Latency Arbitrage
Latency is the difference between the time a signal is generated and the time it is received. It is the transmission time of a message over a communication network. The hours it took Rothschild’s courier to deliver the news of the victory at Waterloo to the floor of the London Stock Exchange were latency. In modern electronic communication networks latency is measured down to the nanosecond. Latency is most important for traders working in transparent, public markets where all participants have access to the same information.
Single Market
For example, take a latency arbitrage trader who is monitoring the June Gold contract on the COMEX. The current market is $1227.0 by $1227.10, 28 lots bid and 19 lots offered. As soon as new market data is available on COMEX, the exchange disseminates that information to all subscribers on the network. A series of sell orders arrive that suggest the price will decline. All of the market-makers rush to quickly cancel their bid orders, or replace them down to a lower price, except one trader who is slow to react. His bid order remains working at $1227.0 for 3 lots. The arbitrage trader seizes on this opportunity and sells to the maker with a stale quote (one that is out of sync with current market conditions), entering a short position. When the market subsequently moves down to $1226.7 by $1226.8, the arbitrage trader buys back his short position at $1226.8, realizing a profit of $0.20 per contract.
Not all stale orders are mistakes. Some are manual orders by traders with a long term view who do not mind buying at a price slightly above the current “fair” market price. And these price discrepancies are small, typically only a few price points. The arbitrage trader must perform hundreds of trades such as the one described above to generate any meaningful profit.
Not all stale orders are mistakes. Some are manual orders by traders with a long term view who do not mind buying at a price slightly above the current “fair” market price. And these price discrepancies are small, typically only a few price points. The arbitrage trader must perform hundreds of trades such as the one described above to generate any meaningful profit.
Multiple Markets
True arbitrage is the ability to buy and sell the same security on different exchanges, at different prices, at the same time. One example of a true arbitrage opportunity that exists in modern finance is the market for Spot FX. As in the precious metals market, spot is a trade that settles T+2 (two days after trade date) and it is the benchmark rate for foreign exchange pricing. By some measures the Spot FX market is the largest in the world, involving trillions of dollars of transactions every day. However, Spot FX is entirely OTC, meaning that trading does not take place on an exchange. Rather there are a multitude of Electronic Communication Networks (ECNs) that act as centers of liquidity and price discovery. And the asset exchanged on each of these venues is the same: a contract to buy one currency and sell another.
Two of the largest ECNs are EBS and HotSpot. Both ECNs offer trading in the major currency pairs, such as EUR/USD, USD/JPY, and GBP/USD. Suppose EUR/USD is trading on both platforms at a price of 1.1191 by 1.1192 (meaning 1 EUR is able to purchase 1.1192 USD). Then a piece of news hits the headlines which is negative for the Euro. Perhaps German Chancellor Angela Merkel has come out saying the currency is too strong, or ECB Chief Mario Draghi has hinted at further quantitative easing, and the currency takes a hit. Traders on EBS react first, sending the market down to 1.1180 by 1.1185. Traders on HotSpot are slower to react, and for a moment prices remain at 1.1191 by 1.1192. This is an example of a crossed market, where the bid on HotSpot is higher than the offer on EBS.
Two of the largest ECNs are EBS and HotSpot. Both ECNs offer trading in the major currency pairs, such as EUR/USD, USD/JPY, and GBP/USD. Suppose EUR/USD is trading on both platforms at a price of 1.1191 by 1.1192 (meaning 1 EUR is able to purchase 1.1192 USD). Then a piece of news hits the headlines which is negative for the Euro. Perhaps German Chancellor Angela Merkel has come out saying the currency is too strong, or ECB Chief Mario Draghi has hinted at further quantitative easing, and the currency takes a hit. Traders on EBS react first, sending the market down to 1.1180 by 1.1185. Traders on HotSpot are slower to react, and for a moment prices remain at 1.1191 by 1.1192. This is an example of a crossed market, where the bid on HotSpot is higher than the offer on EBS.
EBS |
Value |
Value |
HotSpot |
|
Bid |
Ask |
Bid |
Ask |
|
1.1180 |
1.1185 |
Value |
1.1191 |
1.1192 |
This is an opportunity for the arbitrage trader. He takes advantage of the slow reaction time on HotSpot to hit the bid price of 1.1191, simultaneously sending a buy order to lift the offer on EBS at 1.1185. He has locked in an instantaneous profit of 0.0006, or $600 on a 1M notional trade size, and taken no risk. Obviously a strategy that involves certain profit with no risk is extremely attractive, and competition among latency arbitrage traders in FX is especially fierce. Automated systems comb the dozens of FX ECNs, seeking out fleeting discrepancies of fractions of a cent.