Traders and hedge funds who use high-speed methods to gain an advantage in the stock market impose a "tax" on other investors, according to a study released Monday, costing as much as $5 billion per year across global exchanges.
The Financial Conduct Authority (FCA), a regulatory arm of the United Kingdom, found that the trading practice, known as "latency arbitrage," causes the overall volume of trading on global stock markets to decrease.
Latency arbitrage is one of the ways high-frequency traders profit to the detriment of slower trading investors. It involves arbitraging prices gleaned with a low latency - in fractions of a second - from certain exchanges. Better prices are snatched up by high frequency traders before regular investors. The arbitrage practice also has the effect of reducing the incentive for those on the other side of a trade to offer these better prices, which also costs retail participants.
The FCA found the average race between firms lasted 79 microseconds (79 millionths of a second), faster than the blink of an eye, with only the quickest to execute its trade gaining any benefit.
While each race only yielded small wins for traders, the FCA's study tracked 2.2 billion such races over the course of just 43 trading days on the London Stock Exchange. In all, more than 20% of the total trading volume the FCA tracked was found to come from these latency arbitrage races.
"In aggregate, these small races add up to meaningful harm to liquidity," the FCA's study said. "Our main estimates suggest that eliminating latency arbitrage would reduce the cost of trading by 17%."
The Wall Street Journal first reported the study's results.
The FCA study looked at trading activity from August 2015 to October 2015. Although the report did not identify the institutions using this method, the FCA found that six firms won latency arbitrage races 82% of the time.
While latency arbitrage trades on public information, the study found the negative outcome of such high speed trading is that it increases the cost for investors to buy and sell shares. While the FCA's study focused on U.K., its authors said they hoped "other researchers and regulatory authorities replicate our analysis for markets beyond UK equities."
"To our knowledge, most regulators do not currently capture message data from exchanges, and exchanges seem to preserve message data somewhat inconsistently. We hope this will change," the FCA said.