Arbitrage

/ˈɑːbɪtrɪdʒ,ˌɑːbɪˈtrɑːʒ/ 

" the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset "

My first experience with Arbitrage was when I was probably 12 years old. As a kid studying in 7th standard, I did not quite grasp the concept then. But after all these years when I try to think about my first encounter with this beautiful business philosophy, I vividly seem to remember the year 2004.

Background Story 

Personal computers were a luxury during those times and I was privileged enough to have gotten free access to one just a year ago. This was the time when Softwares and games used to come in Floppy disks and everyone had one. But something changed that year. A salesman convinced us that we needed not just a CD reader but also a CD writer and that was probably the most amazing thing that happened to me that year. Oblivious to the fact that disk burners are gonna help me make my first “dollar” at the age of 12, I got engrossed in the new world of PC games that I could now access because I had a CD-ROM reader. Following months, a lot of my friends also ended up having personal computers. And they wanted access to the same games and Softwares that I had. I knew precisely how to make it available for them as long as they could provide me with an empty CD. I would burn the software or game into it and give it.  They weren’t paying me anything, neither did I ask. The intention was to just have common things to talk about and have fun.  Word spread soon, and people started to know me as this kid who could get any software or game they wanted. I also learned that cybercafe owners do this as well but charge a bomb. Which didn’t make a lot of sense to me because the activity hardly took any time and there wasn’t any apparent cost of doing it. But well I wanted to eat Samosas at my will, and decided to charge a small price of Rs 20 (CDs used to cost Rs 10 at that time). Let’s be honest, this was a small town in Bihar, and piracy laws in software weren’t a thing then. As a 12-year-old boy in 2004, I didn’t even know what piracy was. Very soon I went on to assembling and fixing computers around the city after school and added a new revenue stream. 

Early adopters of the Internet had a huge information arbitrage before an internet-savvy generation caught up. There were great businesses and companies built purely on information arbitrage. Google would eventually go on to disrupt this to a great extent and change the dynamics. One of the companies that used information Arbitrage to their advantage was Sify. In 2003 Sify started its i-way chain of internet cafes in India. Sify predicted (and correctly so) very early that the growing middle-class population in India will want to surf the internet and more importantly chat with strangers. In early 2004, Sify also launched integrated webcams in their internet cafes. What better than a chat? A video chat. While other small fragmented internet cafes started sprouting, Sify had capitalized on the right nerve of the Indian audience. The cabins were somewhat private with wide orange colored wooden separators and with computers that looked like they came from the future. Thinking of it now, they had built an amazing product for the audience with a seamless experience. I remember the auto-logout feature that logged the users out once their paid hours were over. Users did not want to get logged out of an active chat session and therefore ended up paying for more hours upfront.

I started my first company with 2 of my friends (I still argue that it was just a side hustle) in 2010 while I was in college. It was a services company that built websites and brand identity for other small businesses. While our first few clients were from India, we quickly started catering to clients from Australia, China, and the US. We realized that my college had an abundance of talent and high energy folks with “let’s build” attitude but not enough real-world projects. Every small business at that time wanted to have an online presence but most of the traditional agencies were outside their budget. We were early to identify the trend and build on that. Students loved us because not only they got the experience and learned cutting edge tech, the job also paid quite well for a college student. Clients loved us because we were able to beat market prices and deliver great results. We ran profitably for 3 years before we decided to pursue other career options for personal reasons.  

Banks & Financial Market

Every business big or small exploits arbitrage at different magnitude. Banks for example hugely benefit from it at various levels. The most obvious example of it is that they borrow from the market at a lesser rate and lend it to others at a higher rate. Banks lend out the borrowed money to different entities by maintaining a balance between risk and growth. The safest bet is to lend the money to RBI at the reverse repo rate but it won’t be good for the economy if the money is parked in RBI and not circulating in the market. So RBI tries to keep this behavior in check by giving low reverse repo rates and further slashing the rates every time the market is doing badly. This behavior is aimed at discouraging the bank from parking their money with RBI and further slowing down the market. There are times when an event creates a unique short term arbitrage that Banks benefit from heavily. For instance, Mutual funds generally have a large amount of liquid cash with them that’s waiting for redemption which they lend in overnight markets (a financial market where the money is borrowed only for one day and is to be returned with interest the next business day. Recently when Franklin Templeton closed 6 of its funds, the event plunged the borrow rates of overnight markets and brought it down to about 2% (which was about 3.5% a month before the event). The reverse repo rate of RBI at that time was 3.75%. Banks having access to this arbitrage doubled their gains by borrowing from overnight markets and lending to RBI at the reverse repo rates. These are some arbitrages where the access is limited to big enterprises like banks. 

Another very interesting scenario is that of Triangular arbitrage that doesn’t happen very often anymore. It’s the situation when exchange rates of three foreign exchanges do not exactly match up. In such cases, traders would exchange an amount at one rate (A->B), then again convert it to a different currency at another rate (B->C) before finally converting it into its original currency (C->A). In this process they make a profit assuming the fact that the exchange rates are not in perfect sync and the transaction costs are negligible. Not to mention, the price differences are generally in fractions of fractions and for this arbitrage to make any substantial profit, a large sum of money has to be moved. Institutions like banks with access to technology and automated systems that could execute on its own the moment they see a discrepancy in exchange rates profit from such arbitrage. 

In financial markets, there also exist arbitrage opportunities that a retail trader can benefit from. A very simple example is that of finding stocks that are traded on multiple exchanges of the same or different countries. For example in the context of India, you can buy a stock on NSE and sell on BSE if there’s an arbitrage opportunity. There are obviously things to keep in mind while executing such arbitrages but it’s in the realm of something a retail investor could do. It might sound complex at first but it is not. In fact, it is one of the simplest and most risk-averse age-old arbitrage trading techniques. The time window to execute on arbitrage trading is generally very small because big companies have automated software to spot these arbitrages. Once they start selling the stocks to take profit from the arbitrage, the cost of the stock goes down and balances itself. However, now there are APIs and softwares available for retail investors and stock traders to automate this and profit from executing such arbitrage tradings.

The concept of arbitrage is beautiful, broad, and dates back to when trading of commodity started on this planet. Almost every business uses it in some way to their benefit.  At its core, the idea is very simple. Someone somewhere in this world is ready to buy something from you at a higher price than what it cost you. As long as enough people are ignorant about the difference in prices, Arbitrage exists and benefits the one who understands it.