Matthew Trudeau is chief strategy officer at crypto asset exchange ErisX. The opinions expressed in this article are the author’s own.
The following article originally appeared in Institutional Crypto by CoinDesk, a free newsletter for institutional investors interested in crypto assets. Sign up here.
Recently CoinDesk published an article titled, ‘High Frequency Trading is Newest Battle Ground in Crypto Exchange Race’ that discusses trading venues offering direct connectivity to their matching engines.
While ErisX has only recently launched its spot market, other crypto exchanges announced their intention to and/or began to enable trading firms to cross-connect (a direct network connection within the data center as opposed to a connection routed over the internet) to their matching engines at least a year ago, so this is not a new development.
Cross-connects are a standard service in global capital markets, utilized across asset classes and market participant types, so the characterization of such connectivity options as “rolling out the red carpet for high frequency traders” is peculiar. Based on the article, none of the exchanges that responded, including ErisX, actually directly offer colocation services (colocation is provided by the datacenter owners/operators).
One of our core views at ErisX is that precision in discussing any important topic is critical, be it institutional interest, custody, etc. so in this piece we are applying the same rigor when discussing “high frequency trading,” “colocation” and “data center-hosted” exchanges vs. “cloud-based” exchanges.
Because ErisX is one of the exchanges mentioned in the article as trying to attract large algorithmic traders with “colocation” offers, we want to more precisely define “algorithmic trading” and “HFT.”
We also want to explain why automated trading can be beneficial to the market and address the distinction, missing in the CoinDesk article, between “cloud” versus “data center-hosted” exchanges and why exchanges hosted in data centers present superior performance and benefits to market participants.
High frequency trading (HFT) has been a topic of debate in large part because of a lack of precision and/or understanding by commentators even in traditional markets. There are different kinds of “HFT” but for this post we will define it as automation of trading strategies enabled by computers to transact a large number of orders in fractions of a second.
Leveraging algorithms, high frequency traders analyze market conditions to manage risk and execute orders based on predefined trading strategies. Blackrock, a global investment management company, did an excellent job of further distinguishing a taxonomy of HFT strategies along with their relative impact on market quality in a 2014 whitepaper US Equity Market Structure: An Investor Perspective.
We would add to the taxonomy in the graphic below a fifth category of fraudulent or manipulative strategies that are prohibited in other markets, are not limited to HFT, and have been shown to exist, although not exclusively, on many crypto exchanges as we discussed in a previous post.
In general, automated market making and arbitrage strategies create greater efficiency in the market as depicted in the above graphic by integrating information into prices more quickly and efficiently resulting in narrower bid/offer spreads, improved price discovery, and fewer and more-fleeting instances of price discrepancies across markets when an asset type, such as Bitcoin, trades on multiple venues.
There is evidence that the cryptocurrency markets are experiencing these benefits on the more reputable exchanges as a result of increasing HFT participation.
In the past 2.5 years spreads have generally narrowed and become more stable, and price discrepancies across trading venues have become less dramatic and less frequent. The below graphic from a 2019 white paper Buying Bitcoin, published by the New York Digital Investment Group, demonstrates this effect from December 2016 through October 2018.
So, while there are a variety of trading strategies that can be automated and labeled “HFT,” some contribute to market quality while some detract from it.
It is important to note our definition of market quality includes deep liquidity and tight bid/offer spreads, supported by fair access, elimination or appropriate management of potential conflicts of interest, and technology that benefits participants.
Cloud vs Data Center Matching Engine
The CoinDesk article mistakenly states that ErisX has a “hardware matching engine.”
In fact, ErisX has located the hardware (servers etc.) upon which its matching engine software runs in a Tier 1 datacenter facility in New Jersey that services a high density of major financial firms including traditional exchanges, brokers and trading firms as well as communications firms, enabling all new and…