The infrastructure of the blockchain-based world of digital assets is being built in the mould of classical finance, and that now includes high-frequency traders.
One of these is a young company domiciled in Gibraltar called Goldbaum & Partners. It is using its license in Gibraltar to introduce regulated HFT to the world of trading blockchain-based assets. “There’s been too much of the Wild West,” says Ryan Rupp French, co-founder and CEO, noting the firm is audited by accounting firm BDO. “We’re merging the new world with the old world, where institutional money comes from.”
Thomas Beute, the shop’s legal counsel, says Goldbaum began trading in February on a purely proprietary basis. Last year’s “crypto winter” had forced a delay in launching a fund, but the firm intends to open to third-party investors. The team hopes to be running around €15 million by the end of the year.
Goldbaum is co-locating its servers with a number of crypto exchanges around the world (or, more accurately, alongside exchanges’ servers in data service centers), while its software harvests all of this trade-related data and analyzes it for market signals. Because HFT strategies involve making hundreds of thousands of ultra-fast trades each day, this amounts to a huge trove of data. This information gets fed into the firm’s artificial intelligence-led programs, enabling the managers to constantly tweak the rules around trading strategies, with a view to reducing volatility or otherwise improving returns.
Goldbaum’s principals say they might consider launching a fundamental trading strategy, and are also eyeing opening an office in Hong Kong. But for now they are building up a track record with their HFT strategy – both in terms of performance, and extracting as much market data as possible.
They would not say where they are co-locating their servers, but say it’s a worldwide distribution of co-lo relationships with those exchanges offering the most liquidity. A number of crypto exchanges, such as Huobi in Singapore and Gemini in the US, have made public their desire to attract HFT flow.
The two biggest challenges to Goldbaum’s strategy are custody and market liquidity. It has established its own custody solution, but the partners note that, in general, investors remain wary of crypto-custody because there’s always vulnerabilities around accessing private keys.
In terms of liquidity, bitcoin is the only currency that enables most arb strategies. HFT relies on liquidity to function properly. Goldbaum says it can execute in milliseconds across the 100 most liquid cryptocurrencies. It also engages in futures and margin trading in bitcoin on the handful of exchanges with sufficient liquidity. But the market still lacks the ingredients for enabling options and short-selling tokens.
HFT is playing an outsized role in the young world of digital assets. In the classical world, HFT was a late arrival to an already established, hugely liquid securities market, one dominated by investors taking long-term views on stocks based on fundamental research.
But from the get-go in crypto, quant strategies (of which HFT is a subset) have been a major component of the investor universe.
A 2019 report by PwC on hedge funds in the crypto space found 37% of their strategies are quant (with 44% of strategies ‘discretionary’ and 19% ‘fundamental’). That is a far higher proportion than in classical finance. PwC estimates there are 150 active crypto hedge funds managing a combined $1 billion.
Quant funds on average charge lower management fees but higher performance fees, PwC says. In 2018, a generally bad year for crypto markets (bitcoin declined -72% against the US dollar), quant funds were the only category to generate a positive return, with the median quant house generating +8% returns.
HFT in the classical world, epitomized in Michael Lewis’s book Flash Boys, relies on super-fast trading and clever algorithms to anticipate and win trades ahead of slower players.
These firms spend vast sums on physical infrastructures – undersea cables, satellite transmissions – to create a fractional advantage in getting signals to travel just that millisecond faster than the next player.
But the most common expenditure is on co-location: paying a stock exchange a fee for the privilege of basing your proprietary server as physically close to the venue’s as possible. This has been the hardware used in campaigns to achieve the lowest possible latency – that is, the time it takes for a server to receive and process a request. Latency combined with algorithms that drive high-volume, short-horizon transactions (usually as market makers, or pursuing various arbitrage strategies) adds up to HFT.
In the US, HFT volumes can make up substantial amounts of total turnover on stock exchanges. Because the goal of HFT is blink-of-an-eye turnover generating tiny but multitudinous gains, the proprietary firms running these require little in the way of capital, making them quite lucrative.
Low latency even allows traders to cancel orders unlikely to turn a profit before a counterparty accepts a bid or offer.
HFT firms tend to compete against one another, creating a furious churn at the low-latency, quant end of the market, while long-term investors glide above the action at a more stately pace.
HFT firms have been blamed on ‘flash crashes’ in US stock markets, at which point volatility spikes can disrupt the real-money buy side. Proponents of HFT say the industry adds liquidity to markets and tightens bid/offer spreads, thereby making the industry more efficient for all investors.