Everyone knows that the speed of trading has accelerated in the past several years. If you are going to be in the high frequency trading arena, it really doesn’t matter how market analysis is done. All the HFT firm cares about is speed. They want to be the best bid, best offer and continually get the edge. In and out, in and out, in and out, millions of times a day. They leave position trading, financial statement analysis, trend analysis, and technical analysis to the schmucks.
There is only so much edge the HFT guys can get in the current environment. Each of them are in a computer arms race for speed. How do they create new edges for themselves? Lay new pipe. Currently, HFT firms are spending millions laying new faster fibre optic cable across the earth. Between New York and Chicago, New York and London, London and Paris, HFT firms are trying to wring out every advantage they can. Milliseconds mean millions.
As Tom McCabe wrote in the article, “When the Speed of Light Is Too Slow: Trading at the Edge”, firms are now delving in even deeper. He wrote, “Dr. Alex Wissner-Gross, a Research Affiliate at the MIT Media Laboratory, and Dr. Cameron Freer, a Junior Researcher at the University of Hawaii, have developed an econophysical mathematical model called “relativistic statistical arbitrage” that provides a strategy for dealing with this new class of light-speed-limited, long-distance trading, in a paper published in Physical Review E. They advise market traders to locate their computers at certain points in between the two markets, with the locations of these points determined by how fast each market can send pricing information to the trading computers.” The HFT firms are employing rocket scientists to get an edge!
Co-location has always been a bit of a controversial issue among professional traders. HFT firms have paid peanuts to exchanges to locate their computers right on top of exchange servers. The old line members and traders can’t get that advantage. In the interest of finding even more speed, the HFT firms are going to use this research to take it one step further.
“Recent advances in high-frequency financial trading have made light propagation delays between geographically separated exchanges relevant. Here we show that there exist optimal locations from which to coordinate the statistical arbitrage of pairs of spacelike separated securities, and calculate a representative map of such locations on Earth. Furthermore, trading local securities along chains of such intermediate locations results in a novel econophysical effect, in which the relativistic propagation of tradable information is effectively slowed or stopped by arbitrage.”
From the paper: “Under these assumptions, the optimal intermediate locations are therefore midpoints weighted by turnover velocity. In Fig. 2 we compute the optimal intermediate locations, as such weighted midpoints for all pairs of 52 major exchanges based on 2008 turnover velocity data reported by the World Federation of Exchange. In practice, intermediate locations could be calculated for specific pair trades using more precisely estimated reversion speeds, or for more complicated transactions involving more than two securities.
Note that while some nodes are in regions with dense fiber optic networks, many others are in the ocean or other sparsely connected regions, perhaps ultimately motivating the deployment of low-latency trading infrastructure at such remote but well-positioned locations.”
HFT firms are beginning to actively seek out Eskimos for hire to take care of some remote servers! No doubt they will figure out how to turn their firm into an Indian casino to avoid paying taxes on profits to the government!
The reason that this technological advance can be made is the physical structure of the fiber optic cable. After all, it’s light that is traveling up and down. Light is matter, and has physical properties that can be manipulated for optimum efficiency. As the researchers point out, “Such slowing or stopping of the propagation of pricing information due to arbitrage is somewhat analogous to the refraction and scattering of light by a dielectric medium, but novel in an econophysical context. We note that the effect exists independently of any communication latency intrinsic to the underlying hardware infrastructure, and would expect to observe a similar effect wherever tradable information en- ters a network “medium” capable of performing local arbitrage. This result also raises the possibility of establishing arbitrage analogs of other concepts from optics and acoustics, such as reflection and diffraction.”
There are limits to the technology, but those are manmade. It’s called margin. The scientists ponder the effects of margin on their hypothesized trading system. In effect, the trader could wind up with a very long position at one exchange, and a very short position at another. The capital requirements could eat up the profitability of the strategy. They say, “In traditional trading with a single exchange, positions that offset each other typically incur reduced margin requirement. However, a dishonest trader in the relativistic scenario, claiming falsely to implement an emulated strategy, could make unfair use of these reduced requirements, if allowed to do so, (italics mine)and hence only a guarantee of both transactions should suffice. With an actual intermediate node, this guarantee could be provided by a local audit. For example, immediately following a pair trade, the intermediate node could transmit a message to each center, cryptographically signed by a trusted local agency, certifying that an offsetting order to the other center that is guaranteed to be filled, such as a market order had just been issued.”
Back in the mid 1980's, there was a pretty decent business arbitraging Eurodollar futures between the CME and the LIFFE. The two exchanges were in a battle for the contract, and sometimes their prices would get slightly out of line. As market conditions dictated, you’d “Sell London, Buy Chicago” or vice versa. Each exchange would charge margin. Once the margin call got up to a certain number, you’d have to arbitrage them off. The cost of carry would eat into your profit-or the bank would just not extend that much credit for you to hold the position.
Because the two exchanges were locked into a competitive battle, their respective clearinghouses didn’t allow mutual offsetting of positions. This is standard in the futures industry. In the SEC regulated cash equity and option industry, it is not the case. The exchanges and dark pools do not see any benefit in having a well run clearing house and farm that operation out. Fungibility is the key reason for that.
Currently clearing is a total mess on the SEC side of the business. It takes three days to clear. Counter parties are not often known. When mistakes happen, like the flash crash, it’s virtually impossible to wade through the data to find out why.
I think it is worth pointing out that when contemplating exchange or national regulation, the regulators need to sufficiently ponder the least common denominator of trader because no matter what safeguards and regulations they put into place, someone will always try and find a way around them.
The other interesting conclusion that the paper has deals with marketplaces. Throughout history, whenever new technology swept into a marketplace, exchanges went out of business or consolidated. The other thing that happens is that technology forces liquidity from one market to another. As one market gets more of the liquidity, any new liquidity naturally goes to that market. We have seen that time after time in competitions between exchanges, and the ongoing competition between open outcry pit and computer screen. Wherever fills are most efficient and quick gets the business.
That is not to say that countries, or exchanges, haven’t tried to use a subsidy or incentive to push the business their way. That certainly happens all the time. But liquidity is the best subsidy. If the exchange using the subsidy takes it away and liquidity leaves, then the conclusion must be that all the volume and trading that took place was a mirage.
Their conclusion, “For example, in the nineteenth century, more than 200 stock exchanges were formed in the United States, but most were eliminated as the telegraph spread. The growth of electronic markets has led to further consolidation in recent years. Although there are advantages to centralization for many types of transactions, we have described a type of arbitrage that is just beginning to become relevant, and for which the trend is, surprisingly, in the direction of decentralization. In fact, our calculations suggest that this type of arbitrage may already be technologically feasible for the most distant pairs of exchanges, and may soon be feasible at the fastest relevant time scales for closer pairs.
Our results are both scientifically relevant because they identify an econophysical mechanism by which the propagation of tradable information can be slowed or stopped, and technologically significant, because they motivate the construction of relativistic statistical arbitrage trading nodes across the Earth’s surface.”
The technological advance marches on. It pays to embrace the new leaps in technology. The industry should not be afraid of it. The over riding concern of the industry regulators and exchanges should be one thing: provide a fair and orderly market for all. This new leap in technology could further fragment marketplaces.
Currently, we have many dark pools of liquidity in the US and Europe. They are beginning to be formed in Asia. The hypothesis behind this technology is that we will have even more mini-markets opening everywhere. I don’t know if this is a good or a bad development, but it bears keeping an eye on.
If the SEC were to ban payment for order flow, internalization, the ability to front run, brokers that are held if a price trades through their order then the market would become flatter, more competitive and better for everyone. But, knowing the SEC, they won’t. Then the new technology will create mini oligopolies where private firms rip off their customers in the dark.
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