In Advance of Flash Boys – Let’s Again Talk Latency Arb




Yesterday, excitement and trepidation substantially heated up over this upcoming Monday’s release of Michael Lewis’s Flash Boys. The chapter list, as well as some selected passages somehow leaked out (they were briefly on display on Norton’s website for the book). It should be no surprise to anyone, given Lewis’s Vanity Fair article a few months back, that the story of Goldman Sachs / Sergey Aleynikov is a substantial part of this book. IEX is apparently featured prominently as well.

CBS’s 60 Minutes is apparently also doing a story this Sunday about IEX, and our market structure. It is not the first time 60 Minutes has touched on our modern market structure – you may recall our own Joe Saluzzi featured in a 2010 60 Minutes piece – How Speed Traders Are Changing Wall Street.

This Sunday’s 60 Minutes piece and Lewis’s Flash Boys are both likely to delve into fairness issues surrounding latency arbitrage, and so we wish to talk about it again this morning.

We first wrote about Latency Arbitrage in 2009 with our white paper – Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading. That paper raised three questions:

1)      Most professionals on Wall Street have taken a standard from our past for granted, that everyone sees the same quote and market data at the same time. What if the time differential between what the HFTs see and what everybody else sees was 5 minutes instead of 5 milliseconds? Would that be acceptable? It is not the amount of time that matters. It’s that a differential exists at all. Who would bet on a horse race if a select group already knew who won?

2)      Is it fair to sell these rights to the highest bidders when market centers are supposed to be protecting all participants’ interests equally? At the end of the day, aren’t market centers charging HFTs a higher fee in exchange for giving them an advance look at the NBBO?

3)      When a market center provides an HFT with the ability to out-maneuver institutional orders, aren’t they putting institutions and their brokers in breach of their fiduciary responsibilities, especially those institutions managing pension funds governed by Employee Retirement Income Security Act (ERISA)?

We also wrote a note to you in 2011 titled A Market Built On Theft Sucks. That note highlighted:

1)      That the SEC knew Latency Arbitrage would come into play in 2005.

2)      Scott Patterson of the WSJ highlighted the latency arbitrage game in a story titled Fast Traders’ New Edge, after visiting with TFS’s Portfolio Manager Rich Gates, who became concerned about latency arbitrage in early 2009 after a Wall Street bank pitched it as a strategy to his firm!

3)      In 2011 even Goldman Sachs acknowledged that latency arbitrage was disadvantaging slower traders in its matching engine, as they hired RedLine for their faster feeds – “ to prevent participants having time to predict price movements based on other venues and take advantage of latency arbitrage opportunities.”

 Finally, recently you may have had the pleasure of individually speaking to a Young Gentleman who recently worked for a bulge bracket firm analyzing institutional trades. His findings have been shocking. He is also highlighting:

1)      Some bulge bracket dark pools are still priced off the SIP – and perhaps intentially so.

2)      The executives at these firms oversee their own high speed proprietary electronic trading, as well as their customer electronic trading solutions (SORs and Dark Pools).

3)      A few banks promised to create a faster data stream – but nothing they created for customers’ orders was as fast as what they created for themselves.

4)      Some bulge bracket dark pools are sending high speed direct IOI feeds to certain participants.

Ok. With our prior work and peachings, and with the Young Gentleman’s work and preachings, and with Michael Lewis’s flashlight, and with 60 Minutes’ flashlight, and with AG Schneiderman’s flashlight, you will all likely see some big changes in the near future. You may expect to see large firms that provide you with SORs and electronic trading tools “get some religion.” You may expect to see some of them make some changes for the better.

We hope!

And while some folks (Rosenblatt’s Schack for example, who tweeted “Latency arb is real. Anyone who knows modern mkt structure wouldn’t deny it. Not sure we need Michael Lewis for that”) are quick to say things like “everyone knows about latency arbitrage, and dark pools being priced off a slow SIP – what’s the big deal?” , we say it is a big deal. It is a needlessly and purposely built-in pickoff feature in our market structure, and becoming desensitized to this weakness does not make it acceptable!

 Enjoy Lewis’s new book. Or don’t enjoy it. But be prepared for some changes. This type of attention has a tendency to create positive change in our industry much more quickly and effectively than any government entity has ever been able to.