High frequency crypto traders could get the same perks as equity traders, but without the drawbacks

Wall Street traders are a needy bunch. 

They want liquidity, robust platforms to trade on, and of course those ubiquitous gray vests with which they can flaunt their respective firms.

In some cases, however, traders want even more than that, according to Kraken chief executive officer Jesse Powell. 

In an interview with The Block, Powell outlined some of the desires of certain large traders on his platform, shedding light on his own personal views on market structure. According to Powell, many traders in the cryptocurrency market are seeking out sweetheart deals to give them advantages over other participants. 

"The big folks, the institutional folks, they generally want advantages in the market," Powell said. 

Colocation

Those "advantages" include, according to Powell, services commonly offered in traditional U.S. equity markets, such as colocation and trading rebates, but are only just finding their way to the nascent digital asset market. Huobi, an Asia-based exchange, is one such firm that has begun offering colocation, the ability to link directly to an exchange's matching engine within the same data center. ErisX, a Chicago-based trading operation, also offers colocation to clients, as does Gemini and London-based Blockchain.com, which recently launched its exchange The Pit. Powell said Kraken is not interested in offering colocation-related services. 

Indeed, it is a controversial practice on Wall Street, despite its prevalence. The way it works is relatively simple. High-speed traders — the Jump Trading and HRTs of the world — store their servers close to where trades are matched, allowing them to interact with the market more quickly than traders putting in an order further away. In the early days of HFTs, speed translated into huge profits. 

Ultimately, as the space got more crowded, the tables turned. Tabb Group estimates that HFT revenues from U.S. equity trading shrunk from $5.7 billion in 2010 to $1.8 billion last year. At the same time, exchanges continued to increase the different tiers of connection. First, from a one gigabyte connection to five gigabyte to 20 — and so on. Traders weren't necessarily asking for more connection, but rolling out new tiers of colocation is a lucrative business for exchanges. 

Or as one market structure observer put it: "There is huge value in colocation in equities, but the cost of extracting the value is almost the same as the value itself."

In crypto, traders once again possibly see speed as an advantage. "They want this kind of stuff," Powell said. "They want co-location services so they have faster connection. They want higher API limits. Higher resolution data." 

"We're not going to do that," he said.

U.S. equity market structure followers might hear echoes of IEX founder Brad Katsuyama in Powell's remarks. 

Katsuyama, who starred at the center of Michael Lewis' book "Flashboys," noticed while he was making large trades on behalf of pension funds clients at Royal Bank of Canada, that his orders would arrive at different exchanges depending on how close their matching engines were to RBC's offices, New Jersey-based matching engines First Bats in Weehawken, then Direct Edge in Secaucus, then Nasdaq in Carteret, and finally NYSE in Mahwah. During this time, high-speed traders with faster connection to the markets could get to, let's say Bats, prior to RBC, buy up the shares Katsuyama was looking to buy and then sell them back at a higher price on Direct Edge. 

A former high-frequency trading executive described a similar type of latency arbitrage. A trader linked directly to Nasdaq, for instance, could see Microsoft trading at a specific price before firms who are looking at the market via the consolidated tap, which aggregates data across all of the exchanges. That asymmetric information would allow the trader to pick off the firms looking to buy at, let's say, $111, because they know it is actually trading at $111 and some change. 

This type of "latency arbitrage" ultimately became associated with all kinds of HFT trading, but there are variations of high-speed trading strategies, as noted by ErisX's chief Matthew Trudeau.

"High-frequency trading" encompasses a wide variety of trading strategies and care must be taken to differentiate predatory practices from practices that benefit end-investors," as noted by a BlockRock white paper, cited by Trudeau in a recent op-ed in CoinDesk. 

Both BlackRock and Credit Suisse concluded in 2017 that HFTs have contributed to a tightening of bid-ask spreads for certain stocks. 

Still, as Joe Saluzzi put it, without a true regulator overseeing cryptocurrency exchanges (bar ErisX, which is regulated by the CFTC), it is tough to say whether cryptocurrency exchanges are doing the right thing. 

"When there is no regulator watching, they can pretty much do whatever they want," said Saluzzi, a long-time opponent of high-frequency stock trading.

As for Kraken, Powell is less interested in speed, arguing in favor of a slower market. 

"I don't think faster markets are necessarily a better thing," Powell said. 

It's an interesting take, given the equity market backdrop in which exchanges are all rolling out so-called speed bumps. 

The market structure mechanism, pioneered by IEX, aimed to slow down high-speed traders by delaying the time it takes for the stock market to ping a trader that a trade has gone though, by coiling up the wires that connect IEX and the brokers trading on its venue. As noted by Alex Osipovich in the Wall Street Journal, a slew of exchanges from Moscow to Toronto are looking to implement speed bumps. Research by Securities and Exchange Commission economist Edwin Hu found that IEX's speed bump resulted in a decline in tradition costs, on average. 

Still, some insiders say that the potential issues that co-location raises in equities wouldn't exist in cryptocurrency markets. 

To start, colocation offers far less of a latency arbitrage advantage in crypto compared to equities due to the geographic dispersion of cryptocurrency exchanges. Gemini's data centers are based in New York. Coinbase's are in Virginia. And ErisX's are in Chicago. Most of the liquidity is in Asia. In equities, most exchanges' data centers are within the same 50 mile radius. 

Rebates

Aside from colocation, Kraken isn't interested in offering rebates for traders on its platform. In U.S. equities, exchanges pay a rebate to market makers, brokers and trading firms to post orders to their venues, while charging market takers, traders looking to make an immediate trade. 

At Kraken, market makers and market takers both pay fees. Meanwhile, exchanges like itBit have begun offering rebates. 

Critics of the maker-taker model, which includes Saluzzi and IEX, argue that the structure incentivizes brokers to trade on venues that add the highest rebates, rather than where they will be best executed for their clients. 

Indeed, the Securities and Exchange Commission is looking to examine maker-taker via the so-called transaction fee pilot program, which for two years would restrict exchanges in certain circumstances from offering rebates to test the impact they have on the market. The pilot, which was approved by the financial watchdog in December, is being held up by Nasdaq and New York Stock Exchange, who view the move as a "harmful experimentation with the market," as per court documents filed July 25. Trading firms such as Citadel Securities and Virtu Financial are backing the NYSE and Nasdaq. IEX has taken a stand against rebates. 

In crypto, however, maker-taker doesn't necessarily raise such questions. Namely, because there aren't really any agency brokers that routing orders on behalf of clients, for one. The reason rebates are controversial in equities is because of the concern that brokers aren't passing them on to clients. For instance, if I am Morgan Stanley, I might be inclined to send more of my client trades to exchange X if it puts me over the threshold to receive a bigger rebate. But with few brokers acting on behalf of clients, the point would be mostly moot. 

Still, let's say the market was rife with agency brokers. Tagomi, which is backed by Peter Thiel's Founders Fund offers a case study of why crypto's unique market structure remedies some of those concerns. 

Tagomi is able to pass on the net price at which they trade, which includes either fees or rebates, onto their clients. As such, clients get the economic incentive that either a rebate or best fulfillment of a trade would offer. In U.S. equities, legacy infrastructure makes it difficult for firms to pass through rebates to their clients. If Morgan Stanley buys 1 million shares of Walmart on Fidelity's behalf, that single trade settles independently of the payment of fees with DTCC or another settlement provider. But since there are no such providers in crypto, trades — fees and all — can settle between Tagomi and its clients. 

Indeed, this type of market complexity is something Powell says he's concerned about creeping into the digital currency market. 

"The more complex the market is, the more advantages a small number of traders have," he noted. 

Still, Kraken and IEX are not without their own market structure complexities. While IEX doesn't operate a maker-taker exchange, it does offer a so-called enhanced market making program. It offers a discount on trading fees to brokers when they meet certain requirements. Kraken Futures, on the other hand, offers a similar discount scheme, interestingly. The exchange has a revenue sharing program in place that rewards traders who "trade significant volume."