How Latency Arbitrage Affects the NBBO

Latency arbitrage is a result of several factors including co-location, HFT, flash trading, and SIP latency, all with their own consequences to the marketplace.  Latency arbitrage, however, has a direct effect of contributing to an altered NBBO.  The National Best Bid Offer, (NBBO), is supposed to be the one accurate price of a stock across the entire market, from all exchanges and off exchange venues. It is intended to be a representation of the “best price.” The problem with this intention is that it is impossible to instantaneously update every single participant in the market, even the national exchanges, at the very moment when a change occurs to the NBBO.  

Information about all stock price changes need to travel among all market participants and the speed at which that occurs varies greatly depending upon the distance between the firms, and the technology a firm is using.   This means that all market participants, including the national exchanges themselves, see a different view point of the NBBO at the exact same moment in time.  This information leakage is not the only pitfall of latency arbitrage.  When these privileged firms execute their privileged trades, the NBBO is actually altered by these front-running executions.  

There may be no quick solution to this latency problem, and maybe not even a long drawn out solution, but there are some tools available now that offer some assistance to traders dealing with this problem.  If we cannot stop the latency arbitrage as we know it, we can tackle it another way – with modern day latency arbitrage tactics.

One tool addressing this very issue is the IEX Signal that is used in their proprietary D-Peg® and Primary Peg orders.  The signal acts like a yellow traffic signal, warning a trader of an upcoming change to the NBBO.  Used for a predictive tool, this IEX signal is utilized in these proprietary orders, and is also termed a ‘crumbling quote indicator’.  It predicts an upcoming price change to the NBBO, basically by observing a stock’s NBBO activity, any changes in that price, and then compiling a prediction of which way it’s moving.  IEX’s signal predicts the upcoming NBBO change, and moves their D-Peg orders out of the way, protecting the investor.

This may be one small tool in a very large fight against a long-time practice, a practice the privileged participants are not willing to give up too easily.  With a computer algorithm conducting trades at lightning speed, we all must realize that we are now at a crucial point in the structure of our financial markets. Latency arbitrage must still be tolerated, although the time has come to take action whenever possible.

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Latency Arbitrage Uses Predatory Computer Algorithms

Latency arbitrage occurs when one party exploits a time disparity and earns a profit, typically with a computer algorithm, when that trade is executed solely due to a latency advantage.  Latency arbitrage has caused several heated discussions amongst all market participants, the government law makers and the SEC for many years now, yet this unfair access to US equity markets is still the core strategy of many predatory trading firms.  

An arbitrage occurs when a simultaneous purchase and sale of a stock is executed by a computer algorithm, and earns a profit based on a price difference.  Latency describes the time difference that firms receives the same publicly traded stock information compared to other one another, not all firms receive the same information at the exact same time.  Thus, a latency arbitrage happens when a firm earns a profit from the purchase and sale of stock when that transaction was executed because of a latency advantage.  

Firms pay large premiums to co-locate their equipment right next to an exchange’s servers, and pay a steep price for premium data feeds, all to reduce their latency.  Cutting edge technology with the purchase of raw data feeds, combined with a reduced latency, allows these firms to see the NBBO substantially quicker than what is publicly available through the Securities Information Processor, (SIP).  

Let’s say that a firm issues a buy order to pay the midpoint of the NBBO (the National Best Bid and Offer) for stock XYZ, and the current market for XYZ is $10.10 x $10.11. Their bid will be at $10.105. Predatory HFT firms, using faster data feeds and co-location to reduce the transmission times, may see that the $10.10 bid is now gone and the market is now $10.09 x $10.10. However, the NBBO has not changed yet, since the SIP is slower than the HFT firms, so that midpoint order is still resting at $10.105. For the HFT firm, it is simply a matter of selling at $10.105, and immediately buying back at $10.10, making a half penny.

While the half penny earned may seem miniscule, keep in mind that their computers are doing this all day long, and with the sheer volume of trades all those pennies add up to billions of dollars.  Billions of dollars that is essentially skimmed off the top of your college savings, the average middle class retirement fund, and hard earned investments.  

Add the fact that the offending firm performing the latency arbitrage assumed absolutely no risk whatsoever.  By seeing the true market before the rest of the world adjusts their orders, they know that their trade is a pretty sure bet.  All due to a speed, or latency, advantage.

This is extremely frustrating for the firm placing the original order as they are trying to get a fair price in the middle of the spread.  At the time of execution, however, they end up paying beyond the best offers in the market.

Another scenario arises due to the multiple venues available.  Various dark pools in addition to the national exchanges, can each have liquidity available, but as you go through collecting that liquidity, HFT firms can front run your order. Assume the same firm above was attempting to buy 5000 at $10.11, and the NBBO showed that quantity available at that price. But as the firm begins to send orders to various venues to purchase that amount, HFT firms see that activity, and jump ahead of the order to take it all at $10.11. The original firm may only get a few hundred shares, instead of the 5000 they saw when they placed the order. Now they are required to pay $10.12 if they want to buy the balance.

A trader gets whiplash from this ‘now you see it, now you don’t’ scenario.  Just by placing the order, they alert the HFT’s of their intention, and can plan on closing at the higher price, unless they find a way to play in the latency game.  

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Latency Disparity Contributes to Arbitrage

Reg NMS and the current fragmented market are obvious contributing factors to latency issues, although there a couple of additional reasons that stand out as to why not all firms receive the same information at the same time.  One contributing factor to this latency disparity is of course the speed of the Securities Information Processor (SIP), and another is the fact that firms co-locate their equipment to the servers of the exchanges.  This advantage of speed combined with a predatory computer algorithm for trading, gives a very unfair advantage of access to see the public NBBO data before trading firms with a slower connection.  

SIP

The SIP is tasked with centralizing all stock market data, then disbursing that data at the same time to all market subscribers.  the SIP has put much focus on improving its latency, although direct data feeds are historically faster than the consolidated feeds.    Some are of the mindset that reducing the SIP latency will create a more fair and efficient market, the issue of latency arbitrage is much more complicated than just reducing the latency of the SIP.  

The SIP latency refers to the time that it takes to receive all stock information, compile it together, aggregate and assemble all data, and then dispense it out.  The latency problem with the  SIP is not the time that it takes to perform these functions, even if that time is improved, it is with the method of disbursing all data.  The transportation of that data is where the challenges lie.  

There will always be a latency issue involved with consolidated data compared to direct data feeds, because there are various sources for the SIP information.  For example, the NYSE houses their data center in Mahwah, NJ, while Nasdaq’s server center is in Cartaret, NJ.  Just a slight different geographic location can make enough of a speed difference that a latency issue is created.

Flash Trading by Co-Location

Flash Trading refers to the practice of exchanges ‘flashing’ buy and sell order information to select premium subscribers, typically these are HFT firms, a fraction of a second prior to when they are publicly available.  This is very controversial as HFT firms use this advantageous information to trade ahead of pending orders, which is also known as front-running.

This predatory practice has been going on for quite a long time, as in 2009 Senator Charles Schumer requested that the SEC ban flash trading altogether, stating that it contributes to a two-tiered market, the privileged few and everyone else.  

Other factors such as computer algorithms, technology, regulations, and distance contribute to latency issues, however, these two main factors of consolidated feed vs. direct feed and flash trading, both lay the groundwork for the current two-tiered market structure.  

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.