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Latency Arbitrage, Market Fragmentation, and Efficiency: A Two-Market Model


Elaine Wah and Michael P. Wellman, U Michigan, Latency Arbitrage, Market Fragmentation, and Efficiency: A Two-Market Model, here.

We study the effect of latency arbitrage on allocative efficiency and liquidity in fragmented financial markets. We propose a simple model of latency arbitrage in which a single security is traded on two exchanges, with aggregate information available to regular traders only after some delay. An infinitely fast arbitrageur profits from market fragmentation by reaping the surplus when the two markets diverge due to this latency in cross-market communication. We develop a discrete-event simulation system to capture this processing and information transfer delay, and using an agent-based approach, we simulate the interactions between high frequency and zero-intelligence trading agents at the millisecond level. We then evaluate allocative efficiency and market liquidity arising from the simulated order streams, and we find that market fragmentation and the presence of a latency arbitrageur reduces total surplus and negatively impacts liquidity. By replacing continuous-time markets with periodic call markets, we eliminate latency arbitrage opportunities and achieve further efficiency gains through the aggregation of orders over short time periods.

Ritholtz, Big Picture, A Market Built on Theft Sucks, here. Doesn’t Narang work for the SEC? The author doesn’t like the SEC but apparently likes Cell Processors. Weird. The “Web of Chaos?” Is this some kind of MIT undergrad trolling The Big Picture? Remember last time that happened, Ritholtz called a bunch of his blog readers “asshats” and threatened to leave the internet.

Manoj Narang, CEO of Tradework, the only HFT firm dying to speak about HFT strategy to regulators, big media, small media, industry panels, and folks in the mall, spent the better part of eighteen months trying to debunk the existence of latency arbitrage. He specifically singled out our white paper, Latency Arbitrage, on numerous occasions. HFT wants you to believe there is no such thing as HFT’s gaming algorithmic orders traveling through the Web of Chaos and Dark Pool land.


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