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Why Crypto Exchanges Should Stay True to Their Retail Roots

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High-frequency trading (HFT) is prevalent in the stock market, and with volatility being suppressed by years of rising markets, it’s natural for those firms to be looking at crypto, which does not suffer from a lack of movement. The question is how crypto participants should react to this. Is it to be embraced or should we view it with caution?

To examine how traditional exchanges view HFT, we need an overview of that ecosystem. For traditional exchanges, the entire customer base is institutional. If you’ve ever bought shares as an individual, it was through a member firm that intermediates the relationship. Retail investors are kept at arm’s length.

Thus, any firm wishing to market make is facing a flow of institutional traders, which can be both large and well informed. Market makers call this “toxic flow”, because the market maker is unlikely to make a profit on the opposite side of such flow. If you need some idea of the value of non-toxic flow, look to RobinHood’s deal with Citadel. This deal is worth substantial money to Citadel (a well known HFT).

Firms that conduct high-frequency trading in traditional markets have already set their sights on the cryptocurrency market. For instance, Flow Traders BV, DRW and Jump Trading have expanded into trading digital assets like bitcoin. This trend is viewed as positive by some since automated market making is a beneficial form of HFT that is supposed to provide more liquidity.

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Market makers are necessary on exchanges because natural buyers and sellers are not in the market at exactly the same time. Participants with a specific purpose want to transact quickly and are happy to pay a spread to the market maker for the convenience. The issue for the market maker is how to flatten the risk profitably, and the answer has in recent times centered on latency. Specifically, market makers want to know when related security is re-priced, so they can re-price their orders, and take advantage of other participants who did not manage to do so.

The endgame is an ecosystem where most exchanges cater to the HFTs. Systems are made extremely low latency, with optimizations across the entire stack; fibre optic cables, layer 1 switches, Field-programmable Gate Arrays (FPGAs), the newest chips, and highly optimized software. Everything is built so that the most sophisticated customers can press their advantage.

Overdominance of HFTs Make Markets More Fragile

But the downside of exchanges catering to HFTs is a homogenization of actors, and as a consequence, fragility.

Anyone wanting to join the institutional market making game needs a very high level of technical competence to make a living. In turn, firms that specialize in this speed game tend to be winners, at the expense of a wider diversity of pricing models. If one firm can execute trades one microsecond faster than everyone else, they will realize a profit while all the slower firms lose out.

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With firms scrambling to build technology that can save as much time as possible and deliver an edge in the market, the end-users are put at a disadvantage. Also, market makers may end up providing wider spreads and reduced order sizes to manage anticipated losses against latency arbitrage, with the costs falling on regular traders.

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It is perhaps not surprising that we get an occasional ‘flash crash’. A few market makers with similar models are running the show, and from time to time it happens they all decide to pull their orders. Automated reactions to a market shock can also mean that liquidity disappears as automated traders cancel orders and halt operations before human traders step in.

How Crypto Exchanges are Responding to HFTs

Some of the major cryptocurrency exchanges have responded to the demands of HFTs by offering features such as colocation services, application programming interfaces, and institutional accounts.

However, platforms that have prioritized scalability and user experience, rather than speed, are the ones attracting the most liquidity. Colocation with a cloud host is well within reach of most institutions and even some private individuals. However, exchanges that have introduced this feature have seen hardly any impact on their volume (as most traders cannot make use of the potential of colocation services).

Other exchanges have pledged to not give any participants an upper hand over other traders. For instance, Interdax is committed to making sure that all clients have equal access to the marketplace, whether they are retail traders or using HFT strategies. Given there are enough retail market makers with a variety of pricing models, the market will be less fragile – which is exactly what Interdax will achieve.

The issue of fairness is also an overlooked aspect of markets. Institutional markets are fair to everyone who has the capital and a large team. Crypto markets encompass a wider range of actors and need to be fair to all participants. The advantages that exchanges provide for HFTs should be limited to make sure retail investors are not short-changed. After all, giving some actors preferential treatment is not consistent with the spirit of cryptocurrency (which is perhaps the most equitable asset class in existence).

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