Measuring Arbitrage in Milliseconds

You don’t need a crystal ball or a tipoff if your computer connections are fast enough.

Some hedge funds are using a trading strategy called “latency arbitrage” to take advantage of differences in the speed of price quotations at U.S. exchanges and dark pools — a practice that reminds some investors of past abuses such as mutual-fund market timing.

“High frequency” quantitative hedge funds at firms such as Citadel Group, D.E. Shaw Group and Renaissance Technologies have direct feeds to U.S. exchanges. These feeds cut the delay on quotes down to milliseconds. During the last two years, many funds have paid for “proximity hosting,” the installation of their servers in the same data centers as the exchanges, to shave more “microseconds,” or millionths of a second, off that latency.

Latency, in electronic trading, is the amount of time a quote or an order spends in the ether, and it’s where many funds are eyeing an edge.

“The fastest one wins,” said a technology officer at a major hedge fund who was sounding out exchanges with an eye to setting up a latency-arbitrage strategy. He said the first step is to maximize the speed of market-data software and exchange connections, and the second is to find the “golden egg” - a venue or counterparty whose information is slower. The only risk, he said, was that “everybody’s getting faster.”

Now that software can trade in and out of stocks at light speed, a fund can exploit lags of milliseconds between different exchanges. Until the Securities and Exchange Commission clamped down on “SOES bandits,” small-time traders and firms were making thousands of dollars a day on lags of a few seconds between exchanges in the late 1990s.

Institutional traders now may be making millions by being a few milliseconds ahead, and some believe the SEC should clamp down again. In one form of latency arbitrage, funds can synthesize quotes from all exchanges and simulate the “National Best Bid and Offer.” The SEC expects brokers to use the NBBO - the highest bid and lowest offer on a given stock across all exchanges - as a price guideline and requires them to have it available to clients.

Exchanges disseminate continuous updates of the NBBO on stocks in separate feeds to the price quotations. Many dark pools, the anonymous stock-trading electronic venues that don’t publish bids and offers, price stocks at the midpoint of the NBBO because they want to give clients some benchmark for their pricing. The delay between the appearance of bids and offers on the direct feeds and the processing of the NBBO at dark pools presents arbitrage opportunities.

If a fund’s computers are fast enough, they can estimate where the midpoint of the NBBO will be fractions of a second faster than dark pools, which allows them to know where the price is going in that pool.

Many quantitative funds, which rely on computer models for trading, have the ability to get in and out of large stock positions in milliseconds, which means buying a stock at current prices at an exchange and selling it in a dark pool after an uptick you know is coming is a cinch.

“You have tomorrow’s newspaper today,” said Richard Gates, a portfolio manager for TFS Market Neutral fund in West Chester, Pa., who looked into a latency-arbitrage strategy after a broker outlined the success other funds had with it. “You’re looking at stale prices. Those are the types of investment strategies that arbitrageurs and hedge-fund managers drool over.”

But Mr. Gates compares latency arbitrage to “mutual fund market timing,” a practice banned in 2003 in which some traders were given tipoffs as to where prices were going.

Regulators acknowledge exchanges transmit quotes through direct feeds more quickly than through the NBBO tape but don’t believe the lag is significant enough for major arbitrage opportunities. One regulator said any “simulated” NBBO would always be a rough estimate because all exchanges disseminate their quotes at slightly different speeds.

In an e-mail seen by Dow Jones, a dark-pool operator estimated the NBBO feed it uses to price stocks was delayed 10 to 15 milliseconds - enough time for a fund to estimate the NBBO using its own feeds and place an order.

Redline Trading Solutions, a financial software firm, claims one of its products can consolidate quotes from direct feeds in a way that sounds like a simulated national best-bid and offer in “single-digit” microseconds.

For the scale of Mr. Gates’ fund, direct feeds to the exchanges proved cost prohibitive. But for larger funds, Mr. Gates said it would be foolish not to engage in latency arbitrage. And he said dark pools, whose profitability is linked to their volumes, may be tempted to turn a blind eye to the activity as long as other clients don’t complain.