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August 04, 2009

Technology Enablers of Latency Arbitrage

Ralph Frankel, CTO of Solace Systems, has a fascinating article on the technology for shaving microseconds and milliseconds off the market-response time they can achieve for high-frequency trading functions. He classifies "tricks of the trade" into five categories, each incorporating sophisticated specializations that combine to provide a significant edge. (And aptly labels this latency arbitrage, as distinguished from statistical arbitrage and any other technique that might be employed in algorithmic trading.)

He concludes by raising the question: "Is latency arbitrage fair?", ultimately answering with "Yes—if you’re willing to invest in the same technology".

The engineer in me is deeply impressed with what the systems from Solace can apparently do. The economist in me is horrified by the waste of resources and talent. Never mind fairness--the latency reduction arms race entails substantial costs (a boon for Solace Systems), but no consequent benefit in overall market performance. The situation gives us a choice to pay the transaction cost in computer software/hardware, or in latency arbitrage, but either way it's a transaction cost.

(Thanks to the Felix Salmon blog for the link to Frankel's illuminating article.)

Posted by wellman at August 4, 2009 03:13 PM

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I had had the impression that something had changed recently in the market rules -- something about trading firms being able pay a fee to get privileged access to orders, milliseconds before those who don't pay such a fee.

But this article seems to imply it's all about the technology.

Could anyone set me straight on this?

Posted by: dreeves at August 12, 2009 03:41 PM

The recent flurry of news attention to HFT was spurred by a NYT article that focused on a particular subspecies, reacting to flash orders. Such orders are "flashed" to a privileged group for a brief interval before going public to the market. This practice has subsequently come under scrutiny by Congress and the SEC.

HFT more generally does not necessarily assume privileged access. The particular play of "latency arbitrage" aims to give a trader the benefit of advantaged access to information through technology. Even if you and I are granted access rights simultaneously, if my computers/networks are faster than yours then I can exploit the information before you get the opportunity.

Posted by: wellman at August 16, 2009 09:42 PM

Looks like the NYT article has motivated politicians to get involved, with their natural instinct being to tax:


Posted by: klochner at August 31, 2009 01:04 PM

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