How Crypto Market Making Works - Aludra July 15 Newsletter
Welcome back to the Aludra newsletter - we hope this edition finds you safe amidst these uncertain times. This week, continuing on our more technical series, we will discuss a new type of trading technique which we have been developing for the past few months and are beginning to deploy: High Frequency Trading (HFT), specifically in the context of market making. So what is HFT and what does its usage in crypto markets mean for the space?
Main Analysis: How Crypto Market Making Works
Date Written: July 15, 2020
In the past, crypto-asset markets have been typically thought of as immature compared to traditional equities and options due to the lack of sophisticated trading strategies coupled with limited infrastructure among trading venues. However, as the crypto-asset markets have continued to mature so too have the trading participants as well as the exchanges to trade on. In this article, we will discuss the growth of High Frequency Trading (HFT) and an application of HFT, market making, as it relates to todays crypto-markets.
What is High Frequency Trading?
HFT is most often referenced in the context of equities and options, and is usually what people think of when speaking about quant trading firms such as Citadel, Tower Research, D.E. Shaw, etc. All of these firms compete utilizing specific types of trading strategies, characterized by sub-second transactions and tens of thousands, if not more, transactions a day in a given instrument. We classify HFTs in the context of other market participants such as the following:
Informed Traders - Individuals who utilize information by trading assets in anticipation of their appreciation or depreciation
Fundamental Traders – Individuals who trade based on economic fundamentals of a financial instrument that are driven by activity outside of the exchange
Precisely what type of strategies we can use are often up to the discretion of the firm, and fairly customizable. However, in this article we will focus on market making, which is characterized by the willingness to buy and sell a security at any price. The objective here is to make a marginally profitable trade and repeat this process ad infinitum. Let’s take a practical example of what would happen without market makers on an exchange.
Markets without Market Makers
Consider this scenario: you are a long term investor who wants to buy a large quantity of Bitcoin. You want Bitcoin, and you’re willing to pay to take liquidity now, so you typically would use a market order. Without market makers on an exchange, it is unlikely that there will be enough liquidity to execute the entirety of your order when you submit it. But why is this so?
You submit a market order for a large quantity. Due to the lack of liquidity, the market price moves away from your order price drastically after you submit your order and a portion of your order never executes. You have to cancel your existing order, and submit a new market order at a higher price to hopefully finish executing your original intended quantity. This process continues as many times as there is liquidity left on the order book associated with your original desired quantity. All the while, you paid a higher price than you originally submitted your order at. None of this sounds appealing, does it?
To combat this, exchanges often incentivize market makers to compete against one another for the privilege of facilitating the trades of both Informed and Fundamental Traders. This incentive often comes in the form of a rebate or 0 cost limit orders once a market maker has contributed a significant amount of volume. As stated, they are simply buying on the best bid and selling on the best offer possible.
As a product of this trading activity, market making has the following effects:
Increased liquidity in a given financial product
Tightening of the average bid-ask spread of a financial product
Does this sound too good to be true? While the lucrativeness of market making is not fabricated, nor are its benefits, realizing these potential profits as a practitioner is far from simple.
Challenges of Market Making and State of Market Making in Cryptocurrency Markets
Low latency is a must in HFT
The biggest problem with executing a market making strategy is minimizing what we call “tick-to-trade.” Tick to trade refers to internal latency of a trading engine, quite literally measuring the time it takes to receive an order book update/tick to the time at which a trade can be sent to the exchange. The less time one spends on this, the earlier they can submit an order. The earlier they can submit an order, the higher the probability of them being matched with a counter party’s order.
Inventory Risk
Inherent to the success of market making strategy is not only just entering a position but being able to exit it before there is substantially large price movement in the opposite of the desired direction. Regardless as to whether an exchange gives a rebate, chronically hanging positions can be a death knell for any market maker and needs to be avoided at all costs. Beyond speed, properly managing inventory risk accounts for being able to minimize any damage from incorrect predictions
Competition and Mechanics of Exchanges
Some exchanges are more eager to attract market makers than others, as we briefly outlined above. A negative aspect of this, however, is that some exchanges can become over crowded and significantly difficult to be competitive in. Staying competitive often can come down to just being quicker, which means significant investment in technology, engineering, and perhaps even seeking co-location w/ an exchange to ensure fast as possible execution. While some market participants have the ability to explore these options, not all do.
Market Making in Crypto Markets Today
There are certainly more than a handful of prop trading firms that have begun and do very successfully trade substantial portions of digital assets. Some firms work with specific newer blockchain projects to help reduce slippage and increase trading volume of the crypto token on exchanges in an effort to promote interest in the project. Despite this current types of market making activity, we believe that its usage in the crypto space is still relatively young across the institutional market and that there is still plenty of room to grow with the industry, particularly as new exchanges are added and existing exchanges grow and advance their infrastructure to support faster trade execution.
Aludra Capital and HFT
We believe as crypto-assets continue to evolve they will more and more closely resemble financial instruments, leading way to more sophisticated investors and participants in the markets. Crypto asset trading is still in a nascent form compared to traditional assets, but the growth and advance of the asset class has been tremendous over the past few days. In keeping with this advancement, we are excited to announce that Aludra is now beginning to make markets across a variety of exchanges and crypto assets. We have recently completed the first iteration of our low latency trade execution engine and are eager to start supporting exchanges and new projects in this manner. In the coming months we will continue to roll out strategies that support the industry as a whole and also begin utilizing the HFT engine for a variety of strategies. Our commitment to creating best in class software, strategies, and partnerships will be at the forefront of this initiative. The launch of these products continues to serve as evidence of our dedication to tackling various problems and seizing a wide variety of opportunities available to us in the digital asset space.
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Disclaimer: This newsletter and article is in no way intended to provide financial advice or a recommendation of investment in any technology, virtual currency, cryptocurrency, or any financial asset. This article is for educational and informational purposes only.