Crypto and the Latency Arms Race: In direction of Pace Bumps and OTC Buying and selling

Max Boonen is founder and CEO of crypto trading firm B2C2. This publish is the primary in a sequence of three that appears at high-frequency buying and selling within the context of the evolution of crypto markets. Opinions expressed inside are his personal and don't mirror these of CoinDesk. 

The next article initially appeared in Institutional Crypto by CoinDesk, a free weekly publication for institutional buyers targeted on crypto property. You'll be able to sign up here.

Matthew Trudeau, chief technique officer of ErisX, provided a thoughtful response final month to a CoinDesk article about high-frequency buying and selling in crypto. Briefly, 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 likely to be unhealthy information for retail buyers.

Whereas I agree with Trudeau that, on the whole, “automated market making and arbitrage methods create larger effectivity available 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 pace caused by electronification really impair market liquidity as they morph into latency arbitrage. It's inevitable that crypto markets turn into a lot quicker, however there's a important danger that some exchanges overshoot and find yourself hurting their buyer base, re-learning the teachings of the standard latency wars just a little too late. Those that do will lose market share to digital OTC liquidity suppliers and various microstructures, which I'll current on this introductory publish.

A short historical past of the latency arms race

Beginning within the mid 1990s, progressive corporations such at GETCO revolutionised the US fairness market by automating the method 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 quicker individuals would thrive. If new info originated in Chicago’s exchanges may very well be processed extra quickly, not solely might a buying and selling agency modify its passive quotes there earlier than everybody else, it might additionally commerce towards the stale orders of slower merchants in New York who couldn't modify their quotes in time, choosing them off because of that pace benefit. This is named latency arbitrage.

Trudeau reproduces an awesome graph from a 2014 BlackRock paper, itself referencing a 2010 SEC evaluation of market construction. On the time, it was changing 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 identical HFT coin.

This dynamic began a frantic race to the underside by way of latencies, the place HFT corporations invested tons of of tens of millions of {dollars} first in low-latency software program, adopted by low-latency {hardware} (GPUs then FPGAs) and low-latency communication networks, resembling devoted “darkish fibre” strains (Unfold Networks, 2010) and radio-frequency towers (McKay Brothers, 2012). (Non-public networks already existed; the arrival of commercially obtainable ones is used as a reference level.)

Why is latency arbitrage dangerous?

Costs are shaped by the interplay of liquidity suppliers and liquidity shoppers or takers. Varied forms 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 be capable of transact effectively as consumers and sellers not often want to transact in reverse instructions precisely on the identical time. In reality, 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 danger that costs could transfer, market makers endeavour to seize a ramification. 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 concerning the course of the market within the short-run (“toxicity”). Latency arbitrageurs are naturally knowledgeable about short-term course, 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 honest clearing worth can be and the way a lot unfold is required to compensate for a given quantity of danger. They make use of quantitative methods to refine and automate this course of. Latency arbitrageurs are primarily attentive to the relative course of associated markets on brief time horizons, and put money into pace know-how in the beginning.

Michael Lewis’ e book, Flash Boys, famously paints a moderately detrimental image of the HFT trade and its influence on buyers. I occur to disagree with Michael Lewis – however critics of HFTs have a degree. Whereas automation in market making has lowered 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 offered earlier places arbitrage on a spectrum from constructive statistical arbitrage to structural methods that embrace latency arbitrage and worse, resembling deliberately clogging up trade knowledge feeds with tens of millions of orders to make it tough for slower individuals 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 trade know-how improved to maintain up with electronification, the random delays so as processing occasions known as “jitter” have gone all the way down to nearly zero, that means that whoever will get to the subsequent trade first is assured to come back out forward. At zero jitter, it's not ample for a liquidity supplier to compete even on the degree of the millisecond; even a 1 microsecond delay implies that the latency arbitrageur’s achieve would be the market maker’s loss. Whereas anybody might be quick, just one individual might be the quickest.

“Numerous the tech I’ve been constructing prior to now 5 years has been about saving half a microsecond, equal to 500 nanoseconds,” explains CMT’s CTO Robert Walker. “That edge might be the distinction between getting cash or buying and selling everybody else’s exhaust fumes. It’s a winner-takes-all state of affairs.”

Due to this fact, 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 value 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 put money into know-how to compete on speeds which can be irrelevant to precise buyers, moderately 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 scale back order sizes to be able 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 pace sport. Excessive-frequency buying and selling agency XTX defined in a comment to the CFTC that “the race for pace in buying and selling has reached an inflection level the place the marginal value of gaining an edge over different market individuals, now measured in microseconds and nanoseconds, is harming liquidity shoppers.” The latency downside is a prisoner’s dilemma that leads to over-investment. “We might each be higher off not spending tens of millions of {dollars} on latency, however if you happen to do make investments and I don’t, then I lose for certain.”

Latency arbitrageurs are typically market-making corporations themselves that, having been pressured to put money into pace, naturally begin placing that costly know-how 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 the moment?

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, large or small. In my view, the flexibility for anybody to plan a buying and selling technique, hook up with an trade and provides it a go is up there within the trade’s psyche with the motto “Be your individual financial institution.” Nonetheless, simply because it occurred to mining, buying and selling professionally is quickly changing into the protect of the largest corporations.

Right now, most crypto exchanges are primarily web sites. That is the one method to help many 1000's of connections concurrently and preserve equal entry. The character of internet know-how implies that “jitter” can't be lowered a lot – the net 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 trade add a random jitter of a number of milliseconds. Beneath is a pattern of latencies, in milliseconds, seen by B2C2 on a widely known crypto trade over a interval of 5 minutes:

As a result of it's not doable to run a low-latency, low-jitter trade in an internet infrastructure, combining the 2 implies that entry have to be tiered – with the outcome that solely specialist corporations resembling B2C2 will profit from the quickest, most costly connectivity choices. Observe that the primary tech downside confronted by crypto exchanges is one among concurrent connections at peak load, when crypto is on the transfer and 1000's upon 1000's of customers all of a sudden join concurrently. Examine 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 unstable. The principle criticism that merchants have towards BitMEX, arguably probably the most profitable crypto trade, is just not about latency however that the trade rejects orders beneath heavy load.

The primary trade to supply a co-location service was OKCoin in 2014, though it's stated that nobody really used the service. Newer exchanges that hoped to draw institutional merchants usually tend to provide co-location, or a minimum of bells and whistles resembling FIX connections: that's the case at Gemini, itBit and ErisX. Unsurprisingly, standard venues such because the CME provide such providers for his or her crypto providing by means of enterprise.

To this present day, a number of crypto exchanges are investing in pace know-how to be able to courtroom new forms of customers. Within the brief run, maybe the subsequent 12 months, it's seemingly that latencies will shrink considerably in crypto. To conjure an knowledgeable view of the long run, although, we have to take a look at what is going on proper now in standard markets, which we'll do within the subsequent installment.

Man in front of trading numbers screen picture through Shutterstock

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