04 Aug BCBS – Issued Working Paper – Quantifying the high-frequency trading “arms race”
August 4, 2021
Summary: The paper uses stock exchange message data to quantify the negative aspect of high-frequency trading, known as latency arbitrage, that uses technology to speed process. This refers therefore to arbitrage opportunities that are sufficiently mechanical and obvious that capturing them is therefore primarily a contest in speed involved. The paper makes three contributions to the literature, with first being methodological, utilizing entirety of exchange message data, as opposed to standard order book data. The second is the set of empirical facts that are documented about latency arbitrage. The third is the development of two new approaches to quantifying latency arbitrage as a proportion of the overall cost of liquidity, for those who are undertaking trading.
Findings: The paper shows races to make trades are very frequent and very fast, and that over 20% of trading volume now takes place in races with other traders and their systems. A small number of firms win large majority of races, disproportionately as takers of liquidity and most races are for small amounts of money, averaging over half a tick. But even half a tick, over 20% of trading volume, adds up and latency arbitrage tax, defined as latency arbitrage profits divided by trading volume, is 0.42 basis points. This amounts to about £60mn annually in the UK and extrapolating from the UK data, it estimates latency arbitrage is worth about $5 billion annually in global equity markets. The new approaches developed to quantify latency arbitrage as proportion of overall cost of liquidity, show that latency arbitrage accounts for 33% of the effective spread. It also accounts for 31% of all the price impact, and that market designs that eliminate the use of latency arbitrage would reduce the cost of liquidity for investors, by 17%.
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