Things are about to get interesting in the cryptocurrency world.
According to an article in the Financial Times, several high-frequency trading firms have started trading operations in cryptocurrencies. DRW, a Chicago-based proprietary trading firm, is the largest such firm that buys and sells bitcoin through Cumberland Mining, a subsidiary. Other trading firms that have invested in cryptocurrencies include Jump Trading, DV Trading, and Hehmeyer Trading. Cumberland bought 20,000 bitcoins at the U.S. government’s bitcoin Silkroad sale in 2015. With their stash of cryptocurrencies, proprietary trading firms act as counterparties for hedge funds and family offices for cryptocurrency trades.
Recent volatility in prices for digital currencies is the main attraction of investing in such asset classes for high-frequency traders. The S&P 500 has had fairly tepid gains this year. In contrast, the rise of cryptocurrencies has been dramatic, with bitcoin – the world’s most widely-used cryptocurrency – up by 500 percent since the start of this year. (See also: Bitcoin Prices Hit Record High.)
That rise, however, has been punctuated with sharp volatility. For example, China’s announcement of a ban on initial coin offerings, which enable exchange of tokens for cryptocurrencies, resulted in a steep $500 price decline for bitcoin. Such conditions are ideal for high-frequency traders, which use algorithms to conduct rapid bulk trades. Even a small change in bitcoin prices can enable high-frequency traders to book profits through massive orders. But it is unclear whether they are using algorithms for cryptocurrency traders. The FT article states that high-frequency traders are using email, Skype, and phones to conduct trades.
A Bloomberg article earlier this year cited other benefits that make cryptocurrency trading attractive to high-frequency traders in China, the largest market for cryptocurrency trading. Those reasons may also apply to high-frequency traders in the United States as well. They include arbitrage of opportunities across multiple exchanges that enable traders to profit from differences in the same cryptocurrency’s prices in different markets, zero transaction costs (in China), and round-the-clock trading. China conducts a majority percentage of its cryptocurrency trading using algorithms, with approximately 60 percent to 80 percent of all trading done by high-frequency traders.
The entry of high frequency traders to bitcoin may not be good news for volatility in cryptocurrency prices. A 2010 paper from MIT’s Sloan School of Management concluded that high frequency trading is positively correlated with stock trading, with stocks overreacting to fundamental news. (See also: Four Big Risks Of High Frequency Trading.)