How does high-frequency trading work on decentralized exchanges?

Following the decentralized finance (DeFi) boom of 2020, decentralized exchanges (DEXs) solidified their place in the ecosystems of both cryptocurrency and finance. Since DEXs are not as heavily regulated as centralized exchanges, users can list any token they want. 

With DEXs, high-frequency traders can make trades on coins before they hit major exchanges. Plus, decentralized exchanges are noncustodial, which implies that creators cannot pull an exit fraud — in theory.

As such, high-frequency trading firms that used to broker unique trading transactions with cryptocurrency exchange operators have turned to decentralized exchanges to conduct business.

What is high-frequency trading in crypto?

High-frequency trading (HFT) is a trading method that uses complex algorithms to analyze large amounts of data and make quick trades. As such, HFT can analyze multiple markets and execute a large volume of orders in a matter of seconds. In the realm of trading, fast execution is often the key to making a profit.

HFT eliminates small bid-ask spreads by making large volumes of trades rapidly. It also allows market participants to take advantage of price changes before they are fully reflected in the order book. As a result, HFT can generate profits even in volatile or illiquid markets.

HFT first emerged in traditional financial markets but has since made its way into the cryptocurrency space owing to infrastructural improvements in crypto exchanges. In the world of cryptocurrency, HFT can be used to trade on DEXs. It is already being used by several high-frequency trading houses such as Jump Trading, DRW, DV Trading and Hehmeyer, the Financial Times reported.

Decentralized exchanges are becoming increasingly popular. They offer many advantages over traditional centralized exchanges (CEXs), such as improved security and privacy. As such, the emergence of HFT strategies in crypto is a natural development.

HFTs’ popularity has also resulted in some crypto trading-focused hedge funds employing algorithmic trading to produce large returns, prompting critics to condemn HFTs for giving larger organizations an edge in crypto trading.

In any case, HFT appears to be here to stay in the world of cryptocurrency trading. With the right infrastructure in place, HFT can be used to generate profits by taking advantage of favorable market conditions in a volatile market.

How does high-frequency trading work on decentralized exchanges?

The basic principle behind HFT is simple: buy low, sell high. To do this, HFT algorithms analyze large amounts of data to identify patterns and trends that can be exploited for profit. For example, an algorithm might identify a particular price trend and then execute a large number of buy or sell orders in quick succession to take advantage of it.

The United States Securities and Exchange Commission does not use a specific definition of high-frequency trading. However, it lists five main aspects of HFT:

• Using high-speed and complex programs to generate and execute orders

• Reducing potential delays and latencies in the data flow by using colocation services offered by exchanges and other services

• Using short time frames to open and close positions

• Submitting multiple orders and then canceling them shortly after submission

• Reducing exposure to overnight risk by holding positions for very short periods 

In a nutshell, HFT uses sophisticated algorithms to continually analyze all cryptocurrencies across multiple exchanges at very high speeds. The speed at which HFT algorithms operate gives them a significant advantage over human traders. They can also trade on multiple exchanges simultaneously and across different asset classes, making them very versatile.

HFT algorithms are built to detect trading triggers and trends not easily observable to the naked eye, especially at speeds required to open a large number of positions simultaneously. Ultimately, the goal with HFT is to be the first in line when new trends are identified by the algorithm.

After a large investor opens a long or short position on a cryptocurrency, for instance, the price usually moves. HFT algorithms exploit these subsequent price movements by trading in the opposite direction, quickly booking a profit.

That said, large cryptocurrency sales are typically harmful to the market because they usually drag prices down. However, when the cryptocurrency rebounds to normal, the algorithms “buy the dip” and exit the positions, allowing the HFT firm or trader to profit from the price movement.

HFT in cryptocurrency is made possible because most digital assets are traded on decentralized exchanges. These exchanges do not have the same centralized infrastructure as traditional exchanges, and as a result, they can offer much faster trading speeds. This is ideal for HFT, as it requires split-second decision-making and execution. In general, high-frequency traders execute numerous trades each second to accumulate modest profits over time and generate a large profit.