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High-Frequency Trading and Crypto Dark Pools: How Do They Work?
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About High-Frequency Trading in Crypto
According to Wikipedia, high-frequency trading, or HFT, is a type of algorithmic trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools.

To put into more day-to-day language, high-frequency trading refers to the usage of specific software that allows traders to make thousands of high-speed trades in a fully automated and efficient way.

This technique of trading has grown alongside the Internet that allowed more and more investors, institutions, and hedge funds to take part. Since cryptocurrencies are a very hot topic these days, high-frequency trading is now starting to appeal more and more to crypto investors from all over the globe.

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High-Frequency Trading on the Coinbase
Source: Medium

About Crypto Dark Pools

The concept of dark pools is not exactly new, as they emerged somewhere around the late 1980s in the US. Dark pools have one main goal, and that is to facilitate block trading by institutional investors. However, they have one major drawback, namely the lack of transparency. This lack of transparency makes them vulnerable to potential conflicts of interest by their owners. This drawback works in the institutional investor’s favor since it may lead to a better price than if a specific sale is performed on a typical exchange.

There are three main types of dark pools: Broker-dealer-owned, agency broker or exchange-owned, as well as electronic market makers.

The first type of dark pools is created by big broker-dealers for their clients. These type of dark pools usually include their own proprietary traders and derive their own prices from the order flow. Some of the most relevant examples of broker-dealer-owned dark pools are Citi Cross and Morgan Stanley’s MS Pool, Credit Suisse’s CrossFinder, and Goldman Sachs’ Sigma X.

The agency broker or exchange-owned dark pools operate as agents. With these types of pools, there is no price discovery involved, as they derive their prices from exchanges. A list of some of the most popular Agency broker or exchange-owned dark pools is composed of ITG PositLiquidnet, and Instinet.

The final type of dark pools is the electronic market makers. This type of pool is offered by various operators. They are similar to the broker-dealer-owned dark pools, meaning that their transaction prices are not calculated from the NBBO. Hence, just like in the case of the first time, there is price discovery involved.

As useful as dark pools might be, they have various advantages and disadvantages. For starters, dark pools have the advantage that the market impact is significantly reduced for large pools. Since they don’t have to pay exchange fees and transactions based on the bid-ask process do not require full spread, dark pools usually have lower transaction costs.

The drawbacks are also worth mentioning. For starters, exchange prices may not reflect the real market. Secondly, pool participants may not always get the best price. Then there’s also aspects such as the vulnerability to predatory trading by NFTs, and the fact that the small average trade size reduces the need for dark pools.

Who is Participating in High-Frequency Crypto Trading?

High-frequency trading is being picked up more and more in the crypto space. This type of trading is usually associated with institutions, retail investors, and crypto exchanges. For firms, it’s a good opportunity to generate high profits for users. Some of the largest high-frequency crypto traders on the market today are established hedge funds and other high-frequency trading institutions.

High-frequency trading is also reserved for crypto day traders who are building their own high-frequency trading strategies. The main advantage is that they don’t require established hedge funds and modern technology to do so. Retail investors usually make use of cryptocurrency trading bots to do their bidding for them.

Crypto exchanges are the last to get into high-frequency trading. More and more crypto exchanges have declared that they are accepting high-frequency traders. In short, all the mentioned parties are usually interested in crypto high-frequency trading due to the crypto market’s volatile nature.

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How Do Crypto Dark Pools Work?

To understand how they work, one must know that a dark pool is a “pool” of liquidity inaccessible to the general public. Thes
e types of pool allow high-frequency traders to make important trades without actually letting the rest of the market know.

They enable traders to get the liquidity of a major exchange without the associated transparency. Crypto dark pools offer traders the possibility of making important trades without the market moving against them.

It’s important to remember that dark pools and high-frequency trading are two processes that are intertwined. Dark pools play a big role in high-frequency trading, but they’re not that popular in the crypto market.

How Will High-Frequency Trading And Dark Pools Affect the Crypto Market?

Even though dark pool adoption in crypto markets continues to be slow, they are becoming more and more accessible in the crypto market. Both high-frequency trading and the acceptance of dark pools in the crypto market are sure to leave their mark soon enough.

The main drawback is the fact that some financial experts consider that high-frequency trading actually causes more volatility within the market. Furthermore, it is believed that high-frequency traders hold an unfair advantage over slower market participants. On the upside, both dark pools and high-frequency trading add liquidity to the market, which is a good thing.

Another advantage of high-frequency trading is the fact that it allows traders to get a small advantage over smaller market participants without impacting the long-term price of an asset. Big dark pools can also have a very good impact on the market as it allows institutional investors to participate in the cryptosphere.

As far as what effect these technologies will have on the crypto market, only time will tell.

by Vladimir Ciobica

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