Institutions have a long history of accusing market makers and other active traders of predatory trading. There is justice in many, but certainly not all, of these complaints. Much of the innovation in U.S. market structure over the last decade or so has been motivated by institutions’ desire to avoid the problems they perceive themselves to have had with traditional liquidity providers. The results have not met expectations: the fragmentation of liquidity into numerous execution venues has in fact increased the ability of computer algorithms to anticipate the routing of large institutional orders. It is entirely legal for a firm to exploit such information, provided that the firm does not have a fiduciary duty to the source of the order.
So it is a matter of considerable interest that RBC Capital Markets has launched Thor™, an order-routing system that is designed (among other things) to ameliorate institutions’ problems with so-called “latency arbitrage.” One of the problems that has resulted from the fragmentation of the equity marketplace is that latency (the time delay between order entry and the actionability of the order at the point of execution) is different for each trading venue to which an institution might choose to route its orders. Thus if it makes use, say, of five trading venues to execute a large order, the portions of its order routed to each venue will arrive at different times. Although the time differences involved are miniscule, they are sufficient to allow high frequency trading algorithms to observe the first order to arrive and to mop up liquidity at the other venues, forcing the institution to buy at a higher price or sell at a lower one than it anticipated.
RBC’s solution is elegant, and somewhat paradoxical: it addresses the problems created by the continual arms race to reduce latency by increasing latency. Orders are routed sequentially to the venues of the institutional customer’s choice, with those routed to the venue that takes longest to access released before those routed to venues with lower latency. The orders consequently appear in the various venues’ orderbooks as close to simultaneously as possible, allowing little or no time for predatory algorithms to anticipate the arrival of orders along the higher latency routes.
The proof of the pudding for this solution will be a matter of how closely it can approach to exact simultaneity. The greater the exactness of timing, the less opportunity for “latency arbitrage,” and precise simultaneity offers no such opportunity at all. Cynics may argue that the financial and computing resources available to high frequency traders will ultimately allow them to defeat this order routing stratagem, but it is difficult to see how, provided that the degree of simultaneity it achieves is sufficiently high. While other forms of predatory trading will still be possible, “latency arbitrage” may soon be a thing of the past.
