In the middle of the East Coast’s slow broil in the summer of 2018, a curious phenomenon surfaced. As a tropical air mass settled in and smothered the metropolitan New York area, a certain breed of stock speculator began feeling the financial heat as the microwave signals linking together various data centers and exchanges began to slow down. These high-frequency traders rely on getting information a fraction of a second before other traders see the same thing and take advantage of minuscule price differences to make money hand over fist.
While you won’t catch us shedding many tears over the billions these speculators lost during the hot spell, we did find the fact that humidity can slow microwave propagation enough to make this a problem for them a fascinating subject, enough so that we covered it in some detail at the time. While financial markets come and go and the technology to capitalize them changes at a breakneck pace, physics stays the same, and it can make or break deals with no regard to the so-called fundamentals.
So it was with great interest that we happened upon Tom Scott’s recent video outlining how one new stock exchange is using physics to actually slow down stock trades, in an attempt to gain a competitive advantage over the other exchanges. In light of the billions lost over the summer to propagation delays amounting to a mere 10 microseconds, we couldn’t help but wonder how injecting a delay 35 times longer using a “magic shoebox” was actually good for business. It turns out to be an interesting story.
Leveling the Playing Field
As a brief review, high-frequency trading (HFT) seeks to make a fraction of a cent profit on each of millions of high-speed, computer executed trades. HFT firms make a lot of money a little at a time, profiting from buying and holding stocks for a mere fraction of a second before dumping them to someone else at a slightly high price – or, by “shorting” the stock by borrowing it at a high price and selling it milliseconds later at a lower price, profiting off the difference once the stocks are returned. It’s the age-old “buy low, sell high” advice that has driven financial markets for centuries, only turbocharged and on steroids with co-location of HFT server systems inside each of the major stock exchanges’ data centers and the aforementioned microwave links for low latency access to the latest information.
But there’s another method that HFT firms use to turn microseconds into micro-profits: latency arbitrage. Basically, it involves using HFT systems to pick out so-called “stale quotes”, which result from the milliseconds it often takes different markets to update their prices. An HFT program looks for stale quotes in one exchange then quickly sends an order to buy or sell that stock to another market with different stale information, exploiting the difference in prices. Sometimes the HFT program wins, resulting in a tiny profit for the HFT firm. Do it a couple of million times a day and you’ve got a business model.
The Magic Shoebox
That business model ends up doing a lot of damage to the markets, often driving the price of some stocks up artificially as HFT algorithms pounce on stale quotes. To even things up, upstart stock exchange IEX decided to try something drastic. They reasoned that by slowing down all the trades coming through their exchange, they could prevent latency arbitrage.
To do that, they commissioned their “magic shoebox” – a rack-mount cabinet with three spools of fiber optic line in IEX’s Weehawken, NJ, data center. The three reels, each about the size as a 3D-printing filament reel, are connected together to make a continuous loop 61 km (38 miles) long. The length was calculated to introduce a precise 350-microsecond delay to all traffic coming and going into the exchange, including the 16 km (10 miles) of fiber optic cable connecting the exchange’s facilities. Everything passes through the delay line, including HFT systems that are trying to find stale quotes. But the delay gives information from multiple markets time to filter through the system, eliminating the potential for stale quote pick-offs.
In a world where faster has always been better, IEX stood the conventional wisdom on its head and found a winning strategy. Not only does their magic shoebox eliminate latency arbitrage, but it also gives IEX an advantage over its competitors that has driven business their way. IEX survived a long, arduous application process with the Securities and Exchange Commission (SEC) and was recently granted the status of a full stock exchange, much to the chagrin of HFT firms and some old-line traders.
They’re still doing business with their 350-microsecond speedbump, albeit with a new version of the magic shoebox. Despite their detractors, they’ve proven that they can level the playing field in financial markets, to the degree that the SEC published a white paper extolling the new exchange’s overall positive effect on the market. And they did it all with the help of simple physics.