What is Latency Arbitrage and How to Overcome it

By: Tom Banta on June 23, 2020

Most organizations that rely upon their networks to deliver high-speed services understand the role that latency plays in their technology infrastructure. For all the remarkable innovations that have transformed online networks, physical distance remains a major challenge when it comes to performance. While many organizations face significant challenges due to latency, the financial services industry has had to deal with a rather unique problem due to a practice known as latency arbitrage.

What is Latency Arbitrage?

The term “arbitrage” refers to the practice of buying an asset from one market and then selling it in another market at a slightly higher value. Ideally, the purchase and sale happen very quickly, capitalizing on an artificial shortage created by the initial purchase. To give a simple example, say there is a vendor selling bottled water on a hot day for $1.00. A person sees the vendor and starts walking toward it, but before they can reach the stand, another person gets there first and buys the last bottle. That person then turns around and offers to sell the bottle to the first person for $1.50.

While the concept is quite old in investment markets, it came into popular usage as the financial industry underwent an unprecedented digital transformation over the last few decades. As markets transitioned to purely digital transactions, many traders realized they could gain an advantage by making purchases faster than everyone else and then selling them at a quick profit.

Going back to the water bottle example, the reason the second person was able to purchase the last bottle of water is because they were closer to the vendor and were able to beat the other person to it. High-frequency traders (HFTs) exploited network latency to do the same thing. Since data speeds are a byproduct of distance, they could reduce the latency of their trades by physically locating their servers closer to the market exchanges. By using sophisticated technology, they could see information about trades a fraction of a second before they could be completed and announced publicly, which allowed them to swoop in, purchase the assets out from under the initial buyer, and then sell them at a profit.

What Impact Can Latency Arbitrage Have on Financial Services Companies?

This practice, which came to be known as latency arbitrage or flash trading, set off a colocation arms race in the financial sector. Financial firms hoping to stay ahead of HFTs migrated their servers to data centers closer to the facilities housing the major exchanges to avoid being “front-run” by low-latency competitors. Some of the data centers hosting those exchanges even rented out space within the same facility to provide the closest possible location. To prevent competition over deployment within the data centers, they often went so far as to require tenants to use a standardized cable length so that servers closer to the exchange servers wouldn’t have a latency advantage.

Failing to take latency arbitrage into consideration can end up costing finance firms quite a bit in additional costs. According to a study by the UK’s Financial Conduct Authority, the practice costs investors about $5 billion globally each year. The same study concluded that completely eliminating the practice would lower the overall cost of trading by 17 percent. In essence, then, latency arbitrage is functioning as a tax traders in financial markets. If a firm doesn’t have the necessary speed to compete with the HFTs, they will quickly find themselves paying more for trades in the space between approving the purchase and the transaction’s actual completion.

How to Avoid Latency Arbitrage with the Right Data Center Strategy

Despite numerous attempts by the US Congress, no legislation has been passed to curtail latency arbitrage. While the financial industry has regulated itself to some extent by limiting the information HFT algorithms need to identify and act on opportunities, a high latency connection can still leave companies at a distinct disadvantage. Reaction time is critical in financial markets, where the difference of even a few hundredths of a second could see an impact in prices.

With the right data center location strategy, financial companies can use edge computing technology to reduce the latency of their networks. Placing servers closer to the data centers that house the nation’s leading exchange markets can help them stay ahead of competitors and prevent their trades from being hijacked out from under them.

Combating Latency with vXchnge

With multiple data center locations across the US, vXchnge can get organizations closer to key financial markets. Our state-of-the-art Philadelphia data center, for example, is located less than a mile from the NASDAQ OMX PHLX, home to one of the world’s largest options markets. For firms looking to get closer to the numerous financial data centers in New Jersey, our Secaucus facility provides world-class connectivity options and low-latency edge computing capabilities.

vXchnge data centers are engineered for perfection and backed by 100% uptime SLAs to ensure high levels of data availability when you need it most. With direct on-ramps to the most popular cloud computing platforms, our colocation facilities allow you to build the dynamic hybrid IT environments you need to stay competitive in the financial services industry. And thanks to our award-winning in\site intelligent monitoring platform, you can retain the same level of control and visibility you would expect from your own private data center, all without having to make the sizable capital investments to build one.

To learn more about vXchnge’s edge computing colocation services can help you overcome latency arbitrage and stay ahead of your competitors, talk to one of our colocation experts today.

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