Update 3rd June 2010: As this post originally drew much of its source material from a Themis Trading white paper, in the interests of balance we would also like to include a link to TradeWorx Inc‘s Public Commentary on the SEC’s Concept Release, where TradeWorx CEO Manoj Narang debunks the existence of the Latency Arbitrage strategy. You can find the TradeWorx document at http://www.tradeworx.com/TWX-SEC-2010.pdf (pay particular attention to page 16, which makes for very interesting reading).

Anyway, here is our original post on the topic…

One of the issues that has caused a fair amount of controversy around high frequency trading recently is that of latency arbitrage.

In simple terms, latency arbitrage is the practice of buying or selling an instrument slightly ahead of other market participants, by taking advantage of small delays in price dissemination. Among high-frequency traders (HFTs), latency arbitrage is a widely used strategy because it enables them to capture a steady stream of profits, with very little risk. So how does it actually work?

In essence, it boils down to two elements.

First, HFTs benefit from tapping into raw exchange data feeds, rather than sourcing their market data via the consolidated quote feeds used by the rest of the market.

Second, they co-locate their servers at the exchange’s data centres, thus minimizing any potential latency that would arise from sending electronic messages over physical distances. According to their detractors, it is these two elements that give HFTs the ability to see prices ahead of the rest of the market and trade on those prices at the expense of other investors.

The Raw Feed Advantage

In the US, most market participants (including professional investors, institutional fund managers and screen-traders) pick up their market data from a consolidated data feed, which includes last traded prices, best bids/offers and market depth from each exchange (plus some ATSs and ECNs). This data consolidation process introduces a small degree of latency, so by the time the data is actually disseminated out to the market, it is already a few milliseconds out of date.

High frequency traders on the other hand, source the raw price data direct from the exchanges. From those raw feeds, they are able to re-engineer the NBBO (National Best Bid/Offer) prices and market depth at faster speeds than the data consolidators (or “plan processors” to give them their official name), thus giving themselves the advantage of being able to see and therefore trade on prices ahead of the rest of the market.

The Co-Location Advantage

In a further bid to reduce latency, most high frequency traders also co-locate the servers hosting their “black box” trading systems in racks at the exchange data centres. As anyone with a basic knowledge of physics will know, the less physical distance an electronic message has to travel from point A to point B, the less latency is incurred along that journey.

This double whammy of being able to source data direct from the exchanges and co-locate their servers at the exchanges’ data centres gives HFTs speed advantages running into milliseconds, which is ample for them to perform consistent, profitable latency arbitrage.

The Controversy

The controversy stems from whether these two elements give high frequency traders an unfair advantage, regardless of how much they pay for the privilege. Regarding the raw data feed aspect, in its Concept Release document (www.sec.gov/rules/concept/2010/34-61358.pdf), the SEC asks whether delays should be introduced to raw data feeds, so that there is no temporal advantage to be gained from using them versus using consolidated feeds. Many would support the introduction of such delays.

As for co-location, many would argue that it is a conflict of interest for exchanges to offer such facilities, because the exchanges should protect the interests equally of all market participants, rather than offering advantages to a select few.

If the SEC does introduce restrictions on co-location and impose delays to raw datafeeds, it will be interesting to see how the high frequency traders respond, particularly those who's main income derives from latency arbitrage. Any changes introduced by the SEC will only apply to US exchanges, so the HFTs may just migrate across to overseas exchanges, unless international authorities like CESR follow suit with similar regulations.

Further Reading

For further reading on the subject of latency arbitrage and high frequency trading, there is an excellent white paper on the topic written by Sal Arnuk and Joe Saluzzi of Themis Trading, which you can download from their site at http://www.themistrading.com. Sal and Joe have also sent a spirited and well-reasoned response to the SEC’s Concept Release, which you can also find at their website.