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The who, how and why of high-frequency crypto trading » Brave New Coin

In the first few years after bitcoin was launched, it was not an easy feat to buy and sell the digital currency. Peer-to-peer transactions with strangers or insecure exchanges were the only options. Fast forward to today and the crypto asset trading ecosystem has matured to the point where it offers many of the same features as the global capital markets.

Regulated exchanges,  OTC brokers, crypto funds, asset-backed tokens, tokenized securities, and billions in market capitalization have all become part of the crypto asset markets.

In the established financial markets, technology has ushered in new ways of trading over the years that have become the standard for many investors today. Notably, high-frequency trading and the use of dark pool stands out. Interestingly, these two trading tools have also ventured into the crypto asset markets an

High-frequency trading in crypto

High-frequency trading (HFT) refers to the use of algorithmic trading programmes that enable investors to make thousands of high-speed trades in a fully automated fashion on an intra-day (occurring within a day) basis. This type of trading is particularly popular among hedge funds and proprietary trading firms.

According to the Financial Times, several leading high-frequency trading houses, including DRW, Jump Trading, DV Trading, and Hehmeyer Trading have entered the crypto asset markets last year. Several newly-launched crypto hedge funds are also using algorithmic trading strategies to generate a return on investment for their investors.

Dutch high-frequency trading house, Flow Traders BV, also recently made a move into the crypto markets, according to Bloomberg. The Amsterdam-based company is making markets in exchange-traded notes linked to bitcoin and ether due to strong investor demand for crypto investments.

“People underestimate crypto. It’s big, and it is to be regulated very soon. The market participants are much more professional than people think. Institutional investors are interested — we know they are because we get requests,” Co-Chief Executive Officer Dennis Dijkstra told Bloomberg.

Moreover, even stay-at-home crypto day traders are able to build their own high-frequency trading strategies — with varying degrees of sophistication — thanks to the emergence of cryptocurrency trading bots. Cryptocurrency trading bots enable investors to build trading strategies based on specific pre-defined buy and set parameters that then automatically execute trades on behalf of the investors.

Additionally, leading bitcoin exchange Coinbase announced earlier this year that it is happy to accommodate high-frequency traders and plans to upgrade its platform to cater for this type of trading.

In light of crypto asset volatility, it should come as no surprise that high-frequency trading has found a home in the crypto asset markets as there is ample opportunity to make intra-day trading profits from trading in and out of an asset given the frequency of significant price swings. 

For example, one day of the average fluctuations in bitcoin’s price is nearly equivalent to the volatility of an interval of roughly 23 trading days for the S&P 500.  

Crypto dark pools

So-called dark pools have also made it into the crypto markets, albeit at a slower rate than high-frequency trading. In the financial markets, dark pools refer to private trading platforms where buys and sellers can execute trades out of the sight of other investors.

Investors who trade in dark pools do so for added liquidity and to prevent the market from seeing what they are buying and selling. This is especially beneficial for large institutional investors whose buy and sell orders can end up moving the market against them.

Currently, the only high-profile crypto dark pool project is Republic Protocol, which is still in testnet phase. Republic Protocol describes itself as “an open-source protocol powering dark pool exchanges” and uses its native REN token to fuel its platform.

The company has received backing from major blockchain investors such as Polychain Capital, Binary Financial and Huobi Capital to create its hidden order book for multi-chain crypto asset liquidity.

Several exchanges and online trading platforms, including TradeHill, Kraken, LakeBTC, and TradeZero, have previously launched crypto dark pools but none of them managed to gain substantial institutional investor attention back then.

Given that a large percentage of bitcoin whales prefer to trade off exchanges using OTC brokers now and that institutional investors interest is higher than ever, crypto dark pools will likely experience strong user uptake in the future.

How will HFT and dark pools affect crypto?

High-frequency trading has been demonized by regulators and pundits as it gives an unfair advantage to HFT traders over slower market participants. Additionally, high-frequency trading has been linked to the 2010 flash crash, which has added to their bad reputation. HFT proponents, however, argue that their trading activities add liquidity to the markets and help to increase market efficiency.

You could argue that more high-frequency trading in the crypto markets could lead to more volatility but there has been no data to date to support this theory. Therefore, while high-frequency traders may have an advantage over smaller market participants, their actions will not have a strong impact on long-term price developments and, thus, have a minor effect on crypto investors.

The introduction of large-scale regulated dark pools, on the other hand, will likely be beneficial for the crypto markets as it will help to attract more institutional investors and high-net-worth individuals provided these platforms manage to earn the trust of the wider investment community.

Moreover, dark pools will likely lower the cost of trading, which will then reduce costs on exchanges as they look to compete with the liquidity offered on dark pools.

While high-frequency trading and dark pools in the cryptocurrency markets may sound like a nightmare to regulators, it is more likely that these technologies will benefit the market and its participants than harm them.

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