Ultrafast Trading Costs Stock Investors Nearly $5 Billion a Year, Study Says
U.K. regulator’s study says ‘latency arbitrage’ imposes a small but significant tax on investors
High-frequency traders earn nearly $5 billion on global stock markets a year by taking advantage of slightly out-of-date prices, imposing a small but significant tax on investors, a new study says.
The study—released Monday by the U.K.’s financial regulator, the Financial Conduct Authority—sheds light on a controversial practice called “latency arbitrage,” in which ultrafast traders seek to react to fresh, market-moving information more quickly than others can.
Such information could range from corporate news to economic data to price fluctuations in other stocks or markets. Electronic trading firms invest in sophisticated technology, such as networks of microwave antennas linking exchanges thousands of miles apart, to process such information and execute trades in millionths of a second.
The FCA’s study comes as politicians in both Europe and the U.S., including Sen. Bernie Sanders (I., Vt.) and Sen. Elizabeth Warren (D., Mass.), have pushed for a financial-transaction tax, a policy aimed in part at curbing high-speed trading. The study could also fuel efforts by exchanges to restructure their markets to limit latency arbitrage—for instance, by introducing split-second delays before trades, known as speed bumps.
Many experts say latency arbitrage raises costs for investors by making everyone in the markets less likely to post competitive price quotes for stocks, knowing that those quotes could get picked off by speedy traders. That, in turn, means investors get slightly worse prices whenever they buy or sell shares, traders say.
Advocates of high-frequency trading disputed the FCA’s study.
“Many academics have debunked the latency arbitrage myth and this paper seems to have a political agenda,” said Kirsten Wegner, Chief Executive Officer of Modern Markets Initiative, a U.S. lobbying group for high-frequency trading firms.
Automated trading has benefited investors over the years by significantly cutting the cost of executing stock transactions—savings that are ignored by the FCA’s study, Ms. Wegner added. She also criticized the study for relying on a relatively small set of U.K. trading data to estimate latency-arbitrage profits on stock exchanges world-wide.
An FCA spokesman denied that the regulator was seeking to advance a political agenda related to high-frequency trading.
Precise data on latency-arbitrage profits is unavailable because of the opaque nature of most high-frequency trading firms.
The FCA’s study called latency arbitrage a “tax” amounting to 0.0042% of daily stock-trading volume. The study’s authors derived that figure by examining about two months of activity at the London Stock Exchange in 2015, using a type of raw trading data that hasn’t been previously studied by researchers.
Although that is a tiny number—less than one-half of one-hundredth of 1%—the study’s authors say it adds up. If latency arbitragers made a similar rate of profits elsewhere, they would have earned $4.8 billion on stock exchanges around the world in 2018, including $2.8 billion at U.S. exchanges, the FCA study found.
Moreover, the impact of latency arbitrage is unevenly distributed, with big investors facing the greatest costs, according to the study’s authors, who include two FCA researchers and a professor at the University of Chicago’s Booth School of Business.
“The latency arbitrage tax does seem small enough that ordinary households need not worry about it in the context of their retirement and savings decisions,” they wrote. “Yet at the same time, flawed market design significantly increases the trading costs of large investors, and generates billions of dollars a year in profits for a small number of HFT firms and other parties in the speed race, who then have significant incentive to preserve the status quo.”
The study found that about one-fifth of trading activity at the LSE was concentrated in brief “races” between firms seeking to engage in latency arbitrage. In such races, two or more firms attempt to trade the same stock at the same time, but only the first can profit by being the quickest to execute its trade.
During the period examined in the study—43 trading days from August to October 2015—about 22% of trading volume in FTSE 100 stocks took place in such races, which on average lasted 81 millionths of a second, the study found. The FTSE 100 is the U.K.’s large-cap index, with such companies as BP PLC and Vodafone Group PLC.
The FCA’s study relied on more than 2 billion electronic messages that trading firms sent to the LSE, or that the exchange sent to traders, during that period.
Such data—which hasn’t been used in past studies of latency arbitrage—showed failed attempts to trade as well as actual trades. That allowed the authors to reconstruct the tiny bursts of activity in which multiple firms raced to seize the same brief profit opportunity.
The data also showed only a few firms can profit from latency arbitrage, a finding that likely reflects the cost of building and maintaining the technology needed for ultrafast trading.
More than 80% of races in FTSE 100 stocks were won by the same half-dozen firms, the study found. It didn’t identify the firms in question.
FCA researchers outline $5bn ‘tax’ imposed by high-speed trading
Paper released by UK regulators homes in on tactic known as latency arbitrage
UK market regulators have calculated that aggressive high-speed traders beating the rest of the stock market to deals amounts to a “tax” of £42,000 ($55,000) for every £1bn traded.
Investors often express concern about the risk of having orders picked off by lightning-fast algorithms seeking to exploit small moves in stock prices, while regulators have been keen to assess the impact of such activity on market stability and integrity.
A new paper — published on Monday and written by Matteo Aquilina and Peter O’Neill of the UK’s Financial Conduct Authority and Eric Budish from the University of Chicago Booth School of Business — focused on a tactic known as latency arbitrage. That is where some high-frequency trading firms use a split-second lead to profit by “sniping” older, uncompetitive quotes in so-called races.
The study found that “races” took place about once a minute for FTSE 100 stocks and accounted for a fifth of overall FTSE 100 daily trading volume. The winners triumph by tiny margins of 0.000005 to 0.000010 seconds.
“We find that the ‘latency arbitrage tax’, defined as the ratio of daily race profits to daily trading volume, is 0.42 basis points, or 0.0042 per cent,” the authors said.
The authors used messaging data, which captures successful trades as well as cancelled transactions, to examine a nine-week period of trading on the London Stock Exchange in the autumn of 2015.
After calculating the “tax”, or value extracted by high-frequency traders, the authors then applied the number to 2018 data and concluded that the sum at stake in latency arbitrage in the UK equity market was about £60m a year. Extrapolated globally, they said that amounts to about $5bn.
“Our main hope for future research . . . is simply that other researchers and regulatory authorities replicate our analysis for markets beyond UK equities,” the authors said.
Researchers argued that the features of the market that give rise to latency arbitrage races have not changed since 2015, meaning high-speed traders still have opportunities for profits.
The top three high-speed trading firms, which the report did not name, accounted for more than half of all race wins and losses. Commercial rivals have tried out “speed bumps” to slow down the market.
A spokesperson for the LSE said. “[Our] markets provide deep liquidity and efficiency for a wide range of market participants.”
Mr Aquilina has conducted other studies on high-frequency trading for the FCA. In 2016 he found no evidence that HFTs could “see the true market” and trade in front of other participants.
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