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This episode aired on BloombergTV on Nov 15, 2012

Latency Arbitrage

Latency Arbitrage is an important concept when discussing High Frequency Trading, and refers to the fact that different people and firms receive market data at different times. These time differences, known as latencies, may be as small as a billionth of a nanosecond, but in the world of high speed trading, such differences can be crucial. So crucial, in fact, that trading firms pay lots of money to be located closer to exchanges’ servers– each foot closer saves one nanosecond. Latency arbitrage occurs when high frequency trading algorithms make trades a split second before a competing trader, and then resell the stock seconds later for a small profit.

Q. What is Latency Arbitrage?

This is a common term in the world of high frequency trading, and very generally refers to the idea that firms don’t all get the same information about publically traded stocks at exactly the same moment in time… some get it sooner and some later, and the difference is known as latency. Some trading firms spend fortunes to ensure they get the data first, and then profit from it by “latency arbitrage”.

Q. Wait a minute. Before we get to how the arbitrage works, why is it that there’s any difference in when certain firms get pricing data?

Ah. This is the point of a massive technology war that’s been going on for several years now. Sounds funny, I guess, but firms are quite literally competing with each other for advantages of nanoseconds – billionths of a second — in getting information. Each foot closer you are to the exchange server saves you one nanosecond. And they get it by simply paying the exchanges for the rights to co-locate with the exchange servers. There’s also a part two: they license the raw data from the exchanges that goes into the national price quotation systems. Bottom line: they’re getting crucial pricing information before the market at large.

Q. And what are the implications? How does that help create arbitrage opportunities?

Here’s one example. A big institution is in the market to buy a big order of a given stock. It will have algorithms execute the trade slowly, trying to get the best price… you know, it will take whatever’s available at, say, $4.50 per share, and then what’s available at $4.51, etc. This is where the “latency arbitrage” can come in. A HFT can see that the algorithm is in the market, and essentially buy up all the available shares at $4.50 an instant before the institution does. Now the institutions algorithm moves on, and looks for shares at $4.51. The HFT sells all the stock it just bought at $4.50, earning a completely risk free penny a share. Sounds small, but estimates are that practices like this are adding up to many millions of dollars per trading day, and several billion per year.

Q. So for an investor in that HFT fund, sounds like a nice way to make profits. Maybe we’ll revisit this topic to discuss implications for the markets in general one day soon.