Electronic copy available at: http://ssrn.com/abstract=1695460
Our financial environment is characterized by an ever increasing pace of bothinformation gathering and the actions prompted by this information. Speed is importantto traders in financial markets for two main reasons. First, the inherent fundamentalvolatility of financial securities means that rebalancing positions faster could result inhigher utility. Second, irrespective of the absolute speed, being faster than other traderscan create profit opportunities by enabling a prompt response to news or market-generated events. This latter consideration appears to drive an arms race where tradersemploy cutting-edge technology and locate computers in close proximity to the tradingvenue in order to reduce the latency of their orders and gain an advantage. As a result,today’s markets experience intense activity in the “millisecond environment,” wherecomputer algorithms respond to each other at a pace 100 times faster than it would takefor a human trader to blink.While there are many definitions for the term “latency,” we view it as the time ittakes to learn about an event (e.g., a change in the bid), generate a response, and have theexchange act on the response.
An important question is, who benefits from such massive investment intechnology? After all, most trading is a zero sum game, and the reduction in fundamentalExchanges have been investing heavily in upgrading theirsystems to reduce the time it takes to send information to customers as well as to acceptand handle customers’ orders. They have also begun to offer traders the ability to co-locate the traders’ computer systems next to theirs, thereby reducing transmission timesto under a millisecond (a thousandth of a second). As traders have also invested in thetechnology to process information faster, the entire event/analysis/action cycle has beenreduced for some traders to a few milliseconds.
More specifically, we define latency as the sum of three components: the time it takes for information toreach the trader, the time it takes for the trader’s algorithms to analyze the information, and the time it takesfor the generated action to reach the exchange and get implemented. The latencies claimed by many tradingvenues, however, are usually defined much more narrowly, typically as the processing delay measuredfrom the entry of the order (at the vendor’s computer) to the transmission of an acknowledgement (from thevendor’s computer).