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28 May 2020

Crypto and the Latency Arms Race: Towards Speed Bumps and OTC Trading

Crypto and the Latency Arms Race: Towards Speed Bumps and OTC Trading

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Crypto and the Latency Arms Race: Towards Speed Bumps and OTC Trading.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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