High frequency trading: Latency arbitrage accounts for 33% of spread, says BIS

Rick Steves

BIS concluded that market designs that eliminate latency arbitrage would reduce the cost of liquidity for investors by 17%.


Latency arbitrage, the negative aspect of high-frequency trading, has been quantified in a report conducted by the Bank for International Settlements (BIS) using stock exchange message data.

The expression “latency arbitrage” means arbitrage opportunities that are sufficiently mechanical and obvious that capturing them is primarily a contest in speed.

The paper used the entirety of exchange message data, as opposed to standard order book data, to measure latency arbitrage and developed two new approaches to quantifying latency arbitrage as a proportion of the overall cost of liquidity.

The key difference between message data and widely familiar limit order book data is that message data contain attempts to trade or cancel that fail.

This allows the researcher to observe both winners and losers in a race, whereas in limit order book data you cannot see the losers, so you cannot directly see the races.

“We show that races are very frequent and very fast and that over 20% of trading volume takes place in races. A small number of firms win the large majority of races, disproportionately as takers of liquidity”, the company announced.

“Most races are for very small amounts of money, averaging just over half a tick. But even just half a tick, over 20% of trading volume, adds up. The latency arbitrage tax, defined as latency arbitrage profits divided by trading volume, is 0.42 basis points. This amounts to about GBP 60 million annually in the UK. Extrapolating from our UK data, our estimates imply that latency arbitrage is worth about $5 billion annually in global equity markets alone”.

The study found the negative outcome of such high-speed trading is that it increases the cost for investors to buy and sell trading instruments. Quantifying latency arbitrage as a proportion of the overall cost of liquidity, BIS found that it accounts for 33% of the effective spread and 31% of all price impact.

BIS concluded that market designs that eliminate latency arbitrage would reduce the cost of liquidity for investors by 17%.

The study found that latency arbitrage races are very frequent (about one per minute per symbol for FTSE 100 stocks), extremely fast (the modal race lasts 5-10 millionths of a second), and account for a remarkably large portion of overall trading volume (about 20%).

The top six firms account for over 80% of all race wins and losses, with the average race being worth just a small amount (about half a price tick), but because of the large volumes, the stakes add up.

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