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High frequency trading (HFT) is one of the most mystical and often misunderstood elements of capital markets. Brought to popular culture with Michael Lewis’ book “Flash Boys,” HFT is synonymous with speed, technological innovation and secrecy.
HFT quant funds remain among the most opaque entities in the trading ecosystem. Part of the obscurity surrounding HFT firms is dictated by the heavy competition in the space, the short lifespan of alpha opportunities and that HFT looks to take advantage of short-term market inefficiencies that can be rapidly corrected once they are well known.
But what if crypto, and specifically, decentralized finance (DeFi), could change the rules of the HFT game? If that sounds grandiose, it’s actually pragmatic when it comes to DeFi.
Jesus Rodriguez is the CEO of IntoTheBlock, a market intelligence platform for crypto assets. He has held leadership roles at major technology companies and hedge funds. He is an active investor, speaker, author and guest lecturer at Columbia University in New York.
Whether we are talking about equities, commodities, currencies or derivatives, HFT strategies operate over a similar infrastructure, including dark pool connectivity, order flow feeds and other pervasive building blocks such as algorithmic stablecoins. Based on blockchain protocols, DeFi is fintech that changes the dynamics of HFT strategies. It represents a new playground for HFT strategies, with new rules that challenge established HFT principles but also add new dimensions to an established industry.
A feature, not a bug
HFT is often seen as a byproduct of inefficiencies in the infrastructure of capital markets and the composition of specific financial products.
So, what happens when we have a new financial infrastructure that considers HFT and some variations like arbitrage trading as a key feature?
This is the case of DeFi automated market makers (AMMs) such as UniSwap, SushiSwap or Balancer, which leverage arbitrage as a mechanism to restore prices in liquidity pools to the right level. The transaction mechanism implemented by AMMs is far from being capital-efficient given that it could require a large number of translations to restore market-fair prices, but it certainly adds a different dimension to HFT. The idea of incorporating HFT mechanics at the core of a new financial instrument such as AMMs is an innovative concept in DeFi.
Flash loans seem to be designed with HFT as a first-class use case. The ability to request large pools of capital in a single transaction is key to enabling different types of HFT arbitrage strategies without requiring large pools of capital upfront. Integrating AMMs and flash loans has enabled products such as flash swaps that have become a favorite of HFT bots.
Other DeFi protocols such as private-pool integrators, algorithmic stablecoins or DeFi indexes seem ideal for HFT scenarios. In the world of DeFi, HFT is expected and even welcomed in some cases. But it’s a different type of HFT. DeFi has changed the dynamics of HFT to an environment in which speed is not the only relevant capability.
The programmable, on-chain nature of DeFi introduces new dimensions that determine the success or failure of HFT strategies
It’s not just about speed anymore
As its name suggests, trading speed has always been a hallmark of HFT techniques. That has been both a blessing and a curse because the HFT market has evolved around trying to get minuscule advantages in speed instead of fundamental technological innovations. In the case of DeFi, trading speed remains highly relevant but it’s far from being the only dominant of successful HFT strategies. The programmable, on-chain nature of DeFi introduces new dimensions that determine the success or failure of HFT strategies.
Though there are many differences between HFT in DeFi and traditional capital market structures, here are five factors that add new dimensions to the design and execution of HFT strategies in DeFi:
Block time speed factor
The simplest definition of HFT in DeFi is strategies that execute trades every block. In traditional markets, some of the most popular solutions to limit the advantage of HFT included introducing trading delays. In DeFi, that’s a native capability of the infrastructure.
Trade transparency factor
How do you design HFT strategies when everyone can see the trades you are trying to execute, and vice versa, you can see your competition’s trades? Transparency changes the nature of the HFT-DeFi game relative to traditional capital markets. Traders must build native constructs for aggressive competition with other strategies that try to front-back run it or simply compete with alternative strategies.
Cost factor
The infamous priority gas auctions (PGAs) in which arbitrageurs engage in transaction bidding has been one of the factors associated with the increase of gas costs in the Ethereum blockchain, and consequently, enable the growth in adoption of other blockchain runtimes such as Binance Smart Chain, Solana or Polygon. From the HFT perspective, strategies do not only need to consider the algorithmic logic behind specific trades but the cost associated with it. In many scenarios, perfectly viable HFT trades could lose their economic viability due to the cost associated with the execution of the transactions.
MEV factor
Miner extractable value(MEV) has become one of the most debated concepts in DeFi in recent years. Initially coined by Phil Daian et al. in the paper “Flash Boys 2.0,” MEV describes the profit that a miner can make based on its ability to place transactions in a block in a specific order. MEV is an important concept in crypto economics and has profound implications in HFT-DeFi strategies. MEV imposes a constraint vector in HFT-DeFi strategies by relying on the miner’s economic interest to determine the ultimate placement of a transaction in a block. Plain and simple, perfectly viable HFT trades in a DeFi protocol can lose money because a miner placed the transaction in an order that favors another arbitrageur.
What’s more, MEV is completely obscure and makes every trade dependent on a party whose economic interest might not be aligned with a given HFT strategy. In recent months, protocols such as Flashbots, ArcherDAO and others have been trying to create more transparent and quantifiable dynamics to mitigate the impact of MEV.
Underlying protocol factor
In traditional capital markets, HFT traders interact with infrastructure that is relatively consistent across different asset classes that have been established for years. In the DeFi space, they need to interact with an infrastructure that is constantly changing with new protocols and runtimes. Playing with an unstable, constantly changing infrastructure presents challenges to HFT strategies in DeFi but also creates waves of new opportunities given the inefficiencies of new protocols entering the market.
A new arena for HFT
DeFi represents one of the most novel technological evolutions that can help trigger innovations in the HFT space. A nascent infrastructure with new financial protocols, blockchain runtimes and programmability as a first-class building block, make DeFi an ideal environment for HFT strategies.
However, HFT in DeFi is different from traditional capital markets. Factors such as block time speed, cost, transparency, MEV and nature of underlying protocols set different dynamics for HFT strategies in the DeFi. To capitalize on the opportunities in DeFi, HFT strategies can’t rely solely on execution speed anymore, and instead, need to leverage technical innovations tailored to the unique characteristics of the DeFi space. HFT in DeFi is not just Flash Boys HFT. It’s more transparent, technologically complex, and frankly, more interesting intellectually.