Rigged Market: How Latency Arbitrage Picks $3 Billion From Your Pockets

traderIf you're like most people, you want to have some money around when you retire so you can enjoy your remaining years. So you buy mutual funds and invest in a 401(k), hoping to get 8% annual returns. If you run a business, you might want to raise capital so you can buy machines and hire people to meet the needs of your customers.

It's much more difficult for these things to happen if the stock market is rigged. But because of huge hedge funds like Citadel Group and Renaissance Technologies, those markets are selling risk-free profits to the highest bidders. One way they're picking your pocket -- to the tune of $3 billion a year -- is through latency arbitrage.

Buying Access to Insidery Information

The practitioners of latency arbitrage make money in two ways: They locate their computers as close as they possibly can to the electronic exchanges that execute their trades, and they pay exchanges to give them actual stock price information before that raw data gets consolidated and sent to most other market players.

Latency arbitrage isn't the only way the wealthiest traders buy access to what I have called "insidery" information. But this practice of using legal, market-moving information that's only available to a small number of traders to profit at everyone else's expense is quite common.

Before getting into the nuts and bolts of latency arbitrage, let's take a look at the people who are profiting from it. These guys get paid staggering amounts of money. For example, Citadel Investments is run by Ken Griffin, who took in $900 million personally in 2009. James Simons, who runs Renaissance Technologies, made $2.5 billion in 2009 -- and $1.7 billion in 2006 and $2.5 billion in 2008.

Making Big Profits -- at No Risk

Griffin, Simons and their latency-arbitrage practicing peers pick that $3 billion out of your pocket each year a penny or two a share at a time. According to my June 4 conversation with Sal Arnuk, a partner at Themis Trading, these high frequency traders (HFTs), which account for 70% of daily trading volume, turn the markets into a "Call of Duty video game with hollowed out buildings and children armed to the teeth with the latest weapons."

The average investor gets quotes from a Standard Information Processor (SIP) that gets bid and ask prices for a stock on a National Best Bid and Offer (NBBO) basis. HFTs pay for data feeds that go into the NBBO prices -- for example, a professional enterprise license from NASDAQ for its TotalView data covering the NYSE, NASDAQ, and Amex goes for $100,000 -- so they know what the actual prices are 100 to 200 milliseconds before the retail investor.

Taking no risk at all, except for the $1.8 billion they pay to the exchanges each year to locate their servers right next to the exchange computers, these latency arbitrageurs make between one and three cents on each trade by getting that tiny jump on you. And despite the volatility in the broader markets during that time, the latency arbitrageurs have been steadily profitable for the last four years.

NYSE Disregards Fairness for Retail Investors

You might have hoped that big exchanges like the New York Stock Exchange (NYSE) would try to keep a level playing field in trading for all market participants. But according to Arnuk, that's not the case. The NYSE is opening a $500 million, 400,000 square foot co-location facility in Mahwah, N.J.

In pitching this facility to HFTs, the NYSE makes a big deal about how it will connect every participant's computers by 1,000 feet of cable to those of the NYSE. Therefore, if Renaissance's computers are 100 feet from those of the NYSE, its trade will take them the same amount of time to reach the NYSE computers as Citadel's computer, which is 800 feet away. Arnuk thinks it's too bad that the NYSE is not more concerned about the fairness of this for the retail investor.

An Illuminating Test Case

Let's look at an example of how latency arbitrageurs make their money. According to The Wall Street Journal, TFS Capital, a $1.1 billion firm that trades for mutual funds and is among those losing out to latency arbitrageurs, decided to conduct a trade to illustrate how it's getting ripped off by them.

The Journal reports that in March, 2010, a TFS trader sent an order to a broker to buy shares of Nordson (NDSN) through an instant message requesting that the order be executed in a specific dark pool (DP). DPs are unregulated alternative electronic stock exchanges, in many cases run by big Wall Street banks, in which buyers and sellers show up anonymously to declare their interest in buying or selling a certain number of shares of stock within some price limit.

The TFS trader asked the broker to execute the order in "broker pool #2", telling the broker not to pay more "than the midpoint between what buyers and sellers were offering, which at the time was $70.49," according to the Journal. But the market price for Nordson shares did not change for a few seconds so the TFS trader "set a trap: He sent a separate order into the broader market to sell Nordson for a price that pushed the midpoint price down to $70.47."

TFS was "almost immediately sold Nordson for $70.49 -- the old, higher midpoint -- in broker pool No. 2, which didn't reflect the new sell order," according to the Journal. Perhaps what happened was that a latency arbitrageur was able to buy the shares at $70.47 in the broader market and sell them to TFS for two cents more.

(How the latency arbitrageur knew that higher price is a mystery. But it may have been due to the practice of pinging the dark pool. This is the practice of sending a series of small orders to the DP to see if the latency arbitrageur can guess the price at which, say, the seller wants to sell.)

Twisted Rationale

In this case, TFS overpaid by two cents a share for its Nordson stock. All these pennies add up to $3 billion a year that should have gone into the pockets of retail investors but instead, help provide those billion-dollar annual paydays for hedge fund moguls like Griffin and Simons.

That doesn't sound like the reason that securities markets were set up. So it's a bit ironic, as Arnuk told me, that the NYSE's Mahwah facility is surrounded by buttonwood trees because it's under a buttonwood tree that the NYSE got started back in 1792.
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