The Impact of Latency Sensitive Trading on High Frequency Arbitrage Opportunities

23 Pages Posted: 2 Feb 2016

See all articles by Alex Frino

Alex Frino

Macquarie University

Vito Mollica

Macquarie Graduate School of Management; Capital Markets CRC Limited (CMCRC); Macquarie University, Macquarie Business School

Robert I. Webb

University of Virginia - McIntire School of Commerce

Shunquan Zhang

Macquarie University

Date Written: May 31, 2015

Abstract

Classical economic theory suggests that excess returns should be competed away as new participants enter the market. This is especially true for the profits from riskless arbitrage. Yet, there is conflicting evidence in the financial economic literature over whether high frequency trading (HFT) profits, in general, (Baron et al [2012]) and arbitrage profits, in particular (Budish et al [2013] and Chaboud et al [2013]), decline as high frequency or other algorithmic trading increases. There are important public policy implications for market microstructure and the social value of investments by HFT firms in being faster if arbitrage profit opportunities persist (in the absence of limits to arbitrage).

There are several different strategies that high frequency and other latency sensitive traders engage in. These include: index arbitrage; spread arbitrage/market making; and correlated arbitrage among others. This study focuses on only one - index arbitrage. Specifically, it examines whether the duration, frequency and profitability of potential arbitrage opportunities between the Australian Securities Exchange (ASX) Share Price Index (SPI) futures contract and the exchange traded fund (ETF), STW, have changed as the number of HFT firms (or intensity of HFT activity) has increased, since the ASX’s introduction of co-location services in February 2012. In addition, we use estimated potential arbitrage profits and compare them to the cost of being co-located to determine the value of minimum latency.

Not surprisingly, we find the frequency and profitability of potential arbitrage opportunities are greater during volatile and high turnover periods - other things equal. We examine the increased competition in high frequency trading by identifying the number of ‘cabinets’ co-located in the ASX’s liquidity center. With increased HFT connections, we observe increasing value, frequency and duration of index arbitrage profit opportunities. Our results are robust to the inclusion of transaction costs. We conclude that the activity of disruptive HFT outweighs the activity of index arbitrage HFTs.

Keywords: arbitrage, high-frequency trading, latency

JEL Classification: G14, G15, G19

Suggested Citation

Frino, Alex and Mollica, Vito and Webb, Robert I. and Zhang, Shunquan, The Impact of Latency Sensitive Trading on High Frequency Arbitrage Opportunities (May 31, 2015). Asian Finance Association (AsianFA) 2016 Conference. Available at SSRN: https://ssrn.com/abstract=2725419 or http://dx.doi.org/10.2139/ssrn.2725419

Alex Frino

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

Vito Mollica (Contact Author)

Macquarie Graduate School of Management ( email )

Capital Markets CRC Limited (CMCRC) ( email )

Level 3, 55 Harrington Street
Sydney, 2000
Australia

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

Robert I. Webb

University of Virginia - McIntire School of Commerce ( email )

Rouss and Robertson Halls 125 Ruppel Lane
Charlottesville, VA 22903
United States
(434) 924-7570 (Phone)

Shunquan Zhang

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

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