FCA study estimates HFT ‘sniping’ costs investors globally $5 billion a year

Analysing billions of message data points from the LSE, the FCA claims eliminating latency arbitrage would reduce the cost of liquidity for institutional investors by 17%.

High-frequency trading (HFT) firms are gaining almost $5 billion in profits globally each year by exploiting tiny speed advantages in equities markets, which the UK’s watchdog has labelled a ‘latency arbitrage tax’ on investors. 

The Financial Conduct Authority (FCA) said that as part of an in-depth study it analysed message data, including attempts or failed to trade messages, from the London Stock Exchange for all stocks in the FTSE 350 index over a nine-week period in 2015 to quantify latency arbitrage. 

Referred to by the market as ‘sniping’, latency arbitrage is defined as the practice whereby HFTs make very small profits by taking advantage of a brief gap, a matter of microseconds, before stock prices realign following a correlated instrument price shift. 

According to the FCA’s research, ‘sniping races’ are very frequent with the average FTSE 100 stock subjected to around 537 latency arbitrage races each day, or one every minute, and the races account for a significant 22% of average daily trading volume. 

The winners typically beat others by 5-10 microseconds, and the activity is concentrated with just a handful of firms winning the majority of the sniping races. Just six firms account for more than 80% of winners and losers of the races in its study. The firms were not named in the study.

The study concluded that the small profits gained by HFTs, the ‘latency arbitrage tax’, calculated as the ratio of daily race profits to daily trading volumes, is 0.42 basis points, equating to £60 million per year in the UK equity market, and $4.8 billion annually across global equity markets.

“As is often the case in regulatory settings, the detriment per transaction is quite small and a 0.42 basis points tax on trading volume certainly does not sound alarming. But it all adds up,” authors of the report from the FCA wrote in an overview. “And remember, we are talking here only about equities. The same phenomenon extends to other asset classes that trade on electronic limit order books such as futures, currencies, US treasuries and more.”

Furthermore, the activity negatively impacts institutional investors more than retail investors who have savings or pensions. The FCA said that sniping races and the ‘flawed market design’ has increased the costs of trading, but eliminating latency arbitrage would reduce the cost of liquidity by 17%.

HFT has been an issue of controversy following the publication of Michael Lewis’ best-seller ‘Flash Boys’, which suggested that the US stock market is rigged to benefit high-speed traders. Proposals have been made to deal with the HFT arms race, including implementing speed bumps on exchanges to slow down firms. Others have suggested continuous trading be eliminated in favour of frequent batch auctions to remove the incentive to trade faster and level the playing field.

The FCA has urged researchers and regulators to replicate its analysis of exchange message data on other markets to gain more insight, but most authorities do not capture the data and exchanges preserve it inconsistently. 

“The limit order book is viewed as the official record of what happened, but we argue that the message data, and especially the ‘error messages’ that indicate that a particular participant has failed in their request, are key to understanding speed-sensitive trading,” the study concluded.