Everyone seems to be focused on the allure of a large institutional investor jumping into the market and being the proverbial rising tide that lifts all boats.
However, as they chase headlines of one big name entry to the next, they are missing some really important entrants that are sliding in just below the surface.
These are the plethora of High Frequency Trading firms that have dived into the cryptocurrency markets. Not only have they started implementing some of their complex market making strategies but they have also brought their lighting fast trading technology with them.
In this post, we will take a look at some of the most important recent entrants into the space and the impact that this could have on the markets.
What is High Frequency Trading?
High Frequency Trading (HFT) is a catchall phrase that is used to categorise hedge funds, market makers and inter dealer brokers who employ speed as one of their prime strategies. Their edge comes from having the fastest algorithms and being able to place trades before anyone else.
In order to be the fastest on the block, HFT firms also have to make use of some of the most advanced trading algorithms in the market. They are also known as programmatic traders as they are heavily reliant on these systems to open and close trades in the blink of an eye.
In the era of electronic equity and bond exchanges, these HFT firms have proliferated and the number of assets that they have started trading has mushroomed. For example, in the below chart from a Deutsche Bank research piece you have the market share of HFT firms in the European and American equity markets.
While the market share is no doubt impressive, there is one illuminating trend. This is that the numbers have remained relatively stagnant over the past few years. In the same piece above, the Deutsche researchers pointed out that industry was facing a decline in revenue and profits.
This would actually make sense.
This because in perfectly competitive markets, the more participants there are chasing lucrative short-term arbitrage opportunities, the less these opportunities present themselves. The HFT markets have been flooded recently and have eaten up the pie of some established firms.
So, what is a highly advanced HFT firm to do when they are squeezed for profit in an established market?
Simple, they merely move to a new and relatively nascent market.
HFT Enters Crypto
Given that cryptocurrencies are still in a relatively new phase of adoption from the institutions, they are the ideal playing ground for these sophisticated and lightning fast algorithms.
Indeed, I have previously covered the profitable arbitrage opportunities that exist in the cryptoccurrency markets. One was able to take place trades on these mispricings manually with your home computer.
These market mispricings are the bread and butter of HFT firms and they were no doubt licking there lips at the risk free profit lying on the table.
Over the past year there have been many of these firms that have turned their systems and strategies onto the crypto markets. For example, you have got Jump Trading LLC , Hudson River Trading LLC, Jane Street Group LLC and Virtu Financial Inc that have all been active in the markets.
Chicago based DRW Holding LLC has even set up an entire unit focused on trading digital assets. The unit, called Cumberland, is actually one of the earliest entrants as they jumped in to the Bitcoin markets in 2014.
There have also been moves by the cryptocurrency exchanges to tailor their services to the HFT firms. For example, Coinbase announced that they would be offering HFT firms what are termed “co-location” services.
Co-location is a well-known business practice between HFT firms and exchanges where the HFT servers can be placed in the same data centre as the servers of the exchange. This gives the trader a distinct advantage as connection latency is almost eliminated.
So, the HFT firms are clearly trying to squeeze profits out of the crypto markets. There are some that are decrying it and some that are cheering it on.
What This Means for Crypto
There are quite a few people who would be skeptical of HFT firms entering the crypto markets. Indeed, they are also quite a contentious topic in their traditional stomping ground of the equity markets.
HFT firms have been singled out for having an unfair advantage and for smothering the competition. They have also been blamed for previous market chaos such as the 2010 Flash Crash that saw the Dow plummet by over 10% in a matter of seconds.
So clearly, they have their detractors and this fear could be present in the crypto markets.
However, the HFTs do provide a beneficial service especially to the likes of large institutions that the crypto community so craves. They provide vast amounts of liquidity that can quickly and easily be deployed.
Liquidity is important for institutions.
It means that they can efficiently get their orders executed without much “slippage” in their order. Mass liquidity will also drive down margins and keep them razor thin. Thin margins will benefit not only the institutions but the entire market.
Moreover, there are other institutions such as quantitative hedge funds that also trade based on computer algorithms.
These hedge funds cannot merely link up their trading systems to the like of a Coinbase or a Binance and start firing off thousands of trades per second. They need the services that are provided by specialised HFT firms.
So, in the end the HFT firms may help smooth the entrance for those institutional investors the crypto markets are hopeful for.
There is one thing that is certain to be eliminated in the presence of advanced HFT firms. This is the presence of previously lucrative arbitrage opportunities that crypto traders have been banking on.
As the HFT firms have demonstrated in the Equity and bond markets, more competition will drive down the potential opportunities for market mispricings. As more of these firms start entering the markets, these profitable trades are likely to disappear.
Indeed, it seems as if this is already the case as one will have observed that the potential for profit from arbitrage across exchanges has been drastically reduced. In some markets, one can even say that they have actually being eliminated.
So, for all those traders among us who have developed their very own crypto trading bots, you may have to find new ways to continually reinvent and keep ahead of the competition.