FTX-HFT contagion?

The initial reaction from traditional financial markets to the sudden bankruptcy of cryptocurrency exchange FTX was dismissive. But could high-frequency trading (HFT) firms be the vector for contagion from crypto to equities and bonds?

On Saturday, the Financial Times reported that FTX had an $8bn-plus hole in its balance sheet, meaning clients with cash and crypto assets held on the exchange face steep or possibly total losses.

FTX said on Friday that it was filing for Chapter 11 bankruptcy in Delaware, together with its affiliated crypto trading fund Alameda Research and approximately 130 other group companies.

Despite the news of the FTX collapse, US equity markets gained further on Friday following a softer-than-expected inflation reading the day before.

For the week, the S&P 500 rose 5.9 percent, the Dow added 4.2 percent and the tech-heavy Nasdaq index jumped 8.1 percent, celebrating hopes that future interest rate rises would be smaller than expected.

Contagion vectors

One reason for the muted reaction of traditional financial markets to the FTX collapse is that—unlike when Lehman failed in 2008 after incurring heavy losses on real estate derivatives—investment banks are relatively immune to the crypto sector.

Last year, the Basel Committee for Banking Supervision (BCBS), which sets the capital adequacy rules for the global banking sector, ruled that banks holding cryptocurrencies would have to set aside enough capital to back the full amount of their exposure.

According to Risk, Goldman Sachs is the only major investment bank actively trading cryptocurrency derivatives.

But when it comes to the electronic market makers who support equity trading, the situation couldn’t be more different.

Every single name in the top ten of a recent ranking of HFT firms is involved in cryptocurrency

High-frequency trading (HFT) firms reportedly account for 50-60 of equity trading and have a sizeable presence in the bond and foreign exchange markets. They thus underpin a large part of the global financial system’s liquidity.

Every single name in the top ten of a recent ranking of HFT firms is involved in cryptocurrency, with many taking large proprietary trading bets.

HFT firms have a natural affinity to cryptocurrency because of the way the digital asset markets are structured.

“Everything sits in the cloud and the exchanges are all operated by ex-Silicon Valley types and less so the legacy Wall Street types,” Jim Greco, a former software developer at HFT firm Getco, said in a February interview.

“It’s a great model because it allows new trading firms to get started very quickly,” Greco said.

“You don’t have to negotiate with a bunch of vendors about getting data centre access or colocating near the global exchange hubs.  Everything’s on Amazon Web Services which makes connecting to trade much easier.”

As most HFT firms are privately owned, information on the potential financial impact of this year’s cryptocurrency bear market is hard to come by.

Nevertheless, there are occasional glimpses of the extent of HFT involvement in the crypto sector.

In February, Jump Crypto, the cryptocurrency trading arm of HFT firm Jump Trading, shelled out a cool $320m of its own funds to cover a loss following a hack on a software ‘bridge’ connecting two cryptocurrency networks, ethereum and solana.

“It’s a great model because it allows new trading firms to get started very quickly”

Jump also reportedly suffered heavy losses in the May collapse of the Terra stablecoin.

Jump last night reacted to rumours of further losses from its involvement with FTX by issuing a public statement. It tweeted:

“We, like all of you, were shocked by the events that unfolded over the past week. Jump’s exposure to FTX was managed in accordance with our risk framework and we remain well capitalised”.

Jump did not disclose any figures for the impact of the FTX failure on its income or capital.

Cumberland, the crypto-trading subsidiary of HFT firm DRW, said on November 9 that it had “virtually no exposure to FTX and our operational controls enabled us to provide deep liquidity to a market in search of it”.

A Protos analysis last year showed significant links between FTX, Cumberland, stablecoin issuer Tether and Binance.

Jane Street, the HFT firm which was the alma mater of FTX chief executive Sam Bankman-Fried and Alameda Research head Caroline Ellison, has not commented publicly on the demise of FTX.

However, last year Ian McGuinn, the firm’s head of crypto business development, said that Jane Street had been an active participant in the crypto market.

Other HFT firms have close past links to FTX in terms of shared personnel.

In the white paper for FTX’s now-collapsed native exchange token (FTT), last updated two months ago, FTX said its traders came from leading Wall Street quant firms and tech companies, including Jane Street, Optiver and Susquehanna.

Neither Optiver nor Susquehanna has commented publicly on the demise of FTX.

This was the largest bitcoin-denominated political donation ever recorded

However, last month Coindesk reported that Jeffrey Yass, the billionaire co-founder of Susquehanna, had donated 100 bitcoin (then worth $2m) to Crypto Freedom, a political action committee (PAC) backing the election of pro-crypto candidates to the US Senate.

This was the largest bitcoin-denominated political donation ever recorded by the Federal Election Commission.

Yass and his wife were the fifth-biggest contributors in the recent US congressional elections, just behind FTX’s Sam Bankman-Fried, who donated $39m to the Democrat party.

HFT firm Citadel, which last year had almost as much US equity trading volume as the Nasdaq exchange, has also not commented on any exposure to FTX.

However, there are multiple links between Citadel and the now-defunct crypto marketplace.

In June, Citadel said it was building a crypto trading marketplace with Virtu, together with venture capital firms Sequoia Capital and Paradigm. Both Sequoia and Paradigm, which were equity investors in FTX, are estimated to have lost more than $200m in the exchange’s collapse. Completing the circle, Sequoia and Paradigm also made a $1.15bn minority investment in Citadel in January.

In September, former Citadel employee Brett Harrison unexpectedly quit his position as the president of FTX’s US exchange.

A month earlier, the US Federal Deposit Insurance Corporation (FDIC) had issued a ‘cease-and-desist’ letter to Harrison and Dan Friedberg, FTX’s chief regulatory officer, over what it said were false claims about FTX users’ accounts being federally insured against loss.

Harrison had previously overlapped with FTX CEO Sam Bankman-Fried at Jane Street between 2014 and 2017, when Harrison led systems trading technology and Bankman-Fried was an exchange-traded fund (ETF) trader.

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