I had a nice conversation this week about high-frequency trading (HFT) in crypto markets. Born out of an idea I had to explore the space generally, a bout of fortuitous timing let me speak with someone who has engaged in it first hand.
I’ve always viewed HFT as a quantitative trading style that combines individual quantitative acumen with technical tools to take advantage of price discrepancies. Market makers in stocks and derivatives markets famously deploy the technique, leveraging coding ability and technical skill to capture trading opportunities first.
Often this involves arbitrage, where one asset has two different prices on separate exchanges. If, for instance, you can buy an asset for $10 on one exchange and nearly instantly sell it for $10.25 on another, you will have essentially secured a riskless profit. Doing so over and over can be highly profitable. Some of the more well-known names in HFT are Jump Trading, Citadel Securities, Virtu and Hudson River Trading.
In popular culture, HFT has been displayed in Michael Lewis’ 2014 book “Flash Boys,” along with the 2018 film “The Hummingbird Project.” Both describe real and fictional, respectively, efforts to help HFT firms speed up their trading reaction times by fractions of a second by running a new, straighter fiber-optic line across the U.S. Today, the fastest firms use microwave or shortwave radio networks.
HFT certainly has its critics. Some write it off as outright cheating, arguing that access to faster throughput enables them to “front run” orders. Others say that it provides an unfair advantage to institutions over individuals. And others attribute rapid crashes in prices to HFT.
Use of HFT within crypto markets could amplify those critiques to symphonic levels. Still, the part of me that enjoys the marriage between markets and technology can’t help but look further.
My curiosity brought me to a conversation with Keone Hon, CEO of Monad Labs. His current firm’s mission centers around delivering a proof of chain (PoS) blockchain, which increases transaction throughput, and maintains compatibility with the Ethereum Virtual Machine (EVM). His prior role included a role as quantitative trading team lead at a separate HFT firm.
And while I spent the first half of this column discussing what I knew (or thought I knew), I’d like to spend the second half discussing what I learned. Here are some takeaways:
What HFT provides to crypto:
Part of the edge is borne out of the nascency of crypto itself. Since there are fewer participants than there are over in traditional markets, price dislocations are more common – meaning larger profits. As more participants come in, those opportunities will become more scarce.
Buyers and sellers are not necessarily prepared to trade at the same time, so HFT firms bridge that time gap, buying from sellers and vice versa.They also compete with other traders to quote prices as tightly as possible.
“At the end of the day, professional automated trading is providing a service, although it may not sound that way,” Hon said.
The different HFT strategies in use:
Candidly, this was my most selfish question. I enjoy all conversations around strategy and how individuals synthesize their own interpretation of data into a plan of action.
It was apparent that a class of strategies exists in HFT. One (mentioned previously) is arbitrage, whereby the trader is looking to take advantage of mispricings across different exchanges. Other strategies are alpha-driven, kicked off by “quantitative signals that come from measuring things happening on the order book,” Hon said.
What stood out to me during our strategy discussion was the need to not only be thoughtful in execution, but in position management and exchange evaluation. Part of the requirement of trading across exchanges involves maintaining inventory there, which brings with it additional elements of counterparty risk, particularly with centralized exchanges.
To that end, I got the sense that Hon feels that decentralized exchanges need to catch up to their centralized counterparts in terms of the user experience and quality of execution. My impression is that part of his current firm’s goal is to bridge the current gap between centralized and decentralized exchanges.
Regulation
How can you have a conversation on crypto and trading and not bring up regulation at least once? On that end, I suspect his response will surprise some. My impression is that Hon views sensible regulation as good, if for no other reason than it lets participants operate within a prescribed framework.
“It’s actually beneficial to make sure that exchanges are playing by the rules. It’s good to make sure that they have proof of reserves and assets that they claim,” Hon said.
This is actually similar to what other crypto participants have told me. A clear set of rules, implemented without malice, would enable crypto participants to operate effectively, efficiently and … quickly.
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Institutional Outlook
Ethereum Needs an Honest LIBOR
In any industry, standardization drives scale. Ethereum’s transition last year to proof of stake (PoS) unlocked an exciting opportunity to create a benchmark that tracks staking yields, which could serve as the basis for financial products that track this rate.
Under PoS, Ethereum block validators, also known as stakers, lock up a portion of their ether (ETH) as collateral to participate in the network’s consensus mechanism. In return for their participation, stakers earn rewards in the form of new protocol emissions and transaction fees.
To fully achieve the promise of this innovation, a standardized benchmark can be produced by capturing and publishing the daily, annualized mean of on-chain rewards across all validators. It would be difficult to manipulate because of the inherent transparency, replicability and immutability of the blockchain – in contrast, say, to the infamously manipulated LIBOR benchmark that powered traditional finance (TradFi) credit markets for years.
Based on a preliminary analysis of how such a benchmark would behave, average protocol emissions appear to trend downward as new validators come online. But it’s clear that the rate skyrockets with material increases to network activity resulting from a flight to safety (FTX’s insolvency) or new network activity (the recent PEPE meme coin frenzy).
A standardized ETH staking rate will provide immediate utility as:
a benchmark
a tool for risk transfer
As a benchmark, an ETH staking rate would work similarly to traditional instruments like overnight index swap (OIS) rates – delivering reference rate utility to market participants. From new crypto-native Sharpe ratios to pricing benchmarks, a standardized ETH staking rate can be used to discount future cash flows – letting investors better assess the present value of their investments in the Ethereum ecosystem.
A standard staking rate would form the underpinning of an important new tool for risk transfer. Interest among natural hedgers, especially validators, and prospective speculators will result in the inevitable formation of a forward curve resulting in swaps, futures and other derivatives. Basis swaps with traditional rates or cross-currency swaps with fiat currencies could provide an interesting new crypto rate onramp, while also allowing structured products to proliferate.
A new staking rate could unlock the next generation of financial products while serving as a building block of Ethereum’s monetary policy. As such, CESR represents an important development in the evolution of the Ethereum ecosystem and a new frontier for innovation in the world of decentralized finance and beyond.
NOTE: CoinFund recently announced that it had partnered with CoinDesk Indices to launch CESR, a composite ether staking rate.
– Christopher R. Perkins, president of CoinFund
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Takeaways
From CoinDesk Deputy Editor-in-Chief Nick Baker, here’s some news worth reading:
JUMP TRADING: The collapse of Do Kwon’s Terra ecosystem was one of the lowest points for crypto in 2022, a year full of low points. It turns out TerraUSD got secret support a year before that from Jump Trading, a giant in traditional finance (TradFi) and crypto markets, The Wall Street Journal reported this week, citing a court filing from the U.S. Securities and Exchange Commission. The article mentions a CoinDesk story from three months ago, based on anonymous sources, that reported on Jump’s role.
MASS DELISTING: Bakkt, the crypto arm of New York Stock Exchange owner Intercontinental Exchange, just delisted a bunch of crypto tokens, including those of decentralized exchanges (DEXs) Uniswap (UNI) and Sushiswap (SUSHI). “Our clients’ and their consumers’ best interests are our core commitment, and our review process ensures those interests are best served when we contemplate the most up-to-date regulatory guidance and the latest industry developments,” Bakkt said when explaining the decision. It’s hard to read that as anything other than Bakkt jettisoning tokens that it suspects U.S. regulators have deemed securities.
CRYPTO ACTIVISM: Activist investors are making waves in crypto, recently targeting Rook Labs (ROOK) and Aragon (ANT). In the Aragon case, the creator of the DAO builder’s platform suggested a $30 million token buyback to appease activists. While the dollar amounts pale next to the sums involved in many TradFi activist battles, the presence of corporate raiders in crypto is an interesting development and a sign the ways of doing things conventionally in finance continue to creep into crypto.
WILD ALLEGATIONS: When U.S. prosecutors go after someone, they usually don’t back down. But in the case of Steven Nerayoff, an early Ethereum adviser, the Department of Justice just dropped their extortion charges related to a crypto startup. The case included some stunning allegations from Nerayoff (that the U.S. government didn’t address publicly): He says that when he was arrested several years ago, he was put in a van and told to spill dirt on anyone on a long list of crypto officials, some of them prominent people like Vitalik Buterin to Caitlin Long. The U.S. government’s intense recent crackdown on crypto has given rise to conspiracy theories that the feds want to kill the industry. Nerayoff’s tale, true or not, probably only fuels those worries.
