High-frequency trading relies on sophisticated algorithms, ultrafast computers, close to zero latency Internet connections and market data that is so fresh you wouldn’t be surprised if there was still steam rising off it. The idea is that you take this incredibly up-to-the-minute data access ability and use it to steal a march on your competition.

High-frequency trading, or HFT relies on computers that are capable of performing multiple trades every second. This delivers benefits which other traders can’t hope to touch. This kind of technology was available before cryptocurrency came onto the scene, and it’s thought that up to 80% of trading volume in some asset markets is handled in this way now. So, it was only a matter of time before crypto traders would decide that leveraging its inherent advantages would suit their own ends.

Most HFT strategies hinge on the idea that the traders executing them are among the very first to do so. They use that incredibly fast execution speed to ensure that they stay slightly ahead of the competition. Cutting-edge systems with the most powerful multicore CPUs and abundant cooling are key to these lightning-fast transactions, but no less important are the visionary minds who came up with the idea that working within the slight variables present right across the market means they can exploit millisecond turnarounds to their advantage.

You may hear terms for strategies such as: location, market-making, arbitrate, pinging, and news-based trading. Each one has its merits and drawbacks, and all of the strategies are not always available to all traders. Debate continues around whether the existence of this uneven playing field is ethical, but then ethics have never been known to put too much restraint on money making up to now. It’s true to say that the cryptocurrency world is still in its infancy, so there’s a gold rush mentality that seems to preclude overlooking advantages if they don’t seem fair. There are fortunes to be made and traders want to make them, so until someone stops them they will keep doing that. Still, governments have taken notice and regulatory bodies are moving in to weed out abuses, but while the strategies are still being used, let’s take a look at them one at a time.

Colocation

This is the practice of siting a trading server as close as possible to a currency exchange’s data center, because the closer it is to the data, the lower the latency. This is important because the further you are away from the source, the more out of date the information is by the time you receive it, and in trading, literally every millisecond counts.

With normal exchanges, every user may suffer as a result of communication delays. Normal retail investors won’t be affected too negatively by the slight drag on processing, but for the high-frequency trader, the tiniest of delays can mean the difference between profit and loss. Once everybody has invested in the best equipment available, the only other variable they can control is physical proximity to the data center that feeds their chosen exchange. Investors have been known to locate their facilities in the same area as a datacenter, but it’s also possible to house private servers on-site instead. Customers can even be cross connected to the main server, and in that case there is and even a need for an Internet connection. It’s more like an intranet that reduces transmission delays to an absolute minimum, and this is what we mean by “colocation.” It may seem like a lot of trouble to go to, but in this case, time quite literally is money, and milliseconds of delay could end up costing you millions.

In the cryptocurrency markets, some exchanges are already offering this kind of connectivity. HitBTC, Gemini and ErisX exchanges have all been offering colocation options to their clients for more than 12 months now. This lets firms use HFT strategies to give them a considerable trading advantage over ordinary traders.

Market-making

Traders with large amounts of resources have long employed the strategy of market-making. They put those resources to work placing both bids and asks into the same market, thus providing liquidity and profiting from the spread.

It’s usually large firms that do the market-making in regular trading, and it has its fans who approve of the practice because of the ample liquidity it injects into the market. With sufficient orders on both sides of the book, makers give other clients an opportunity to always move funds. Major exchanges commonly have contracts with one or more of these market-makers, and clearly with that kind of approval there can be no surer sign that it’s viewed as beneficial to the health of the system as a whole.

Emerging firms are now offering market-making services for cryptocurrency, but HFT market makers are usually small, private outfits who don’t have a contract with the exchange. They leverage their better performance to ensure that it is their own bids and asks that are making the market. They may be effectively performing an identical service to that of major public firms, but these smaller players are not as reliable.

Arbitrage

Price differences can exist between examples of the same asset across different markets. Price inconsistencies can crop up between exchanges, and if anyone is able to identify them, they can be exploited for profit. Given the volatility of cryptocurrencies, price discrepancies are even more prevalent than in standard markets, but they’re eliminated quickly by market forces, given that every trader has the same level of access to them.

HFT traders may be able to use their speed advantage to find these inconsistencies before anyone else. Specialist computer software has been created to identify such price anomalies in real time, so orders can be created hundreds of times faster than a typical trader can manage to take advantage of them.

Unfortunately, this whole system seems to be self-regulating, and it’s been observed that as more traders seek to pile in and profit from arbitrage, the less it actually returns.

Pinging

Pinging involves HFT practitioners using a string of small orders made in quick succession to uncover larger orders that have been made using segmentation — meaning divided into smaller parts — so that the market price isn’t overly affected.

It’s an approach that uses small orders to test a range of prices, locating the high and low range that big a mover is aiming to sell for. The method of detection is delivered by algorithms run by blisteringly fast computers. They can seek out opportunities many times second, and when they find one, they can purchase this asset straightaway, right at the low end of the range and sell it to their “victim” at the high-end of the range, securing a lightning-fast profit.

This method typically troubles big movers and is frequently at play in places known as “dark pools.” These are either private exchanges or forums that don’t report their order book in real time. Regulations typically require transaction information to be released, but it’s perfectly possible to delay it for long enough for big institutional users to perform large trades without immediately impacting the market. However, such systems are primed for victimization by HFT practitioners who can take advantage of the “pinging” technique to find other users of dark pools and trade against them. This can reduce the profits of non-HFT traders and make the dark pool less attractive as an option.

News-based trading

This is the way the trading always used to be. Traders would pick up the latest news about market assets and make purchases or sales in response. It’s difficult not to use news information to inform trades, and many seek news that hasn’t been released to the public yet. This is what’s known as “insider trading” and is prohibited by law but reputedly still widely practiced.

HFT can be used to traders’ advantage again here because advanced software can be used to analyze news stories as soon as they are released, and then place orders in response instantaneously. The software is clever enough to work out which asset is featured in the story, and even whether it’s good or bad. This isn’t quite the same as insider trading but leveraging the speed of a computer to make these sorts of snap decisions gives traders a huge advantage over mere humans mulling a story over in real time and deciding what to do about it.

Is high-frequency trading beneficial to the crypto market?

There are strong opinions on both sides. Some think it gives an unfair advantage, while others think it adds stability and liquidity to the crypto market. It’s clear to see that it does put non-users at a disadvantage. Traditional traders just can’t compete. But regulations are loose enough at the moment that traders want to take advantage of any edge they can get, so you can pretty much guarantee that they will do just that until someone stops them. It runs counter to the initial vision for cryptocurrencies—that of reimagining money and removing it from the control of the elite, but once again, the elite have found a way to reassert their influence.

That said, algorithms and algorithm-based trading systems are not perfect. With so much volatility, the sheer speed of HFT systems can sometimes spark major selloffs in mere seconds. This increased risk element can damage unwary traders.

Fans of HFT say that it adds more liquidity to exchanges where it’s used, with the result that typical traders get a better chance of finding matching orders and moving their money swiftly. Also, there’s improved efficiency in price discovery, which should reduce the spread across bids and asks (and so actually decreasing arbitrage opportunities overall). Some say that the more efficiency and liquidity HFT brings, the lower the chances of flash crashes happening and affecting everyone. Finally, non-HFT traders naturally benefit from the overall stability that the practice brings.

Which companies provide high-frequency trading for cryptocurrencies?

High-frequency trading for cryptocurrencies is an industry tactic that’s still in the early stages of its development but some firms now offer digital assets to their clients, and at least one crypto exchange is offering their clients the tools they need to get started.

Recently, numerous old-style HFT firms have also begun to join the decentralized assets party. Cumberland Mining, a subsidiary of Chicago-based firm DRW is the biggest. Others include Jump Trading, DV Trading and Hehmeyer Trading. Even so, there are very few cryptocurrency exchanges that can currently offer eitherthe tools or the speed required for HFT.

Alternatively, firms like Gemini and ErisX offer colocation, but others such as Coinbase and HitBTC provide colocation as well as dedicated tools for HFT users. With APIs such as FIX and Streaming, these sites can execute trades with minimal delays.

Sophisticated software and on-site hosting can now give users the potential to explore these trading strategies that we’ve mentioned. Some exchanges offer a demo trading option, allowing users to experiment using live market data with no risk. Cryptocurrency enthusiasts will no doubt find this option appealing.

High-frequency trading may not suit every trader, but for those with an adventurous streak, it’s a great new avenue to explore, and while regulation may come in to curtail it in future, it’s currently an exciting new frontier that’s becoming more accessible by the day.