Max Boonen is founder and CEO of crypto buying and selling agency B2C2. This publish is the first in a collection of three that appears at high-frequency buying and selling in the context of the evolution of crypto markets. Opinions expressed inside are his personal and don’t replicate these of CoinDesk.
The next article initially appeared in Institutional Crypto by CoinDesk, a free weekly e-newsletter for institutional buyers centered on crypto property. You may join right here.
Matthew Trudeau, chief technique officer of ErisX, provided a considerate response final month to a CoinDesk article about high-frequency buying and selling in crypto. In brief, CoinDesk reported that options linked to high-frequency buying and selling in standard markets have been making an entry on crypto exchanges and that this is perhaps unhealthy information for retail buyers.
Whereas I agree with Trudeau that, on the whole, “automated market making and arbitrage methods create higher effectivity in the market,” I disagree together with his assertion that making use of the standard markets’ microstructure blueprint will enhance liquidity in crypto.
I’ll clarify beneath that, pushed to their restrict, the advantages of velocity led to by electronification truly impair market liquidity as they morph into latency arbitrage. It’s inevitable that crypto markets change into a lot sooner, however there’s a important threat that some exchanges overshoot and find yourself hurting their buyer base, re-learning the classes of the standard latency wars somewhat too late. Those that do will lose market share to digital OTC liquidity suppliers and different microstructures, which I’ll current on this introductory publish.
A quick historical past of the latency arms race
Beginning in the mid 1990s, modern corporations such at GETCO revolutionised the US fairness market by automating the strategy of market making, historically the remit of people on the ground of the New York Inventory Trade. These new entrants began by scraping info from the exchanges’ web sites, earlier than the APIs and buying and selling protocols that we now take with no consideration.
Digital buying and selling corporations rapidly realised that sooner members would thrive. If new info originated in Chicago’s exchanges could possibly be processed extra quickly, not solely may a buying and selling agency alter its passive quotes there earlier than everybody else, it may additionally commerce towards the stale orders of slower merchants in New York who couldn’t alter their quotes in time, selecting them off because of that velocity benefit. This is called latency arbitrage.
Trudeau reproduces an incredible graph from a 2014 BlackRock paper, itself referencing a 2010 SEC overview of market construction. At the time, it was turning into clear that passive market making, a socially helpful (“constructive”) exercise, and the by-product of aggressive latency arbitrage, have been two sides of the similar HFT coin.
This dynamic began a frantic race to the backside by way of latencies, the place HFT corporations invested tons of of hundreds of thousands of dollars first in low-latency software program, adopted by low-latency (GPUs then FPGAs) and low-latency communication networks, corresponding to devoted “darkish fibre” traces (Unfold Networks, 2010) and radio-frequency towers (McKay Brothers, 2012). (Personal networks already existed; the arrival of commercially obtainable ones is used as a reference level.)
Why is latency arbitrage dangerous?
Costs are fashioned by the interplay of liquidity suppliers and liquidity shoppers or takers. Numerous varieties of takers function on a spectrum between the latency-insensitive long-term buyers, with horizons in months or years, to the quickest high-frequency takers who interact in latency arbitrage.
The enterprise mannequin of liquidity suppliers is to bridge the hole in time between consumers and sellers. With out these market makers, buyers wouldn’t have the ability to transact effectively as consumers and sellers not often want to transact in reverse instructions precisely at the similar time. Actually, with out an OTC market, how would they agree a worth?
Makes an attempt to construct investor-to-investor platforms in standard markets have broadly failed. In compensation for taking the threat that costs could transfer, market makers endeavour to seize a diffusion. The unfold set by the makers is paid by the takers and relies upon, inter alia, on volatility, volumes and, crucially, on the diploma to which takers are on common knowledgeable about the path of the market in the short-run (“toxicity”). Latency arbitrageurs are naturally knowledgeable about short-term path, having witnessed worth modifications in one other a part of the market fractions of a second earlier than others can.
Market makers concern themselves with what the truthful clearing worth can be and how a lot unfold is required to compensate for a given quantity of threat. They make use of quantitative methods to refine and automate this course of. Latency arbitrageurs are primarily attentive to the relative path of associated markets on brief time horizons, and spend money on velocity expertise first and foremost.
Michael Lewis’ guide, Flash Boys, famously paints a slightly adverse image of the HFT trade and its impression on buyers. I occur to disagree with Michael Lewis – however critics of HFTs have some extent. Whereas automation in market making has diminished spreads considerably for retail buyers in comparison with the pre-internet period, it’s the winner-takes-all nature of the latency arms race that’s damaging to liquidity previous a sure level.
The BlackRock chart introduced earlier places arbitrage on a spectrum from constructive statistical arbitrage to structural methods that embody latency arbitrage and worse, corresponding to deliberately clogging up alternate knowledge feeds with hundreds of thousands of orders to make it troublesome for slower members to course of market knowledge in actual time.
The issue with latency arbitrage is that it’s now largely a battle of monetary clout. As alternate expertise improved to maintain up with electronification, the random delays so as processing instances known as “jitter” have gone all the way down to nearly zero, that means that whoever will get to the subsequent alternate first is assured to return out forward. At zero jitter, it isn’t enough for a liquidity supplier to compete even at the degree of the millisecond; even a 1 microsecond delay signifies that the latency arbitrageur’s acquire can be the market maker’s loss. Whereas anybody may be quick, just one individual may be the quickest.
“Numerous the tech I’ve been constructing in the previous 5 years has been about saving half a microsecond, equal to 500 nanoseconds,” explains CMT’s CTO Robert Walker. “That edge may be the distinction between being profitable or buying and selling everybody else’s exhaust fumes. It’s a winner-takes-all situation.”
Subsequently, latency arbitrage is dangerous as a result of it results in a state of affairs of pure monopoly that hurts competitors. Finish customers pay the worth through two transmission mechanisms. One, the latency race has resulted in making constructive passive methods unprofitable in any respect however the highest frequencies, forcing market makers to spend money on expertise to compete on speeds which might be irrelevant to precise buyers, slightly than on analysis to enhance pricing fashions. This represents a barrier to entry that lowers competitors and will increase focus. Virtu’s newest annual report signifies that it spent $176 million on “communication and knowledge processing,” 14% of its 2018 buying and selling income, a rising proportion. Secondly, liquidity suppliers quote wider spreads and cut back order sizes with a view to recoup their anticipated losses towards latency arbitrageurs; an efficient subsidy from finish customers to the quickest aggressive methods.
Sarcastically, many high-frequency merchants abhor the velocity sport. Excessive-frequency buying and selling agency XTX defined in a remark to the CFTC that “the race for velocity in buying and selling has reached an inflection level the place the marginal price of gaining an edge over different market members, now measured in microseconds and nanoseconds, is harming liquidity shoppers.” The latency downside is a prisoner’s dilemma that results in over-investment. “We’d each be higher off not spending hundreds of thousands of dollars on latency, however if you happen to do make investments and I don’t, then I lose for certain.”
Latency arbitrageurs are generally market-making corporations themselves that, having been compelled to spend money on velocity, naturally begin placing that costly expertise to extra aggressive makes use of. Latency arbitrage is a behaviour; it doesn’t map to a monolithic class of buying and selling corporations.
The place does crypto stand at this time?
Crypto buying and selling is a web-based trade with broadly equal entry. For now.
The ethos of crypto is that anybody can take part, huge or small. In my view, the means for anybody to plot a buying and selling technique, connect with an alternate and give it a go is up there in the trade’s psyche with the motto “Be your personal financial institution.” Nonetheless, simply because it occurred to mining, buying and selling professionally is quickly turning into the protect of the largest corporations.
At present, most crypto exchanges are primarily web sites. That is the solely option to help many hundreds of connections concurrently and preserve equal entry. The character of internet expertise signifies that “jitter” can’t be diminished a lot – the internet is parallel, not single-thread. This acts as a pure barrier towards latency arbitrageurs: a single-digit millisecond latency benefit in getting from Binance to Bitstamp is much less advantageous if the internals of the alternate add a random jitter of a number of milliseconds. Beneath is a pattern of latencies, in milliseconds, seen by B2C2 on a well known crypto alternate over a interval of 5 minutes:
As a result of it isn’t doable to run a low-latency, low-jitter alternate in an internet infrastructure, combining the two implies that entry have to be tiered – with the outcome that solely specialist corporations corresponding to B2C2 will profit from the quickest, costliest connectivity choices. Notice that the principal tech downside confronted by crypto exchanges is one in every of concurrent connections at peak load, when crypto is on the transfer and hundreds upon hundreds of customers instantly join concurrently. Evaluate to Amazon’s web site round Christmas, to not the NYSE; the NYSE doesn’t see a 10x improve in linked customers when shares are risky. The primary grievance that merchants have towards BitMEX, arguably the most profitable crypto alternate, is just not about latency however that the alternate rejects orders beneath heavy load.
The primary alternate to supply a co-location service was OKCoin in 2014, though it’s mentioned that nobody truly used the service. Newer exchanges that hoped to draw institutional merchants usually tend to supply co-location, or not less than bells and whistles corresponding to FIX connections: that’s the case at Gemini, itBit and ErisX. Unsurprisingly, standard venues corresponding to the CME supply such providers for his or her crypto providing by the use of enterprise.
To at the present time, a number of crypto exchanges are investing in velocity expertise with a view to court docket new varieties of customers. In the brief run, maybe the subsequent 12 months, it’s doubtless that latencies will shrink considerably in crypto. To conjure an knowledgeable view of the long term, although, we have to take a look at what is occurring proper now in standard markets, which we’ll do in the subsequent installment.
Man in entrance of buying and selling numbers display screen picture through Shutterstock