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Triangular arbitrage

Exploiting a mismatch between a cross rate and the two dollar rates that imply it, by trading round three pairs back to the starting currency.

If EUR/GBP is quoted away from the level implied by EUR/USD and GBP/USD, a trader can convert euros to dollars, dollars to pounds, and pounds back to euros, ending with more than they started. The act of doing it pushes the three prices back into line, which is why the cross-rate stays honest.

In practice these gaps last milliseconds and are captured by automated systems co-located near matching engines. Retail platforms cannot reach them, and the bid-ask-spread on three legs usually exceeds the mispricing.

Example: EUR/USD 1.0840, GBP/USD 1.2700, so EUR/GBP should be 0.8535. A stale quote shows 0.8555. Selling EUR 1,000,000 at 0.8555 into pounds, then pounds into dollars, then dollars into euros returns about EUR 1,002,340, a EUR 2,340 gain before costs.

Related: cross-rate, latency-arbitrage, interbank-market, liquidity-provider

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Bid-ask spread in an order bookSell orders stacked above buy orders with a gap between the best of each.SELLERS (asks)50.0690050.051,40050.0460050.011,10050.002,30049.99800spread = 0.03BUYERS (bids)
The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.

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