Hi all!
If you’re in the U.S., I hope you enjoyed a restful and energizing Labor Day weekend. I imagine at least some of you did, since the markets have been obligingly quiet over the past few days.
To ease you back into the rigor of rapid market development, in THE BRIEFING this week, B2C2 CEO Max Boonen goes deep into the world of high speed trading in crypto markets, in what is just the first entry in a series of posts. Buckle up: you probably won’t find this level of detail anywhere else.
Next week we kick off our inaugural Invest: Asia conference. If you’re in or near Singapore on September 11-12, come on by the Marina Bay Sands Convention Center for a compelling array of panels, exhibition stands and CoinDesk Live tapings, as well as the fun networking opportunities that characterize all of our events.
Meanwhile, read on…
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Max Boonen is founder and CEO of crypto trading firm B2C2. This post is the first in a series of three that looks at high frequency trading in the context of the evolution of crypto markets. Opinions expressed within are his own and do not reflect those of CoinDesk.
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Crypto and the Latency Arms Race: Towards Speed Bumps and OTC Trading
Matthew Trudeau, chief strategy officer of ErisX, offered a thoughtful response last month to a CoinDesk article about high-frequency trading in crypto. In short, CoinDesk reported that features linked to high-frequency trading in conventional markets were making an entry on crypto exchanges and that this might be bad news for retail investors.
While I agree with Trudeau that, in general, “automated market making and arbitrage strategies create greater efficiency in the market,” I disagree with his assertion that applying the conventional markets’ microstructure blueprint will improve liquidity in crypto.
I will explain below that, pushed to their limit, the benefits of speed brought about by electronification actually impair market liquidity as they morph into latency arbitrage. It is inevitable that crypto markets become much faster, but there is a significant risk that some exchanges overshoot and end up hurting their customer base, re-learning the lessons of the conventional latency wars a little too late. Those who do will lose market share to electronic OTC liquidity providers and alternative microstructures, which I will present in this introductory post.
A brief history of the latency arms race
Starting in the mid 1990s, innovative firms such at GETCO revolutionised the US equity market by automating the process of market making, traditionally the remit of humans on the floor of the New York Stock Exchange. Those new entrants started by scraping information from the exchanges’ websites, before the APIs and trading protocols that we now take for granted.
Electronic trading firms quickly realised that faster participants would thrive. If new information originated in Chicago’s exchanges could be processed more rapidly, not only could a trading firm adjust its passive quotes there before everyone else, it could also trade against the stale orders of slower traders in New York who could not adjust their quotes in time, picking them off thanks to that speed advantage. This is known as latency arbitrage.
Trudeau reproduces a great graph from a 2014 BlackRock paper, itself referencing a 2010 SEC review of market structure. At the time, it was becoming clear that passive market making, a socially useful (“constructive”) activity, and the by-product of aggressive latency arbitrage, were two sides of the same HFT coin.
This dynamic started a frantic race to the bottom in terms of latencies, where HFT firms invested hundreds of millions of dollars first in low-latency software, followed by low-latency hardware (GPUs then FPGAs) and low-latency communication networks, such as dedicated “dark fibre” lines (Spread Networks, 2010) and radio-frequency towers (McKay Brothers, 2012). (Private networks already existed; the arrival of commercially available ones is used as a reference point.)
Why is latency arbitrage harmful?
Prices are formed by the interaction of liquidity providers and liquidity consumers or takers. Various types of takers operate on a spectrum between the latency-insensitive long-term investors, with horizons in months or years, to the fastest high-frequency takers who engage in latency arbitrage.
The business model of liquidity providers is to bridge the gap in time between buyers and sellers. Without those market makers, investors would not be able to transact efficiently as buyers and sellers rarely wish to transact in opposite directions exactly at the same time. In fact, without an OTC market, how would they agree a price?
Attempts to build investor-to-investor platforms in conventional markets have broadly failed. In compensation for taking the risk that prices may move, market makers endeavour to capture a spread. The spread set by the makers is paid by the takers and depends, inter alia, on volatility, volumes and, crucially, on the degree to which takers are on average informed about the direction of the market in the short-run (“toxicity”). Latency arbitrageurs are naturally informed about short-term direction, having witnessed price changes in another part of the market fractions of a second before others can.
Market makers concern themselves with what the fair clearing price would be and how much spread is required to compensate for a given amount of risk. They employ quantitative techniques to refine and automate this process. Latency arbitrageurs are primarily attentive to the relative direction of related markets on short time horizons, and invest in speed technology first and foremost.
Michael Lewis’ book, Flash Boys, famously paints a rather negative picture of the HFT industry and its impact on investors. I happen to disagree with Michael Lewis – but critics of HFTs have a point. While automation in market making has reduced spreads significantly for retail investors compared to the pre-internet era, it is the winner-takes-all nature of the latency arms race that is damaging to liquidity past a certain point.
The BlackRock chart presented earlier puts arbitrage on a spectrum from constructive statistical arbitrage to structural strategies that include latency arbitrage and worse, such as intentionally clogging up exchange data feeds with millions of orders to make it difficult for slower participants to process market data in real time.
The problem with latency arbitrage is that it is now mostly a battle of financial clout. As exchange technology improved to keep up with electronification, the random delays in order processing times called “jitter” have gone down to virtually zero, meaning that whoever gets to the next exchange first is guaranteed to come out ahead. At zero jitter, it is not sufficient for a liquidity provider to compete even at the level of the millisecond; even a 1 microsecond delay means that the latency arbitrageur’s gain will be the market maker’s loss. While anyone can be fast, only one person can be the fastest.
“A lot of the tech I’ve been building in the past five years has been about saving half a microsecond, equivalent to 500 nanoseconds,” explains CMT’s CTO Robert Walker. “That edge can be the difference between making money or trading everyone else’s exhaust fumes. It’s a winner-takes-all scenario.”
Therefore, latency arbitrage is harmful because it leads to a situation of natural monopoly that hurts competition. End users pay the price via two transmission mechanisms. One, the latency race has resulted in making constructive passive strategies unprofitable at all but the highest frequencies, forcing market makers to invest in technology to compete on speeds that are irrelevant to actual investors, rather than on research to improve pricing models. This represents a barrier to entry that lowers competition and increases concentration. Virtu’s latest annual report indicates that it spent $176mm on “communication and data processing,” 14% of its 2018 trading revenue, a growing proportion. Secondly, liquidity providers quote wider spreads and reduce order sizes in order to recoup their expected losses against latency arbitrageurs; an effective subsidy from end users to the fastest aggressive strategies.
Ironically, many high-frequency traders abhor the speed game. High-frequency trading firm XTX explained in a comment to the CFTC that “the race for speed in trading has reached an inflection point where the marginal cost of gaining an edge over other market participants, now measured in microseconds and nanoseconds, is harming liquidity consumers.” The latency problem is a prisoner’s dilemma that leads to over-investment . “We would both be better off not spending millions of dollars on latency, but if you do invest and I don’t, then I lose for sure.”
Latency arbitrageurs are sometimes market-making firms themselves that, having been forced to invest in speed, naturally start putting that expensive technology to more aggressive uses. Latency arbitrage is a behaviour; it does not map to a monolithic class of trading firms.
Where does crypto stand today?
Crypto trading is a web-based industry with broadly equal access. For now.
The ethos of crypto is that anyone can participate, big or small. In my opinion, the ability for anyone to devise a trading strategy, connect to an exchange and give it a go is up there in the industry’s psyche with the motto “Be your own bank.” However, just as it happened to mining, trading professionally is rapidly becoming the preserve of the biggest firms.
Today, most crypto exchanges are essentially websites. This is the only way to support many thousands of connections concurrently and maintain equal access. The nature of web technology means that “jitter” cannot be reduced much – the web is parallel, not single-thread. This acts as a natural barrier against latency arbitrageurs: a single-digit millisecond latency advantage in getting from Binance to Bitstamp is less advantageous if the internals of the exchange add a random jitter of several milliseconds. Below is a sample of latencies, in milliseconds, seen by B2C2 on a well-known crypto exchange over a period of 5 minutes:
Because it is not possible to run a low-latency, low-jitter exchange in a web infrastructure, combining the two implies that access must be tiered – with the result that only specialist firms such as B2C2 will benefit from the fastest, most expensive connectivity options. Note that the main tech problem faced by crypto exchanges is one of concurrent connections at peak load, when crypto is on the move and thousands upon thousands of users suddenly connect simultaneously. Compare to Amazon’s website around Christmas, not to the NYSE; the NYSE does not see a 10x increase in connected users when stocks are volatile. The main complaint that traders have against BitMEX, arguably the most successful crypto exchange, is not about latency but that the exchange rejects orders under heavy load.
The first exchange to offer a co-location service was OKCoin in 2014, although it is said that no one actually used the service. Newer exchanges that hoped to attract institutional traders are more likely to offer co-location, or at least bells and whistles such as FIX connections: that is the case at Gemini, itBit and ErisX. Unsurprisingly, conventional venues such as the CME offer such services for their crypto offering by way of business.
To this day, several crypto exchanges are investing in speed technology in order to court new types of users. In the short run, perhaps the next 12 months, it is likely that latencies will shrink significantly in crypto. To conjure an informed view of the longer term, though, we need to look at what is happening right now in conventional markets, which we will do in the next instalment.
– Max Boonen
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SPONSOR:
Genesis is one of the world’s largest digital currency trading and lending firms. We offer investors the ability to buy, sell, borrow and lend a multitude of assets in a trusted and regulated way. For more information visit: www.genesistrading.com or email us at info@genesistrading.com.
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* there’s not as much this week as usual (is that a sigh of relief I hear?), but in keeping with custom, these are the six articles I found most compelling
BIG IDEAS
*The Simple Case for Investing in Blockchain: Blockchain Letter, August 2019 (Pantera Capital) – The crypto asset class is one of the few as yet uncorrelated to the rest of the market.
*Reimagining the Momentum Effect: New Momentum Factors for Crypto-Assets (Jesus Rodriguez) – Blockchain data and momentum investing – it’s not just about price any more.
*Bitcoin & Macroeconomic Uncertainty (Galaxy Digital Research) – Bitcoin’s correlation established macro assets is increasing, which could suggest that the cryptocurrency is becoming part of investors’ reaction functions.
The Crypto Custody Conundrum: What Are We Even Talking About? (CoinDesk) – If we don’t even have a clear idea of what the word means, how can we figure out how best to design processes and legislation that protect crypto investors?
A Crypto Fix for a Broken International Monetary System (CoinDesk) – Michael Casey argues that instead of creating a whole new global currency, central bankers should work to develop digital currency interoperability.
Carney’s Dollar Question Has an Obvious Answer to Bitcoin Fans (Bloomberg, paywall) – The case for bitcoin as a global reserve currency.
Stop obsessing about price, Bitcoin today is stronger than ever (Tomer Federman) – In August, bitcoin’s hash rate – an indicator of the strength and security of the network – hit an all-time high.
India’s efforts to stifle cryptocurrencies could be doomed to fail (Financial Times, paywall) – How does a country go about banning a cryptocurrency?
The bitcoin price can finally be understood (FT Alphaville) – Some illuminating (um??) graphics on market factors and feedback loops.
Beyond Bitcoin: Why There Will Be More Than One Successful Cryptoasset (Forbes) – Matt Hougan of Bitwise argues that using the term “cryptocurrency” mentalizes us to think of one potential use case, whereas it’s more likely that there will be several, each with its lead asset.
Coinbase Study Says 56% of Top 50 Universities Have Crypto Classes (CoinDesk) – So many say that lack of education is the biggest barrier to adoption and investment.
*Nathaniel Whittemore (@nlw) crowdsourced the summer’s crypto trends and narrative outlook, and summarized his findings in a thought-provoking twitter thread.
MARKETS
Customers Can Deposit Bitcoin to Bakkt’s Warehouse Starting Next Week (CoinDesk) – The Intercontinental Exchange-backed bitcoin futures provider will open its custody warehouse to users on September 6, in preparation for its impending futures contract launch.
Winklevoss Twins’ Gemini Exchange Joins Silvergate Crypto Payments Network (CoinDesk) – The crypto exchange’s institutional will be able to make almost instantaneous US$ transfers to other members of the network, at any time of the day.
Binance Launches Two Crypto Futures Platforms for User Testing (CoinDesk) – The crypto exchange is asking users to vote for the platform they prefer, in exchange for trading fee discounts; it is also launching a simulated trading competition with prizes.
R3 Partners With Dubai Firm to Tap $120 Billion Sukuk Market (CoinDesk) – Dubai-based fintech startup Wethaq will use R3’s Corda blockchain to manage the sale, issuance, management and financialization of Sukuk securities, Islamic financial certificates similar to bonds.
Bitcoin’s Surge Means Smaller Rivals May Be Due for Rallies (Bloomberg, paywall) – Although bitcoin’s dominance is increasing, so is its correlation with other crypto assets.
PROFILES
Mad Crypto: The curious case of Gemini (The Block, paywall) – Although the crypto exchange appears to be struggling to grow in volumes and relevance, it has the rare luxury of focusing on a long-term strategy.
Billionaire Investor Eyes $1 Billion Crypto Hedge Fund (CoinDesk) – Elwood Asset Management, owned by Alan Howard, head of the Brevan Howard hedge fund, is launching a platform to make strategic investments in other crypto hedge funds on behalf of institutional clients.
CRUNCHING NUMBERS
Some Interesting Weekly Data from Bitcoin and Ethereum (IntoTheBlock) – Blockchain data analysis shows that sentiment remains bearish for the two leading cryptocurrencies, although ethereum has seen some intriguing large transaction activity.
Coinbase-Backed Nomics Launches Trading Transparency Product (CoinDesk) – Crypto data firm Nomics has launched a “Transparent Volume” service which filters out “fake volume” data for asset trading analysis.
CoinMarketCap is set to adjust crypto ranking standards, release metric to weed out fake volumes (The Block) – The crypto data site is tweaking its recent listing changes, which resulted in “harsher-than-expected” rank drops.
REGULATORS AT WORK
SEC Chief’s Crypto Skepticism Sets Up Facebook Clash Over Libra (Bloomberg, paywall) – Jay Clayton, chairman of the U.S. Securities and Exchange Commission, reviews the impact cryptocurrencies have had on his tenure.
Venture-Capital Stalwart Battles Washington’s Crypto Crackdown (Wall Street Journal, paywall) – At a private event earlier this year, a16z founder Marc Andreessen urged the regulators in the audience to provide both more clarity on crypto rules, and support for the technology’s development, especially given its potential role in improving the internet.
ECB’s Mersch Warns Over ‘Treacherous Promises’ of Facebook Libra (CoinDesk) – Facebook’s digital currency could weaken the ECB’s control over the euro, and undermine its international role.
Crypto Lobby Fights to Contain Backlash From Facebook’s Libra (Bloomberg, paywall) – With so much regulatory attention focused on Facebook’s stablecoin proposal, sector advocates worry that all crypto assets may come under fire.
STABLECOINS
In search for stability in crypto-assets: are stablecoins the solution? (ECB) – A report by the European Central Bank on stablecoins and their potential impact on crypto asset markets.
Crypto Exchange Says It’ll Handle Regulators Better Than Libra (Bloomberg, paywall) – Binance, the largest crypto exchange in the world in terms of volume, plans to engage with regulators from day one as it prepares to roll out its stablecoin issuance platform.
PAPERS
Facebook’s Libra: Big Bang or Big Crunch? A Technical Perspective and Challenges for Cryptocurrencies (John Taskinsoy) – The technical aspects you were afraid to ask about.
Howey should be distributing new cryptocurrencies: Applying the Howey test to mining, airdropping, forking and initial coin offerings (Benjamin Van Adrichem) – Mining, forking and airdropping are likely _not_ investment contracts, but ICOs most likely are.
Pathways to European Policy and Regulation in the Crypto-economy (HY Chiu) – EU policy development for the crypto economy should follow a “systemic” rather than a “sectoral” approach.
PODCASTS
*A16Z: Katie Haun interviews Marc Andreessen on the parallels (and differences) between the development of the internet and that of crypto – a good listen.
CRYPTO STREET PODCAST: Tyrone Ross Jr. talks about the role of cryptocurrencies in financial independence – a lot of passion in this one.
GLOBAL COIN RESEARCH: Joyce Yang and Mike Kayamori, CEO of Japan-based crypto exchange Quoine, talk about IEOs, ICOs and the development of crypto markets in Japan.
OFF THE CHAIN: Anthony Pompliano dives into an epic and wide-ranging chat with his Morgan Creek partner Mark Yusko on the characteristics of great investors, the weight of ideas, how risk is in the eye of the beholder, support for entrepreneurship, how banking is misunderstood, and how hard it is to “get” bitcoin.
A-HA!
Who Should Provide Central Bank Digital Currency? (American Institute for Economic Research) – JP Koning argues that leaving the creation of central bank digital currencies to private companies ("synthetic CBDC") with accounts at the central bank would be better for financial competition, CB efficiency and banking.
Investors should beware the smoothness of private capital returns (Financial Times, paywall) – The inflow of money into private property and private equity, in spite of the existence of REITs and mutual funds, shows that liquidity is not perhaps the investor priority the security token market would like us to think.
Exclusive: Fake-branded bars slip dirty gold into world markets (Reuters) – The gold is real, but the markings aren’t: a way to mask the bars’ true origin. A fascinating report.
*ECONTALK (podcast): Humility is essential for lifelong learning, yet people expect their leaders to show total confidence – how can we reconcile the two?
INTELLIGENCE SQUARED (podcast) – Rosamund Urwin chatted with Shoshana Zuboff about the business models behind data capture, as well as the urgent need to figure out what we want from our online activity, and, more importantly, what we don’t want.
HIDDEN BRAIN (podcast) – Harvard researcher Dan Gilbert talked about why humans are so bad at predicting our future satisfaction with a decision, how to get around that, and how sometimes it’s better to not know the outcome.
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FIRMS
Crypto custodian Kingdom Trust has filed a lawsuit against competitor BitGo and Bitcoin IRA for allegedly using its trade secrets to steal clients.
Sygnum, one of the first crypto companies to obtain a conditional banking and securities dealer license from Swiss regulators, has applied for a capital markets services license from Singapore, according to reports.
Have a tip? Drop me a line at noelle@coindesk.com. |
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In case you missed it last week, we have published the second in a series of introductory reports to crypto markets. The first one, "Crypto in Context", serves as an overall primer; "Crypto Custody", the new addition, introduces some of the challenges of asset safekeeping and provides an overview of efforts to solve them.
You can download both reports for free here.
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Previous newsletters: 37, 38, 39, 40, 41, 42, 43, 44, 45, 46, 47, 48
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CoinDesk is not an investment advisor. This newsletter is for informational purposes only, and any comments here do not constitute investment advice. |
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Institutional Crypto - Crypto Markets and the Latency Arms Race