its effect is to bring prices to fundamental values and to keep markets efficient.
Shleifer, A., & Vishny, R. W. (1997)
Arbitrageurs also provide liquidity to the markets, especially illiquid ones. Illiquid markets often see greater price discrepancies and thus offer more lucrative arbitrage opportunities. Ample liquidity ensures a smooth trading experience and quick order fulfillment, as well as protects against market shocks such as flash crashes.
Finally, most arbitrageurs are heavily engaged in hedging. Arbitrage involves buying and selling many assets at the same time, which means owning lots of assets simultaneously. These may go up or down in price, so arbitrageurs hedge their bets to mitigate the risks of potential price volatility.
Capitalizing on Price Variations Across Markets
Arbitrageurs’ main purpose is to capitalize on price discrepancies across markets.
On market A, asset X may be trading at $100, while on market B, it may be going for $95. An arbitrageur will buy the asset on market B simultaneously selling the same amount on market A for a 5% profit.
Most arbitrageurs use automation to speed up this process, buying and selling the same asset across various markets tens, hundreds, and potentially even thousands of times a minute. Others look for more hidden arbitrage opportunities that aren’t widely known (e.g., volatility arbitrage, risk arbitrage or merger arbitrage, and ETF mispricing).
Young markets like crypto often offer superior arbitrage opportunities. In the years before the ICO boom in 2017 Bitcoin arbitrage opportunities would frequently reach 20% and beyond.
Consequences of Arbitrage on Market Dynamics
Arbitrage has profound consequences on the way virtually all markets work. Arbitrageurs are responsible for equalizing prices across crypto, FOREX, and other exchanges, even real estate markets.
Arbitrage is crucial for redistributing liquidity across markets. Suppose an asset is trading at a discount on a particular exchange, for example. In that case, an arbitrageur can buy it and fill the orders of market makers on that exchange, narrowing the bid-ask spread and perpetuating trading. Then, they can become market makers themselves on another exchange, which creates more liquidity for that market.
Technological Tools Used by Arbitrageurs
Arbitrageurs most commonly rely on automated algorithmic trading bots to do their work for them. To capitalize on price differences in highly liquid, “arbbed out” markets (i.e., markets where arbitrageur activity has reduced the profit opportunities), arbitrage traders must be incredibly quick and precise. In practice, this is only possible through the use of automated trading.
Popular arbitrage bots include those from :
An ultra-fast internet connection, multiple servers distributed around the globe, and a lot of computational power are also often necessary for profitable arbitrage today.
Conclusion
Arbitrage trading is a major part of global financial activity, providing liquidity, helping reduce market inefficiencies, and maintaining the fair value of assets across markets.
Shleifer, A., & Vishny, R. W. (1997). The limits of arbitrage. The Journal of Finance.
https://scholar.harvard.edu/files/shleifer/files/limitsofarbitrage.pdf
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