The digital asset market is currently experiencing unprecedented growth. In January 2021, the total market cap of all cryptocurrencies surpassed $1 trillion for the first time.
While digital assets are still a relatively immature asset class compared to many others, several indicators now point to a significantly more mature market than when the last big bull run occurred from 2016 to late 2017. During that period, much of the growth came from retail investors who poured funds into mostly rather questionable early-stage projects conducting token sales. Many of them have since failed, along with a few notable exceptions that stood the course.
This time around, the rally comes after some notable developments in the sector. Firstly, the current highs are largely attributable to new institutional inflow beyond the continued retail interest. Furthermore, there are clear signs of more professionalism than in the days when digital assets were often known as the “wild west” of finance. Institutional infrastructure is now far more widely available, including custodial and lending services, prime brokerage, security and auditing firms, and data and analytics providers.
A Field of Opportunity for Quant Traders
Cryptocurrencies, as an entirely digital asset class, have a lot to offer quant traders. According to the 2020 PwC/Ellwood Crypto Hedge Fund report, only 48% of crypto hedge funds use a quantitative strategy, with 36% opting for discretionary trading. However, 2019 data from the same report shows that, on average, quant methodology outperforms the alternatives.
Moreover, in 2018, which was overall a challenging year for cryptocurrencies, quantitative trading was the only approach which yielded positive returns.
Source: PwC, 2020 Crypto Hedge Fund Report
Therefore, the numbers clearly illustrate that quant traders have an edge in digital asset markets.
There are other benefits besides. Cryptocurrencies are traded 24/7, meaning that a successful quant strategy could outperform a similar strategy based on traditional assets simply by virtue of being able to trade more often and more consistently. In addition, cryptocurrencies and digital assets can also be used as a way to diversify a strategy that encompasses a broader range of assets.
However, recent developments notwithstanding, some key structural differences remain between the digital and traditional asset markets. Thus, before moving your quant strategy into digital assets, here are a few key considerations to keep in mind in order to ensure a smooth transition.
A successful low timeframe quant strategy will require access to the most liquid trading venues. A key challenge in the digital asset space is that liquidity remains fragmented across a large array of venues. As on-chain trading is too expensive, slow and inconvenient for most traders, the industry has remained largely dependent on centralized exchanges, brokers and other market makers including OTC desks. More recently, however, decentralized exchanges have started to gain recognition among institutional traders, as well as cross-chain bridging solutions which create liquidity pools with decentralized governance.
In either case, a good digital asset trading solution will allow you to use smart order routing to algorithmically slice your orders and execute them across multiple venues where the price and liquidity on offer are currently most favourable. For this to work, however, connectivity to a wide range of execution venues (whether centralized or decentralized) is crucial and a core prerequisite for best execution and slippage minimization. This is a significant operational challenge for most institutional traders because crypto exchanges rarely use standardized financial communications protocols like FIX. Most venues have adopted REST and Websocket APIs to provide connectivity, which are implemented and documented differently for every exchange. Indeed, even on the rare occasions when FIX is available, the specification standards used in traditional capital market trading infrastructures tend not to be adhered to. As a result, maintaining reliable connectivity with all venues at all times opens up a can of worms in terms of bug testing and maintenance. For institutional trading firms, this can become an arduous technical challenge that wastes precious resources. Thus, it is worth checking whether your digital asset trading platform can handle this for you by providing venue connectivity as a service.
Order and Execution Management
As discussed above, despite the greatly increased maturity of digital asset markets in recent years, liquidity remains highly fragmented in comparison to traditional asset classes. This increases the danger of falling victim to front-running, particularly when executing larger orders.
A robust order and execution management system (OEMS) can help to overcome this issue by dispersing larger orders into smaller chunks that don’t attract the attention of frontrunners. Similarly, the right OEMS can maintain order flow through fragmented markets while minimizing fees and slippage.
Furthermore, transparent record-keeping regarding order execution can provide a demonstrable record to clients that trades have been executed at the best price, with the lowest fees.
When dealing with digital asset exchanges, one important thing to bear in mind is that you need to pre-fund your trades by sending funds to your account prior to executing transactions. Obviously, when executing a quant strategy, it would be quite impractical to have to manage a plethora of accounts and keep them all constantly funded in real time. In addition, this would introduce an unacceptable degree of counterparty risk for most institutional traders, particularly if pursuing a strategy like cross-exchange crypto arbitrage that relies on pricing differentials between multiple exchanges. In short: the more exchanges you transact on, the more counterparty risk you are exposed to, irrespective of the amount of due diligence you do.
Although some exchanges do offer a line of credit if you have established a relationship with them over time, it would be costly and inefficient to establish such contacts with a wide range of exchanges. Luckily, however, there are service providers in the secondary market that allow you to “outsource” this relationship. This allows you to programmatically fund orders immediately before they are executed (and automatically withdraw the funds right after) with 0 block confirmations across a range of different exchanges, thereby minimizing the need for prefunding. Good digital asset trading platforms will include this as a core feature in order to simplify connectivity with venues and greatly reduce counterparty risk.
AlgoTrader offers an all-in-one institutional trading solution, comprising a best-in-class OEMS that provides rock-solid reliability in connecting to a broad range of liquidity venues and reliable data providers for both digital and traditional assets. The platform covers every stage of quantitative trading, from strategy development and backtesting, through to execution management using a wide selection of both pre-built and customizable execution algorithms.
If you’re an institutional quant trader looking to move into digital assets, then save yourself time and headaches with AlgoTrader. Get in touch with us today.