Why the hesitation?
With the inevitable negative headlines that any ‘boom market’ brings, institutional cryptocurrency investors can be (understandably) hesitant. From conversations with our customers many initially worry about unreliable trade execution, as a result of the fragmentation of the crypto-exchanges. However robust solutions exist to address this.
Bitcoin has also been deemed an extremely volatile asset, with regular downturns and flash crashes, but it has had some of the largest price appreciations in modern history and in short time frames.
Legitimacy in this new asset class was boosted last year when the then UK Chancellor, Philip Hammond unveiled a fintech strategy for the UK, setting up a crypto asset task force to help businesses make best use of blockchain technology. The task force, formed from representatives from the Treasury, the Bank of England and the Financial Conduct Authority underpins a move by the UK Government to encourage new entrants into the market.
Additionally in November 2019 a legal panel led by senior High Court Judge Sir Geoffrey Vos, with the Chairman of The Law Commission of England and Wales ruled that crypto assets are legally equivalent to property with “all the indicia (signs) of property,” providing a green light to institutional investors considering crypto assets.
So what should institutional investors consider and what are the challenges?
For the most part, traditional hedge funds have avoided Bitcoin but this is definitely changing. In fact, we have seen strong interest from a select group of specialist trading hedge funds who are beginning to trade crypto assets via our link with Bitfinex, (we provide outsourced connectivity and hosting services to Bitfinex and also manage co-location services for Bitfinex’s institutional clients).
To implement a diverse investment strategy, investors can look to execute trades across many exchanges by keeping all exchange accounts open and monitoring them through different interfaces. Maintaining target allocations in this way, which institutional investors must do, is difficult. Moreover, this fragmentation of crypto-exchanges can create liquidity and slippage issues, as even small trades can consume liquidity and cause prices to slip.
Cross Crypto-Exchange Arbitrage
We have worked to overcome connectivity challenges for High Frequency Traders (HFT) firms seeking to deploy strategies such as arbitrage in crypto. Crypto arbitrage is the act of simultaneously buying on one exchange while selling on another exchange to capture an immediate profit. For example; you buy 1 BTC for a price of $10,000 on one exchange and sell instantly on another exchange that has BTC priced at a higher value, in this case say $10,100 – an instant $100 profit results.
It is important to understand the types of HFT strategies that can be pursued in crypto. Strategies include maker taker, taker taker, TWAP, iceberg and especially proprietary algorithms. So all the strategies that work in traditional finance work in Bitcoin and Ethereum, where the liquidity is higher. So this is comparable to traditional Forex platforms – very familiar territory for institutional clients.
If you have a single exchange strategy, the Bitfinex gateway, for example, can be used by traditional High Frequency Traders to connect and deploy strategies. The complexity comes if you want to connect to multiple exchanges and you have a strategy that works on two (or more) exchanges together, such as a maker/taker strategy where, for example, the trader makes on one platform and takes on a different platform. Of course every crypto-exchange has a different API set up, different mechanics and a different way to handle latency, so it is really complex. An obvious solution would be a single API to connect and route orders through multiple crypto-exchanges and this is coming, having been standard in the FX market for years.
In terms of the complexity each exchange that an HFT firm connects to can have different parameters. If an HFT firm needs to connect to ten different exchanges, it needs to have studied every single protocol, every single format of responses of APIs. This is an example of the complexity around deploying HFT strategies across multiple crypto-exchanges. Still, there is of course a lot of money to be made in cross crypto-exchange arbitrage now, with Bitcoin being so liquid.
Then there is the issue of risk management, which is a crucial element of trading in any asset class. Crypto-exchanges are perceived as being vulnerable to hackers and I often discuss with potential institutional clients the importance of checking security set ups. Our network, which is hosted in a Swiss data centre in the heart of Crypto Valley, is highly secure and reliable. We offer a FIX feed and ISP link to Bitfinex’s digital asset gateway, providing a simple and secure way for traditional trading firms to diversify and provide their clients with opportunities to trade this increasingly popular asset class.
The growth potential for HFT in crypto
According to Paolo Ardoino, CTO, Bitfinex “Spreads are still quite big. There is a big opportunity here in having the expertise of HFT. Having a latency advantage and being located nearby the data centre really brings it back to the good old days of the past where there were far fewer HFT firms. These HFT firms could make a lot of money doing cross-exchange arbitrage and exploiting the spread between one exchange and another. Now of course in traditional finance these strategies become much more difficult because of the high levels of competition. But the crypto market is still really young. There are still a lot of exchanges that send orders through web servers that are really slow. So if someone is nearby the exchange and can have a set of APIs that allow a high number of orders, the money that can be made is really high.”
Finally, but equally important, are audit and compliance needs. While institutions must monitor and retain meticulous details on their traders’ positions, triggers and pre-trade limits, the features of crypto-exchanges and the need to work across multiple exchanges create a challenging situation. As a result, many funds are trading and monitoring crypto-investments through spreadsheets. Investors need a solution that provides professional-grade trade order, execution, compliance and risk management features to meet their regulatory and operational needs.
Same issues different market
We see many of the same issues that affected connectivity in the early days of the electronic FX market coming to bear in crypo sector. Being colocated with the relevant exchange is key, as is a solid and reliable infrastructure with full 24x7 support to resolve connectivity issues quickly and effectively. All of these areas have to be covered effectively to provide a full service offering in this new market place.
Dedicated crypo funds
One interesting aspect to this market is how quickly dedicated crypto funds have appeared with all the benefits of connectivity and colocation to trade via either FIX feed or dedicated VPS solutions. This demonstrates the diversity of entities starting to trade crypto and take up is in line with what happened in the FX market. Currently there appears to be three different strands emerging. Firstly those who are trading digital assets - the private trader - likely to be from a non-trading background, who has adopted the crypto world. Secondly, the crypto funds mentioned above. And third, professional hedge funds and brokers who already trade multiple asset classes and have started to look at the crypto sector as liquidity and volatility are favourable to achieving positive alpha results.
All of these aspects show we are only at the start of this journey in the digital assets arena, with industry standards starting to be used in connectivity and trading. Matched with innovation in the digital assets custody area, the opportunities both to trade digital assets with effective risk management and compliance can only help see exponential growth over the foreseeable future. Long live digital assets!