Quantitative hedge funds, computer-powered, emotionless and systematic investing has been the flavor for some time. By actively avoiding human, it was believed that quantitative strategies would also dodge Scylla of greed and the Charybdis of fear. As far as we know, algorithms are emotionless. But the popularity of these algorithms, from the early successes of pioneers in the space such as Renaissance Technologies (whom we here at Compton Hughes are a great admirer of) have inspired a horde of imitators and encouraged countless traditional asset managers to copy their techniques. With so much competition with similar strategies, U.S. financial markets, where quant traders are most active, have become a battleground for competing algorithms that are designed to exploit even the tiniest and most fleeting opportunities. The inefficiencies that were once rife, have now been arbitraged away by the swelling tribe of like-minded, machine-powered traders.
The same way that a whole street full of hot dog stands kills off the entire hot dog market, quant traders have essentially arbitraged themselves out of alpha in the traditional capital markets. And while some quant trading hedge funds have moved offshore, to less liquid and less developed markets, others have started to take a closer look at cryptocurrency markets, where spreads are substantial, liquidity is varying and volatility (a quant trader’s best friend) is a given.
Last year, Morgan Stanley estimated that the total amount managed by quant strategies, ranging from simple ones (like throwing a dart blindfolded at a dartboard with stock names) to high-octane algo-heavy ones, was around US$1.5 trillion. Given the sheer size of the amounts being managed, together with ETFs, it’s no surprise that combined, these funds are responsible for almost 90% of all U.S. stock trading. Compare that with the cryptocurrency markets, where a US$200 billion market cap these days is cause for celebration and it’s obvious why the quant funds haven’t turned up on the floors of the cryptocurrency exchanges — yet. As algorithms and trading behavior become increasingly copied in the traditional capital markets, the opportunities for alpha become progressively whittled down. Many of the market glitches, inefficiencies and arbitrage opportunities have simply dried up — which means that other than offshore, hedge funds are increasingly looking to diversify into other alpha-generating products.
Already, Northern Trust, Fidelity Investments and other traditional big names are offering many of the traditional custodial and fund administration services which are a precursor to hedge funds entering into the cryptocurrency trade. With fund administrators increasingly learning the ropes from existing cryptocurrency traders on how to dole out daily and monthly NAVs and the likes of PwC and KPMG gearing themselves up for their audit functions, it’s more a matter of “when” and not “if” algo-driven traders start pouring into the cryptocurrency markets.
But does this spell the end for home-brew cryptocurrency day traders?
Not by a longshot. Fortunately, many of the best cryptocurrency exchanges were built by those inspired by the cypherpunk movement and the decentralized ethos. For instance, unlike on the NYSE or NASDAQ, where access to APIs (Application Programming Interface) is tightly controlled to a group of industry insiders, almost all cryptocurrency exchanges provide their APIs so that whether you’re a trader wearing pajamas trading from home or at a prop trading desk — the playing field is level. Cryptocurrency exchanges also impose rate limits — both for technical reasons (most exchanges would freeze up without these rate limits) as well as fair-play reasons. What this means is that there isn’t a significant advantage to be had by siting your trading desk near the exchange — unlike on Wall Street where HFTs try to locate themselves as close to the NYSE’s servers as possible to lower the lag in the fiber-optic cables. Rate limits on cryptocurrency exchanges ensure that all players have a fair shot at the trade. Finally, the ticket size. Almost all cryptocurrency exchanges charge a fee on trading which is a percentage — there is no minimum flat fee and no minimum trade size for efficiency. What this means is that even the smallest trades (which we do) are still viable, because there is no minimum trading fee. This means that even a trader with a small pile of cryptocurrency can trade as if they were a large fund, making and scalping millions of trades a month.
While much of the regulatory, custodial and administrative infrastructure necessary to give quant funds the green light to enter cryptocurrencies are in the process of development or are yet to be developed, the writing is on the wall. Some of the most storied companies in the financial world are pouring, money, manpower and machinery into building the infrastructure that will allow funds to start trading easily in cryptocurrencies — it’s just a matter of “when” and not “if.”