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

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

8. September 2019. by adminBTC
Max Boonen is founder and CEO of crypto trading firm B2C2. This submit is the primary in a collection 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 replicate these of CoinDesk.  The next article initially appeared in Institutional Crypto by CoinDesk,

Max Boonen is founder and CEO of crypto trading firm B2C2. This submit is the primary in a collection 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 replicate these of CoinDesk. 

The next article initially appeared in Institutional Crypto by CoinDesk, a free weekly e-newsletter for institutional traders centered 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 had been making an entry on crypto exchanges and that this is likely to be dangerous information for retail traders.

Whereas I agree with Trudeau that, on the whole, “automated market making and arbitrage methods create higher effectivity out there,” I disagree along with his assertion that making use of the standard markets’ microstructure blueprint will enhance liquidity in crypto.

I’ll clarify under that, pushed to their restrict, the advantages of pace led to by electronification truly impair market liquidity as they morph into latency arbitrage. It’s inevitable that crypto markets grow to be a lot sooner, however there’s a vital threat that some exchanges overshoot and find yourself hurting their buyer base, re-learning the teachings 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 submit.

A short historical past of the latency arms race

Beginning within the mid 1990s, revolutionary 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 Alternate. 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 individuals would thrive. If new info originated in Chicago’s exchanges might be processed extra quickly, not solely may a buying and selling agency modify 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 modify their quotes in time, selecting them off because of that pace benefit. This is called latency arbitrage.

Trudeau reproduces a terrific graph from a 2014 BlackRock paper, itself referencing a 2010 SEC evaluate 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, had 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 thousands and thousands of {dollars} first in low-latency software program, adopted by low-latency {hardware} (GPUs then FPGAs) and low-latency communication networks, reminiscent of devoted “darkish fibre” strains (Unfold Networks, 2010) and radio-frequency towers (McKay Brothers, 2012). (Personal networks already existed; the arrival of commercially accessible ones is used as a reference level.)

Why is latency arbitrage dangerous?

Costs are fashioned by the interplay of liquidity suppliers and liquidity customers or takers. Numerous sorts of takers function on a spectrum between the latency-insensitive long-term traders, with horizons in months or years, to the quickest high-frequency takers who have interaction 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, traders wouldn’t be capable of transact effectively as consumers and sellers hardly ever want to transact in reverse instructions precisely on the similar time. In reality, with out an OTC market, how would they agree a value?

Makes an attempt to construct investor-to-investor platforms in standard markets have broadly failed. In compensation for taking the chance 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 in regards to the path of the market within the short-run (“toxicity”). Latency arbitrageurs are naturally knowledgeable about short-term path, having witnessed value adjustments 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 value could be and the way 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 quick time horizons, and spend money on pace expertise at the beginning.

Michael Lewis’ e-book, Flash Boys, famously paints a fairly unfavorable image of the HFT trade and its influence on traders. I occur to disagree with Michael Lewis – however critics of HFTs have a degree. Whereas automation in market making has diminished spreads considerably for retail traders 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, reminiscent of deliberately clogging up change information feeds with thousands and thousands of orders to make it troublesome for slower individuals to course of market information in actual time.

The issue with latency arbitrage is that it’s now largely a battle of monetary clout. As change expertise improved to maintain up with electronification, the random delays so as processing instances known as “jitter” have gone right down to just about zero, which means that whoever will get to the subsequent change first is assured to come back out forward. At zero jitter, it’s not enough for a liquidity supplier to compete even on the degree of the millisecond; even a 1 microsecond delay signifies that the latency arbitrageur’s achieve would be the market maker’s loss. Whereas anybody might be quick, just one particular person might be the quickest.

“A whole lot of 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 earning money or buying and selling everybody else’s exhaust fumes. It’s a winner-takes-all situation.”

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 spend money on expertise to compete on speeds which can be irrelevant to precise traders, fairly 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 information processing,” 14% of its 2018 buying and selling income, a rising proportion. Secondly, liquidity suppliers quote wider spreads and cut back order sizes in an effort to recoup their anticipated losses towards latency arbitrageurs; an efficient subsidy from finish customers to the quickest aggressive methods.

Mockingly, many high-frequency merchants abhor the pace recreation. 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 price of gaining an edge over different market individuals, now measured in microseconds and nanoseconds, is harming liquidity customers.” The latency drawback is a prisoner’s dilemma that leads to over-investment. “We might each be higher off not spending thousands and 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 pressured to spend money on pace, 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 as we speak?

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. For my part, the power for anybody to plan a buying and selling technique, hook up with an change and provides it a go is up there within 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 changing into the protect of the most important corporations.

Immediately, most crypto exchanges are basically web sites. That is the one approach to help many 1000’s of connections concurrently and preserve equal entry. The character of internet expertise signifies that “jitter” can’t be diminished 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 change 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 change over a interval of 5 minutes:

As a result of it’s not doable to run a low-latency, low-jitter change in an online infrastructure, combining the 2 implies that entry should be tiered – with the consequence that solely specialist corporations reminiscent of B2C2 will profit from the quickest, most costly connectivity choices. Notice that the principle tech drawback confronted by crypto exchanges is one in all 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 enhance in linked customers when shares are risky. The primary criticism that merchants have towards BitMEX, arguably probably the most profitable crypto change, is just not about latency however that the change rejects orders below heavy load.

The primary change to supply a co-location service was OKCoin in 2014, though it’s stated that nobody truly used the service. Newer exchanges that hoped to draw institutional merchants usually tend to supply co-location, or no less than bells and whistles reminiscent of FIX connections: that’s the case at Gemini, itBit and ErisX. Unsurprisingly, standard venues such because the CME supply such providers for his or her crypto providing by means of enterprise.

To today, a number of crypto exchanges are investing in pace expertise in an effort to court docket new sorts of customers. Within the quick 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 going on proper now in standard markets, which we are going to do within the subsequent installment.

Man in front of trading numbers screen picture through Shutterstock

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