To lessen the advantage which latency arbitrageurs, such as high-frequency traders, have, two other solutions apart from frequent batch auctions have been proposed, namely speed bumps and transition zones. These two solutions specifically aim to remove the ability of high-frequency traders to front-run using “inside” information gained from securities exchanges.

Frequent batch auctions reduce the number of races to the top of the order book and therefore curtail the speed advantage of latency arbitrageurs. However, frequent batch auctions do not differentiate between fair and unfair speed advantages. Rather, it deals with the concern that a consistent speed advantage would result in a monopolistic market structure, as explained before.

The practice of front-running large orders on a security is considered unfair and detrimental to markets. In doing this, high-frequency traders make a profit but do not provide any market liquidity in return. The speed bump and transition zone approaches specifically aim to solve this.

To aid our understanding, we give a simplistic explanation of how high-frequency traders use front running to gain an unfair advantage.

Assume a security, say PhiCorp, trades on two exchanges, ExNorth and ExSouth, and the high-frequency trader, HFT, has the fastest connection to both these exchanges. Also assume that there are currently 500 PhiCorp shares on offer on ExNorth at $1 per share and another 500 shares on offer at ExSouth, also at $1 per share. So how can the HFT make a profit?

This can happen if, for example, an investor sends a market order to ExNorth to buy 1000 PhiCorp shares. Now 500 shares of the order are filled on ExNorth at $1 per share, while the unfilled part of the order is sent to ExSouth. Meanwhile, the HFT receives information that all the shares of the best offer on PhiCorp have traded on ExNorth. Based on his knowledge of historical order sizes the HFT deduces that there is a good chance that the 500 share trade is part of a larger order. The HFT then uses his speed advantage to buy the remaining 500 PhiCorp shares on offer at $1 on ExSouth. He then offers the same shares at a slightly higher price on ExSouth, say $1.01, but at a price that is low enough so that it still is the best offer available on both exchanges. The second portion of the investor’s order is then completed at this higher price. The investor ends up paying more than $1 per share with the difference being the profit made by the HFT.

Refer to the article by Jacob Adrian (2016)1 for a more detailed explanation and also variations of this: for example, how do high-frequency traders sniff out large split orders?

The IEX exchange implemented a speed bumpwhich, indiscriminately, delays everybody’s access to their exchange. The length of the delay is such that nobody trading on IEX will have “inside” information on the national best bid and offer prices. In terms of the above example, this gives IEX enough time so that the second part of the investor’s order can be executed on ExNorth before the HFT can intervene.  (IEX has recently been approved as an official exchange.)

Alternatively, in High-frequency trading: A white paper by Kashanah (2014), information transition zones are proposed which involves delaying access only to those who have “inside”  information on the national best bids and offers.  This, however, is a more complicated solution as market participants need to be classified based on their speed, which could change at any time.

With both these solutions, trading will continue to take place in virtually continuous time. Inside information, or front running, on an exchange-listed security, using information from another exchange, will be eliminated. If enough exchanges adopt either of these methodologies, front running on large orders by high-frequency traders could mostly be prevented.

However, the two solutions do not deal with the latency arbitrage of related securities, such as ADRs, derivatives or ETF’s, using information gathered from exchanges. A typical example would be the Samsung Electronics Corporation, where the shares trade on the Korean Stock Exchange and GDR’s are listed on the London Stock Exchange.

This type of arbitrage cannot be regarded as front running, as it does not attempt to profit from jumping ahead of a large placed order. Rather, price information on a security is used to gain an advantage in trading in a related security. However, it could still be argued that the playing field is not fair or that we might end up with one or a few participants making all the latency arbitrage profits. Synchronised frequent batch auctions, as discussed previously, is a straightforward and elegant solution to reduce the advantage of latency arbitrageurs in general.

1Jacob Adrian, ‘Informational inequality: How high-frequency traders use premier access to information to prey on Institutional Investors’, Duke Law and Technology Review, vol 14, nr. 1, 2016, pp. 256-279.