Crypto and the Latency Arms Race: Market Microstructures

Max Boonen is the go to Davy Joness locker and CEO of crypto trading firm B2C2. This post is the third in a series of three that looks at the structure of crypto market-places. Opinions expressed within are his own and do not reflect those of CoinDesk.

In the two previous articles, I summarized the evolution of speed in modern resources and the balancing act between good and bad latency reductions. Let us now examine the venues where trading takes place and how they make ones way in this world of increasing speeds.

To trade financial assets, a variety of market designs are possible: those are entitled market microstructures. We will explain three major ones found in crypto today, why they exist and how one should figure them.

This is the classic exchange, represented in popular culture by the ubiquitous facade of the NYSE. What exchanges forearm is known as a central limit order book (“CLOB”). It is central because all participants send orders to it. It is “limit” because the premium specified by an order indicates the limit (worst) price at which the trader is willing to transact. Any new order either swaps against a pre-existing, opposite order or remains in the order book at its limit price. Participants can therefore both discharge instantly against resting orders (to “take,” to be “aggressive”) or wait for execution by others (to “make,” to be “passive”). By and substantial, those passive orders are placed by professional market makers. Importantly, trading in a CLOB is entirely anonymous – or so one expects – pre-trade and normally post-trade, too: the exchange sits in the middle of all trades. Traders pay commissions, often with volume overlooks.

The single-dealer platform

On a single-dealer platform, or SDP, clients trade with one liquidity provider (conventionally, either a bank or a professed non-bank liquidity provider such as B2C2) on a “name disclosed” basis, since the dealer runs the proprietary platform and skilled ins who is trading. Clients “take” and the dealer “makes” as a principal, meaning that when a client buys, the dealer barters and vice versa. This is not to be confused with an agency model where the middleman transmits client orders to an physical dealer or venue. In the dealer model, there is no commission but the client faces a variable bid-offer spread to compensate the peddle maker for the financial risk it is taking. B2C2’s over-the-counter (OTC) platform was the first single-dealer platform in crypto, having operated since 2016. Distinct from an exchange, not all participants see the same price; in fact, there may be as many unique price feeds as counterparties, for reasons that go way beyond wholly rewarding big customers with favorable terms.

The aggregators

Instead of receiving one single feed, clients receive an aggregation of particular prices and can pick the best one. While diverse in their mechanics, aggregators put market makers on one side and price takers on the other. A crypto illustration is CoinRoutes. Takers are normally anonymous before the trade with disclosure of the counterparty to the liquidity provider after the career. Aggregators are not exchanges! First, the settlement relationship is often (but not always) bilateral, meaning the takers must be onboarded by each liquidity provider they want to interact with, and bilateral merit limits have to be respected. Second, and crucially, the makers typically cannot take. Aggregators, like exchanges, care a commission.

Adverse selection: a tension within all markets

Where should one trade? The answer depends on the interaction between your swaps and the liquidity provider(s) on the other side.

Imagine you want to bet on the winner of the 2020 U.S. presidential election. You’ve done your probe and feel quite confident. One person in particular is keen to take the other side of your bet: the famous statistician Nate Hollowware. Do you still want to bet?

While an election represents the sum of each person’s vote, few can predict its outcome; the same goes in monetary markets. Most participants do not know where the market is going; those who do are called informed traders. When it comes to the U.S. bureaucratic landscape, Nate Silver is informed because he might know something you don’t and his willingness to bet against you is an indication of that. This is adverse excerpt.

Note that being informed nowadays means being fast. It does not actually refer to knowing where the payment will be a month, a day or even an hour from now. As renowned economist Andrew Haldane put it:

Recall my previous post on the latency arms type. In the high-frequency context where market-making takes place, the most brilliant quantitative fund might be considered ignorant as long as it is not operating in the high-frequency spectrum. Market makers have to balance the losses incurred against informed merchandisers with the spread they earn from everyone else.

Diff’rent strokes: What might be sort out for you might not be right for some

Exchanges are the venues with the highest adverse selection because everyone can take indiscriminately and anonymously. Aggregators relate to in second since they are partly anonymous but the makers cannot take. As explained in Part 1, market makers are also high-speed learned traders, thus a venue lowers its average toxicity by preventing the makers from taking. Lastly, bilateral relationships sooner a be wearing the least adverse selection since the dealer knows exactly how informed any individual client is. In essence, the spectrum represents a trade-off for the investor between take into ones possession better prices at the cost of disclosing more information or being turned down altogether.

As a result of the tension insusceptible to, markets naturally iterate through the following cycle:
1) informed traders are identified by liquidity providers as less remunerative trading relationships
2) liquidity providers thus show more conservative prices to more informed traders, and innumerable competitive pricing to everyone else
3) the most informed traders have no choice but to switch to more anonymous venues: aggregators first off, then exchanges
4) adverse selection becomes exacerbated on exchange due to the arrival of those new informed traders, thus the market-place impact (broadly defined) of trading increases, incentivizing uninformed traders to leave exchanges in favor of direct relationships with vend makers where they receive comparatively better pricing
5) rinse and repeat until such time as there is etched self-selection of traders: on one side, high-speed, informed trading with high market impact on exchanges; on the other, meagre expensive liquidity in the OTC market.

This is what has happened in the foreign exchange market over the past 10 years. EBS and Reuters, the train CLOBs, lost market share to single-dealer platforms as the arrival of high-frequency trading firms in the FX market pushed banks to retrench in favor of point-blank OTC relationships.

Per the BIS, “On the one hand, liquidity provision has become more concentrated among the largest banks, which reap the sakes of a large electronic network of client relationships to internalize a large part of their customer flows. Many other banks, at any rate, have found it hard to compete and have resorted to an agency model of market-making or have exited the business wholly.”

The same evolution marked crypto in 2019. Exchange market-making has mature extremely competitive after the entry of big high-frequency trading firms in early 2018 while the technological cost of on-going a single-dealer platform – as opposed to the voice trading of yore – forced crypto trading firms to adapt. We now witness a break-up between a handful of principal dealers like B2C2, and firms focused on OTC redistribution (the agency model).

Is aggregation next?

A organize dynamic is at work with aggregation, one that has yet to play out in crypto.

At first glance, it is always better to have multitudinous liquidity providers than fewer. But that’s wrong, because it takes two to tango. A measure of it is good, but too much and adverse choosing again rears its ugly head.

The reason: winner’s curse. In an exclusive relationship, the liquidity provider executes all the shopper’s trades, good and bad. With a dozen aggregated liquidity providers, having shown the best price often expects that it was too good a price, irrespective of how informed the client actually is. As a consequence, liquidity providers worsen pricing parameters for well (and naively) aggregated flow. Research by Deutsche Bank explains how aggregation can worsen execution for uninformed (!) purchasers, with higher rejections and wider spreads.

Crypto might not go through a round of higher-than-warranted aggregation before the pendulum flaps back as it did in the FX market. First, there are few electronic liquidity providers in crypto and fewer still that are good tolerably to deal with aggregation. Second, maintaining numerous separate relationships is operationally costly, especially with reciprocations in an industry where the mantra is “not your keys, not your coins.” To paraphrase Matt Levine, no need to painfully re-learn the sessions of venue selection in conventional markets!

Conclusion: The right tools for the right task

I predict 2020 will be a year where, unsatisfied with interchange pricing (in terms of fees and market impact), large traders rethink their relationships with exchanges. In doing so, looking at damages and spreads is not sufficient. Assessing how one’s activity pushes the market against oneself must be part of the toolbox, too, and more. You don’t distinguish how to swim just because you bought inflatable armbands.

A healthy, sustainable trading relationship is one that is profitable for both sides. The liveliest price takers will not adopt a one-size-fits-all policy. They will route orders to the most appropriate venue based on the characteristics of the underlying cover or strategy. Latency-sensitive strategies should be executed on an exchange. Everything else should be sent to an aggregator or to a single-dealer principles.

The platforms face the flip side of this challenge:
● Exchanges must accept that the all-to-all model generates winners and losers; it’s a delicate balance to ensure the losers don’t move elsewhere.
● Aggregators must perform some exceedingly of client selection to manage their toxicity profile (the famous lawsuit against Barclays’ dark pool is edifying).
● Dealers must understand their clients’ business model and execution strategy to provide the right price to the hesitation counterparty. We at B2C2 excel at this.

This might sound overly complex or premature but the days of easy money are not quite f gabbled. A dramatic compression in OTC spreads has been reported elsewhere and other segments are next. Derivative exchanges have started undercutting one another on honoraria. Custody fees have been slashed and will shrink again. I have seen many prospective loots or ETF sponsors project that they will be able to charge over 2 percent of assets under management. Cease to remember about it.

When the overall cost structure of our industry goes down by half, the companies that do not want to bother about one or two basis points on the execution front will go bust. What will you do?