Putting The Brakes On High-Frequency Trading With Physics

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.

The “Magic Shoebox” – 61 km of fiber optic cable introduces a 350-microsecond delay to all trades. Source: IEX

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.

65 thoughts on “Putting The Brakes On High-Frequency Trading With Physics

      1. EDSAC used delay lines with an average access time of 222 microseconds, so the total delay of the line should be 444 microseconds.
        Because sound waves in mercury are much slower than light in glass fibre, the delay was actually longer than 61km of glass fibre.

    1. Rather than banning, why not impose additional capital gains taxes on high frequency trades. Anyone who buys and sells the same holding/company/fund/whatevr within the same trading day gets hit with an x% capital gain tax. If they buy/sell within the same hour, 2x% tax, and within the same minute 10x%.

      I believer there’s (limited) value in providing liquidity, but at some point it become goofy, and maybe even dangerous.

      1. Taxes are rarely a solution. It’s just another form of theft anyway. The free market is excellent at working around that and why bother. WE HAVE PHYSICS!! I’ll take an engineering solution over a bureaucratic/legal one any day. We need more engineers/scientists and less bureaucrats/lawyers.

          1. Giving back a bit of what was stolen in a form that I *MIGHT* want does not fully (or at all) nullify the original crime. If I steal your I-Phone, sell it on the black market for $100 and then buy you a pizza, a crime has still been committed.

          2. “Giving back a bit of what was stolen in a form that I *MIGHT* want does not fully (or at all) nullify the original crime. If I steal your I-Phone, sell it on the black market for $100 and then buy you a pizza, a crime has still been committed.”


            As much is market based now days… seems the government can earn interest on the taxes for the period they hold the funds and just refund everything back. Oh wait… yeah that was a joke eh? Just enter some numbers in a computer… woops… that was funny too?

            I thought I made a comment regarding the Derivatives market and maybe was deleted or something or was in another post. Armed robbery with Tax Fraud Rackets with gross frauds and cheats paperwork is something I never really observed until seeing how bad some act and justify their existence from the origin of their government entity. This was prior to comprehending how Attorney’s work with paperwork alone the was asked one time (or was that more than once) if I was interested in Process Serving and was like &$%! no. Strange… due processes?

            I’m still going with there is a large faction of easy money from the tax revenue schemes… oops… I meant streams… that must have been overwhelmed by brute force poisonous assaults with intent to maim mental facilities so they can exhibit (they must not know others notice) their natural instincts that are related to their closest relatives the Bonobos that look more human in oral maxillofacial characteristics at best led on by the Chimpanzees with similar visual characteristic traits.

          3. My assessment lately has been something like this:
            Yeah… I’m guessing President Reagan assassination attempt where we changed the tax code and started selling off assets to the World. Huh… World owns stuff in the U.S. and therefore has more rational for stuff like our worst traitors coming in that are more legal on the defensive. I mean gentlemen… who’s genius administration started selling commercial infrastructure our U.S. government employees lease?


            Probably the volatility issues go back earlier liberal something:

            Causation due to P.O.W.’s influence gone overboard copy cat ancient Roman or something modernized and they’re not on a lb of salt?

            Regarding Liberia, cannabalism and the in between breed that doesn’t look as official:

            Great interview for the leadership insight from the start… however, this time (t=146 and watch until at least 3:40) on is eye opening if you’re not aware:

            Regarding the Fashion Industry and Social Media (note the presentation is great from the beginning also… I like speeding up however as is a little slow, t=274):

      2. >” why not impose additional capital gains taxes ”

        Because any time the government taxes something, it’s sure to stick around. Politicians see tax money as a means to spend to buy votes, and once they make that commitment the state becomes dependent on the tax revenue to function, so, in order to maintain the revenue they set the tax at a level that does not get rid of whatever it was supposed to – instead it merely sets the tax at a level that maximizes the tax income from that source.

        For example, take tobacco tax. The point is to discourage smoking, but the tax isn’t nearly high enough to do that – instead, the amount of tax is carefully calibrated to the point of maximum return according to the laws of supply and demand: if the tax is too high, demand would drop and the tax revenue would dwindle, so the tax is just high enough to make the government a ton of money, but not high enough to make a great difference in the smoking population.

        1. @Luke Very true statement about taxes. Taxes rarely do much good and never so when the taxing is done by the unaccountable. Only at the local level like paying for city roads, police, and other common infrastructure does it make any sense. I’m sorry to everyone here, but I cannot hold back the gif any more. (really, I tried) :-)

          TAXES!!! TAXES!!! BEAUTIFUL LOVELY TAXES!!! — The voice of a tyrant.

          1. So why do I keep seeing new taxes to build roads, etc? What happened to the taxes that they collected thru income tax, property, gas tax, etc.

            I think the politicians are using the taxes to buy votes and to pay for the ever increasing payroll in the government.
            Imagine those retirees receiving the same salary or more from the city after they retire. That is basically keeping the same employee forever (continuously paying them) and then hiring a new employee to replace that retired employee.

            If you have 10,000 employees and 1000 retires this year, you hire 1000 employees to replace these 1000 retirees. At the same time, paying these retirees forever until they die. Now you have 11000 employees. 1000 not working (retired). Continue doing that for decades and you’ll have to find more funds to pay your ever increasing payroll.

      1. Yes, we can resolve this whole thing simply by taxing short term cap gains at 100% and long term cap gains as income. Then the market immediately reverts to what it was designed to be – support of good companies doing good work.

      1. Those other merchants that use Amazon as retail retail, do so at their own decision. There has to be some value in that, despite Amazon undercutting their sales price, or those merchants would use other means than Amazon. As long as Amazon shows the customers all vendors, there is no discrimination

        1. The merchants may be ignorant of the situation. It costs them money to keep following the situation, so Amazon can always cheat a little knowing nobody takes any action because it costs them just as much to fight the abuse than endure it.

    2. It would be simpler just to put a 0.01% (yes, one one hundreth of a percent) tax on all stock trades. NYSE averages about $170billilon in trades every day. So that would bring in $17million a day in tax revenue and about 4.25 billion a year. So trading a share of amazon at $1625, it would be taxed $0.16. That wouldn’t affect most investors who hold long term. But that would completely ruin HFT.

    3. When I finally found out how HFT works, I was dumbfounded that you could just cancel a trade. You agreed to pay a price for a thing, then welched on the deal (millions of times a second!). Canceling a trade seems like the kind of thing that should require physical forms, stamped in triplicate, and a written explanation.

      1. It’s not cancelling a trade, it’s cancelling an order before it gets fulfilled. That’s only one of several strategies, and a fairly bad one at that. If you’re always cancelling and creating new orders, you’re going to be pretty near the back of the line when the exchange does eventually match your price.

    1. Eagle eyes much?

      Thanks for the catch, FTFY. The space bar on my keyboard was sticking when I wrote this. I popped it off and beheld the horrors within. I knew there would be crumbs, but cat hair? There’s no cat in my office…

  1. It would be simpler just to put a 0.01% (yes, one one hundreth of a percent) tax on all stock trades. NYSE averages about $170billilon in trades every day. So that would bring in $17million a day in tax revenue and about 4.25 billion a year. So trading a share of amazon at $1625, it would be taxed $0.16. That wouldn’t affect most investors who hold long term. But that would completely ruin HFT.

        1. Most of us are long term investors. So why do you care what’s happening in microseconds timeframe?

          Play where you are comfortable.
          Don’t blame HFTs. They are not hurting anyone. They are actually there to provide liquidity.

          1. 23 May 2018 – “One theory that has been proposed for why market fragility could be higher today is that because HFTs [high-frequency trading] supply liquidity without taking into account fundamental information, they are forced to withdraw liquidity during periods of market stress to avoid being adversely selected,” Charles Himmelberg, co-head of global markets research at Goldman, said in a report Tuesday. “In our view, this at least raises the risk that as machines have replaced people, and speed has replaced capital, the inability of the market’s liquidity providers to process complex information may lead to surprisingly large drops in liquidity when the next crisis hits.”

          2. “they are forced to withdraw liquidity during periods of market stress to avoid being adversely selected,”

            If HFTs do not exist, liquidity being referred by the statement above does not exist to begin with. The effect is the same. HFTs or not, when there is market stress, liquidity is absent.

            The HFT game is played at 10 microsecond level. No one is getting hurt.

          3. HFT is based on becoming a (small) middle man and taking money for no real added value.

            If you argue that HFT is adding value because it makes profit, you’re making a circular argument.

      1. That’s fearmongering,commerce (the actual marketplace) doesn’t need the various exchanges. Because the traders don’t produce nothing of value the exchanges need commerce , more than commerce needs exchanges Trader are of little to know value added. Lest those who have vested interest, and their customers if business thrives or fail determine the value.

    1. Simpler, yes, but a tax based on the sale price doesn’t make sense. A fairer system would be to capture a portion of the gain as suggested by others above. This would also be more market neutral in terms of not providing disincentives to trade.

  2. Michael Lewis (The big short, Liars poker, Boomerang) wrote about this in his book “Flash boys”. He mentions the IEX exchange, and the magic shoebox with 38km of fiber optic cable for introducing delays.

    I like the bit about hiring the puzzlemasters to figure out how the system could be gamed in order to figure out how to eliminate HFT friendly trader options and signal tells that hft traders use to sniff out whether people are interested in buying a stock.

    I highly recommend listening to the audiobook.

    The stuff with the Goldman Sachs programmer made me a bit sad though.

  3. I wonder what the insurance premium and annual cost is for insuring clients investments and how that process works. I recall brokers can buy insurance against losses… unless was a network marketing buy in scam line. If so, do they have to make a claim and payout to their clients as I’ve never observed that? Wonder how insurance against losses works for HFT when you’re a broker?

    1. You can’t. Insurance only protects against pure loss (there is a chance of loss, and no chance of gain). Trading is a speculative loss (chance of gain and loss).

  4. Delays are just dancing around the root problem, which is that we treat the market as an asynchronous system so those with physical proximity have an advantage.

    Much simpler, more effective, and more transparent than farting about with delays is to make the market synchronous and impose a clock on transactions that has a period much longer than global comms delays, e.g. 1 second. In each second, everyone globally gets the same pricing info and everyone can submit buy/sell orders which are treated without any regard to their order of arrival except with respect to clock periods. Any order received before a transaction deadline which can be paired with a converse order in that period will be executed, batchwise at the same price with every other transaction in the same clock period.

    You got your order in 10ms before someone else? So what, as long as you both got in before the next transaction deadline.

    No one gets to game the market with HFT, no one gets to do any front-running, it’s all a level, even playing field.

    The fact that we do not run markets like this – fairly and transparently – should tell you a lot about their purpose and for whose benefit the markets are actually operated.

    1. Sounds like a great idea in principle with everyone having an even shot at getting their trade in. Of course, given the way people do things, some people would be more equal than others so we would just be trading one kind of elite for another. First the latency elite and then the bribery elite. I’m not sure that once the dust settles for such a change that the elitist group would become all that different. Like trading the black and white penguins for all the flightless ones. :-)

  5. High Frequency Traders tend to co-locate in the same data centers as the stock exchanges to keep the latency down. There are complex technical solutions to try to ensure that everyone gets the same data at the same time (Bloomberg uses local synchronisation machines for example), but with exchanges trading with time units as small as 1ns then there are going to be issues with doing that.

    1. Talk about a market being wound tight and causing almost intantaneous sell/buy mass runs. It reminds me of the time many years ago when I would tend to the facilities of a hog farm. Each pig would be super-busy doing its thing and they all would be oblivious to my approach no matter how much noise I would make, until I got too close to one of them and then mass hysteria would happen and the whole herd would suddenly in unison rush to the far side of the pen. I never was able to keep that from happening no matter how I approached. There was always that tipping point where I went from being completely ignored to being the only event going on. …talk about a panic run….crazy….I tink of those pigs often when I see tall candles in market graphs.

      1. Unfortunately computers tend to make the financial system more chaotic rather than less. They do however have to follow exchange rules, and the exchanges could, for example, mandate a minimum hold time of, say, 1 minute – that’s to say that when you buy something then you have to wait until you can sell it. That would put a limit on HFT. The problem is that the exchanges make a lot of money from the co-location and transaction fees, so they are not going to do that unless forced.

        The other thing you need to remember is that there are other systems out there trying to spoof the HFT systems into trading. They do this by placing bids or offers, and then almost immediately withdrawing them. If the HFT system sees and acts on this data then they take a bath. It’s an electronic war from both sides.

  6. I believe the VLA radio telescope array uses a similar technique to sync their timebase signals between antenna receivers. They use retractible fiber optic reels between antennas. Thus, even though the antennas actually move around the timing clock remains syncronized between all the receivers.

  7. HFT and a LOT of other speculation could easily be thwarted by a simple fixed per-transaction tax. Maybe a dollar. No serious investor will mind losing that (transaction fees are usually much higher than that for us normal folks) while finally getting a more level playing field in return – currently, it’s a zoo out there and particularly the small investor is getting fleeced.
    HFT is incredibly harmful to our societies and economies: The exchanges were established to help build companies with good ideas using capital not currently needed elsewhere. HFT is a parasite sucking on that cash flow, making money while bringing no appreciable benefit to society and, even worse, skewing the prices. Every investment is at least a bit of a gamble, but with HFT it’s like a casino, where the odds are intentionally stacked against you.

Leave a Reply

Please be kind and respectful to help make the comments section excellent. (Comment Policy)

This site uses Akismet to reduce spam. Learn how your comment data is processed.