Latency arbitrage: a tax credit for low latency traders

Latency arbitrage is in the news again today, as the Wall Street Journal published a story titled Fast Traders’ New Edge. This “edge” is not exactly a “new” trading technique, or even a new story. It has been well chronicled over the last year in the press. In fact, the Journal published an article more than a year ago on precisely the same topic. But it is a popular topic, the equivalent of business tabloid news. There is no shortage of populist anger over Wall Street moneymaking tactics and it is easy to line up industry experts to sound off on the unfairness of it all.

The truth is that latency arbitrage is like any other kind of arbitrage. From Wikipedia:

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

For example, if an algorithmic trading system takes in currency feeds from New York and London and spots a disparity between the two, it can buy on one market and short on the other until the disparity disappears. Traders have been doing this for decades: finding, and taking advantage of, market inefficiencies. Nobody seems to flip their lid over this kind of activity. All perfectly legal and accepted.

With latency arbitrage, an algorithmic engine again takes in two different feeds, this time a raw data feed from somewhere like the NYSE and a consolidated feed representing the National Best Bid and Offer (NBBO), and buys and sells differences between the two. Instead of inefficiencies across markets, it finds inefficiencies across time. Mechanically, it is just two available sources of information exposing an inefficiency. All perfectly legal, but not quite as accepted.

To me this is similar to saying that someone who takes advantage of an obscure IRS tax credit is somehow cheating the system. The tax code is there to define the rules, and it’s our job to play within them. Similarly, when hedge fund strategists sit down to research profit opportunities, they do so using rules laid out by the SEC. If latency arbitrage is deemed uncool and currency arbitrage is okay, the regulating bodies will change the rules. And the algorithmic hedge funds will change their practices to find low risk money elsewhere. Until then, the outrage over latency arbitrage is little more than populist grandstanding.