Controversial practice imposes small but dramatic tax on investors, according to financial watchdog
A new study by the U.K. Financial Conduct Authority (FCA) has determined that high-frequency trading (HFT) firms take in nearly US$5 billion on global stock market activity annually from a controversial practice.
Through so-called “latency arbitrage,” ultrafast traders are able to act on up-to-the-second, market-moving information — including corporate news, economic data, and price fluctuations across different stocks or markets — more quickly than other investors. As reported by the Wall Street Journal, such high-speed firms invest in sophisticated technology that lets them process data and enact trades in millionths of a second.
The FCA’s study referred to latency arbitrage as a “tax” representing 0.0042% of daily stock-trading volume, a figure calculated from an examination of two months’ worth of activity in 2015 at the London Stock Exchange (LSE). That rate of profit would have added up to US$4.8 billion on stock exchanges globally in 2018, the study’s authors said, including US$2.8 billion at U.S. exchanges.
The impact of latency arbitrage, they added, is not evenly distributed. For everyday investors who are making savings and retirement decisions, the tax seems small; but for large investors, the trading costs are dramatically larger as flawed market design amplifies the effect of the tax. The upshot, according to the researchers, is “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.”
Within the two-month window studied, approximately a fifth of trading activity was focused on short “races” between two or more firms that aim to engage in latency arbitrage. Using over 2 billion electronic messages that trading firms sent to the LSE, or vice versa, the researchers were able to reconstruct failed attempts at high-speed trading as well as actual trades.
Because of the costs associated with building and maintaining the technology needed for ultrafast trading, only a few firms stand to profit from latency arbitrage, as shown by the data in the study. The same half-dozen firms emerged as winners in more than 80% of races to trade FTSE 100 stocks, the study found.
“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,” the Journal said, noting how exchanges around the world have explored the use of speed bumps as a way to level the field.
But the study was disputed by HFT advocates, including the CEO of Modern Markets Initiative, a U.S. lobbying group for HFT firms. “Many academics have debunked the latency arbitrage myth and this paper seems to have a political agenda,” Kirsten Wegner told the Journal.
Wegner contended that investors have enjoyed significantly lower costs of executing stock transactions over the years thanks to automatic trading. She also pointed out that the study’s extrapolated latency-arbitrage profits on stock exchanges around the world based on a relatively small set of U.K. trading data.
“Precise data on latency-arbitrage profits is unavailable because of the opaque nature of most high-frequency trading firms,” the Journal noted.