1. High Frequency Trading Firms (HFTs) have a structural advantage in the market, by virtue of being able to able to access trading exchanges directly. Normally, there are 13 exchanges and numerous “dark pools” (basically like exchanges but do not show volume) where orders are submitted; these orders are then aggregated into what is known as the SIP feed, and the SIP feed broadcasts the best bid and offer to traders. HFTs pay to subscribe directly to the exchanges and dark pools, so that they can get the information the same time as the SIP feed – or faster, if their computers and connections are faster. This allows HFTs to jump ahead and orders dependent upon the SIP feed. In sum, the time difference between the SIP feed and the HFTs direct access to exchanges enables very low-risk form of trading that is referred to as latency arbitrage. The longer the time gap between the SIP feed and direct access feeds, the more opportunities there are for HFTs to profit from latency arbitrage.
2. HFTs can slow down the process by which the SIP feed aggregates and processes the orders from exchanges and dark pools by using a tactic known as quote stuffing. Quote stuffing is the practice of creating false orders that are immediately withdrawn. They do not constitute a real intent to buy and sell. Instead, quote stuffing is simply a form of spam, which is intended to slow down the process by which the SIP feed can aggregate rates from exchanges to determine the best prices. In this way, quote stuffing is a tactic that creates latency arbitrage opportunities. Quote stuffing is illegal, and one high frequency trading firm, Citadel, has already been fined for it.
3. Quote stuffing, along with increased fragmentation of trading occurring across exchanges and dark pools rather than centralized through the SIP feed, can create greater uncertainty in the market. This may be the primary impact for traders and investors. The immediate actions of HFT may result in slightly higher trading prices – which will only be of significance to very short-term traders for whom a 0.25% change in price meaningfully changes the trading opportunity – though the uncertainty that comes from liquidity fragmentation and quote stuffing creates structural risk in the market, and the scenario in which trading stops because the exact price cannot be determined. Many view flash crashes as a by-product of the environment that HFTs have created.
How High Frequency Trading Firms Use Quote Stuffing and Latency Arbitrage to Create Almost Risk-Free Profits
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