The Cost of Latency in High-Frequency Trading

55 Pages Posted: 17 Mar 2010 Last revised: 27 Feb 2013

Ciamac C. Moallemi

Columbia Business School - Decision Risk and Operations

Mehmet Sağlam

University of Cincinnati - Department of Finance - Real Estate

Date Written: February 5, 2013

Abstract

Modern electronic markets have been characterized by a relentless drive towards faster decision making. Significant technological investments have led to dramatic improvements in latency, the delay between a trading decision and the resulting trade execution. We describe a theoretical model for the quantitative valuation of latency. Our model measures the trading frictions created by the presence of latency, by considering the optimal execution problem of a representative investor. Via a dynamic programming analysis, our model provides a closed-form expression for the cost of latency in terms of well-known parameters of the underlying asset. We implement our model by estimating the latency cost incurred by trading on a human time scale. Examining NYSE common stocks from 1995 to 2005 shows that median latency cost across our sample roughly tripled during this time period. Furthermore, using the same data set, we compute a measure of implied latency, and conclude that the median implied latency decreased by approximately two orders of magnitude. Empirically calibrated, our model suggests that the reduction in cost achieved by going from trading on a human time scale to a low latency time scale is comparable with other execution costs faced by the most cost efficient institutional investors, and is consistent with the rents that are extracted by ultra low latency agents, such as providers of automated execution services or high frequency traders.

Keywords: High-Frequency Trading, Latency

JEL Classification: G10

Suggested Citation

Moallemi, Ciamac C. and Sağlam, Mehmet, The Cost of Latency in High-Frequency Trading (February 5, 2013). Available at SSRN: https://ssrn.com/abstract=1571935 or http://dx.doi.org/10.2139/ssrn.1571935

Ciamac C. Moallemi (Contact Author)

Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States

HOME PAGE: http://moallemi.com/ciamac

Mehmet Sağlam

University of Cincinnati - Department of Finance - Real Estate ( email )

Carl H. Lindner College of Business
Cincinnati, OH 45221
United States
(513) 556-9108 (Phone)

HOME PAGE: http://homepages.uc.edu/~saglammt/

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