Sharks in the Dark: Quantifying Latency Arbitrage

Abstract

Using proprietary order book data with participant-level message trac
and matching engine time stamps, we investigate stale reference pricing in
dark pools. We document a substantial amount of stale trading which im-
poses large adverse selection on passive dark pool participants. We show that
HFTs almost never provide dark liquidity, instead frequently consuming dark
liquidity, in particular in order to take advantage of stale reference prices. Fi-
nally, we examine several market design interventions to mitigate stale trades,
showing that only mechanisms to protect passive dark liquidity, such as ran-
dom uncrossings, are eective at ensuring accurate reference prices.

Keywords: high-frequency trading, dark pools, latency arbitrage, reference prices

JEL Classification: G10, G14, G18