Trading crypto vs. traditional asset classes
Where are we now and where do we go from here?
Excerpt 1 from the Cryptto Whitepaper
In this article we are going to explore the market of professional crypto trading: define its boundaries, structure, and key characteristics, compare it to traditional asset classes trading and analyze how it is likely to evolve going forward.
Professional trading of cryptocurrencies is a part of a much larger market of investing in publicly traded assets or claims on assets. This large market can be broken down into investing in traditional public markets (stocks, futures, options, etc.) and the crypto markets (cryptocurrencies, tokens, etc.).
Here is a diagram¹ illustrating the “universe” of public markets investing: both traditional and crypto.
The first divide here is between the active and passive investment management. It arises from the cornerstone theoretical question of whether the financial markets are efficient or not.
If, as was argued by the Nobel prize winner Eugene Fama² in 1970, markets indeed are efficient, meaning that the asset prices always incorporate and reflect all available information, then one cannot “beat the market” by actively selecting under- or overpriced assets to buy or sell.
In this case, one’s goals should be diversification (to diversify away the risk of the individual assets), asset allocation (to achieve the desired risk/return profile), and trading costs minimization (through low turnover). For most investors, it’d mean investing in a broad-market index (index fund, to be precise)³.
However, empirical evidence points to the fact that the financial markets are often far from efficient. Lack of liquidity, market fragmentation, incomplete information, and a number of behavioral factors can and regularly do create market inefficiencies. In fact, Eugene Fama himself, by the time he got his Nobel prize in 2013 for his 1970s work on efficient markets, has basically proven their inefficiency⁴.
Market inefficiencies are even more pronounced in the nascent crypto markets where they can often be spotted with a naked eye, creating ample opportunities for the active investment strategies to earn healthy risk-adjusted returns.
The key divide within the active investment management category is between the investing per se and trading or speculation.
“Investing is buying an asset, or claim on an asset, based on an estimate of the fundamental value of the underlying asset. The investor buys the asset because he feels the price is below the asset’s value or that the price will increase because the asset’s value is increasing at a rate that will produce an attractive return. The value is determined by the cash flows the asset will provide its owners over the asset’s useful life”⁵. Investing necessarily deals with the longer time horizons (months to years) to realize its returns.
Trading or speculating (we believe these terms should be used interchangeably) “is buying or selling an asset based solely on expected price changes without regard to either the asset’s fundamental value or changes in that value”⁶.
Trading/speculating, in turn, could be either professional or casual/amateur. It is the proliferation of the latter that is responsible for the often-negative connotation of the word “speculation”.
Professional traders “have extensive experience, have developed key insights and judgment, and are systematic and disciplined in their strategies”⁷. It means that professional traders clearly understand the edge they have, the reasons they have it, and the conditions that are necessary to systematically realize it. Professional trading is dealing with short time horizons — from microseconds to days and weeks, very rarely months.
Two gravest mistakes many inexperienced participants in financial markets make are speculating while thinking that they are investing and considering themselves professional traders while clearly lacking the expertise and discipline to be one.
At CRYPTTO, we concentrate on the intraday, ultra-short-term trading. Speed is our home turf, we have been perfecting our strategies and technology trading US equities, options, and futures for over a decade, and everything we do is optimized for speed by design. We fall into the professional trading bucket — behind our every strategy is a clear trading thesis that is extensively tested before going into production, and then is re-tested and optimized again before scaling. We manage expected profitability and risk of our strategies tightly, we do not rely on the market’s mercy as our strategies do not make directional bets.
Now that we have defined the market we are in, let us look at key market elements and participants and try to outline major differences between the traditional and crypto markets.
Traditional public markets
By the traditional public markets here we mean one of the most developed and high-volume asset classes — US equities. It’s structure is defined in part by the legacy of its three-hundred-years’ history and in part by the ever-increasing regulations and the technological evolution.
The key gatekeepers in traditional markets are the brokerdealers. Virtually all traditional public markets orders flow through them — both from the individual investors and large institutions. Before the advent of the “discount brokers” made possible by the rise of the internet, broker-dealers made their living mainly by charging hefty transaction fees.
Fees have come down a lot recently, and now the main source of broker-dealers’ income is the so-called order flow internalization or, in other words, selling the “unsophisticated” retail order flow to the large marketmaking firms⁸ who are are happy to pay for the opportunity to trade against retail market participants. In fact, almost all non-directed orders⁹ from individual investors are sold to the wholesale market makers¹⁰ and are matched and executed outside the exchanges.
This leaves the exchanges with the predominantly “sophisticated” institutional order flow, making profitable trading there exponentially more difficult.
Trading competition within the exchanges is so vigorous, that, sending an order to the exchange, you have not more than 1 in 10 chances to trade with an actual person. 9 times out of 10 on the other side of your trade will be a market maker or a proprietary HFT firm.
Market structure and order flow for the institutional investors in traditional public markets differ only slightly. The broker-dealers are still there as the gatekeepers. The first difference is that there is a lot less internalization of the order flow happening as the wholesale market makers are less interested in buying it¹¹.
The second difference is that the key issue for the institutional buyers and sellers is to hide or mask their intention of posting a large order so that the market makers/HFTs won’t jump ahead, effectively increasing institution’s trading costs. This leads to the extensive employment of execution algorithms, breaking down orders between exchanges, dark pools etc. by both the institutions themselves and the brokers at their direction. Whether they succeed or not in doing this is beyond the scope of this discussion (hint: not really).
Crypto markets
Market structure and order flow for the institutional investors in crypto markets is basically the same as for the retail investors, just the order flow itself is skewed in favor of the OTC trading desks and away from DEXes.
There are 3 major buckets into which the differences between the crypto and traditional market structure fall.
Bucket 1 — differences that appeared because the crypto markets were developed from scratch with no legacy customs and regulations.
This bucket includes the absence of the broker-dealers and the clearing houses.
It means that the order management is basically performed by the investors themselves, and the settlement is done either by the exchanges or by the smart contracts in case of DEXes.
It is difficult to say whether it’s a good thing or a bad thing — there are arguments for both. And it is entirely possible that the institutions performing functions similar to the current broker-dealers and the clearing houses will develop (in fact, they already do). However, it is hard to imagine that these institutions will ever become so all-encompassing as it is the case in the traditional markets.
Bucket 2 — differences that developed because of the specific properties of blockchain and crypto technologies and cannot be recreated in the traditional markets.
First and foremost, this bucket consists of the decentralized exchanges and the ability to securely and efficiently perform P2P exchange transactions enabled by the smart contracts.
Decentralized exchanges are almost unsuitable for the professional trading at the moment due to lack of speed, low liquidity, and high transactions costs. However, we clearly see this situation changing as the industry and the technology develops.
We might even say that there is a high chance that the decentralized exchanges are the future of the cryptocurrency markets.
Bucket 3 — differences that exist because the crypto markets are still in the early stages and which will inevitably disappear as they develop.
The main difference here is the much smaller share of the market makers and HFTs in the total transaction volume. It is hard to estimate with any type of precision, but our best guess is that still over half of all transactions on centralized exchanges and around 90% on DEXes are natural order flow transactions. And if we disregard instances when the cryptocurrencies are traded just in order to increase the total trading volume of a token or an exchange — the natural order flow transactions’ share is even higher.
Thus, compared to the traditional markets, the exchange order flow is still relatively unsophisticated, and the competition levels in systematic intraday trading are low. However, that is bound to change.
Future Crypto Trading Market Developments
All new markets and industries in free economies follow pretty much the same path. Once a new market or an industry is established, companies start moving in. In the beginning, competition is low and the first movers are able to earn outsized returns for a while. However, high returns inevitably attract new entrants, unless there are firm barriers to entry (which are exceptionally rare, contrary to most people beliefs¹²).
Increased competition unavoidably drives down the returns across the industry. New players continue entering and driving down the returns until they are no longer above average (above their cost of capital, to be precise), making new entry unattractive.
All industries without barriers to entry inescapably end up with a high level of competition, where only a few most efficient players remain truly profitable (earning returns higher than their cost of capital). And true barriers to entry are very difficult to come by: first mover advantage, economies of scale, high capital requirements, and even proprietary technology — the usual things that come to mind — are not true barriers to entry, as they can and will be overcome, provided the expected returns are high enough¹³.
That is exactly what has happened with intraday trading industry in the traditional markets.
Fifteen or so years ago in traditional markets, you would be able to execute arbitrage opportunities manually — you just had to type fast. News propagated over minutes – you had plenty of time to react and still make a profitable trade. The assets had wider spreads. In a single-dealer market such as NYSE, you typically were able to deduce specialist’s intentions and trade along with him. Index and ETF arbitrage was relatively easy — both deviated from their fair value regularly.
As the technological evolution made electronic trading possible, the “easy money” to be made led to the proliferation of quantitative/algorithmic/high-frequency trading firms — hundreds if not thousands of them popped up on the Wall Street.
Ever increasing competition inevitably changed the market: manual arbitrage opportunities are long gone, news propagates over tiny fractions of a second, spreads are minuscule, institutions and market makers mask and hide their orders, indexes and ETFs hardly ever deviate from their fair value.
Thus, many of the strategies that you had been able to execute manually 15 years ago simply do not exist anymore and for most of what is left you’d need a top-tier infrastructure, systems, technology and back-office stack to compete.
But even that might not be enough — exactly as predicted for the industry with no defendable barriers to entry, only the most efficient players survive once the competition catches up. During the recent years, the intraday trading industry saw a wave of bankruptcies and consolidation. Now, only a handful of the largest and a small amount of the most efficient small players are left.
In crypto, the current situation clearly resembles that of the traditional markets 15 years ago.
Professional systematic trading in crypto markets certainly does provide outsized returns at the moment. Just look at how the news of the recent addition of Zcash to Gemini propagated:
This is May 14th, 2018 when Gemini announced the addition of Zcash to its trading pairs that led to a spike in Zcash’s trading volume and price. Each candle on the graph represents a 5 minutes interval. As you can see, even if you reacted 15 minutes after the announcement was made, you could still make a 10–20% return from your trade.
Those timeframes and returns are unthinkable in the traditional markets. Here is a recent example of equity traders reacting to Amazon’s earnings:
The first trades had happened microseconds after the press-release became available and the trading opportunity was gone in under 3 minutes.
That is why crypto markets already do and will continue to attract new entrants.
In crypto, there are even fewer barriers to entry than there were in the traditional markets. Moreover, as more and more professional traditional markets players move to crypto once the initial institutional inertia is overcome and the regulatory environment is clear enough, their skills and experience will provide them with the immediate advantage.
Continuously increasing competition in crypto trading, as in any other industry, will inevitably drive down average returns and, eventually, push the weakest players into unprofitability. In crypto it will take much less than 15 years — the manual arbitrage in crypto markets is virtually over already, and it took less than a year.
To remain competitive, crypto traders will need to evolve and seek a totally different level of expertise, infrastructure, and resources.
The CRYPTTO platform will provide exactly that.
This article is the first in the series based on the CRYPTTO Whitepaper. Follow us not to miss the rest or simply download the Whitepaper.
Footnotes:
¹ This diagram and its subsequent analysis heavily draw on the work and thinking of Columbia Business School Value Investing professors Paul Johnson and Tano Santos;
² https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1970.tb00518.x
³ Buying an index fund can also make sense even if you do not believe in market efficiency — in case you do not have access to active strategies that can consistently outperform the markets after accounting for all fees and trading costs. In fact, in traditional markets, buying an index fund would probably be by far the best investment strategy for most of the unsophisticated individual investors;
⁴ https://www.sciencedirect.com/science/article/pii/0304405X93900235
⁵ ⁶ ⁷ https://www.linkedin.com/pulse/fundamental-value-paul-johnson/
⁸ That’s what made possible the creation of the famed “zero fees” brokers, the “robinhoods” of the world;
⁹ Orders, for which the sender did not specify execution venue (i.e. NYSE or NASDAQ);
¹⁰ Source: Bank of America Merrill Lynch’s Market Structure News (March 2018);
¹¹ The explanation of why they do not want to pay for the institutional order flow is beyond the scope of this whitepaper. But, in short, it has to do with the regulations that oblige to execute the internalized orders at the best market bid or ask (across all US markets) at the moment of internalization. For small retail orders it means that the market maker will earn the spread minus the internalization fee with virtually zero risk. With the large institutional orders market makers run into the real risk of market moving against them while they still hold this large order in their inventory;
¹² For an excellent discussion of the barriers to entry and competition in general we suggest reading Competition Demystified by Bruce Greenwald, which has heavily influenced our thinking and the ideas, presented in this article;
¹³ Not to waste time and space here, we invite you to read the Competition Demystified by Bruce Greenwald to clear any doubts you may have.
