Chicago Stock Exchange Targets Latency Arbitrage With Delay

  • CHX echoes some of modern trading’s harshest critics with plan
  • Speed bump resembles the one at IEX’s Investors Exchange

Speed bumps are catching on in U.S. markets.

The Chicago Stock Exchange just revealed plans for a 350-microsecond speed bump, similar to the famous delay on IEX Group Inc.’s Investors Exchange, which started trading last week as the 13th official U.S. stock exchange. The idea is to make trading more fair by blunting the advantage of some of the fastest traders.

But there’s a key difference: Whereas IEX slows down everyone using its exchange, the Chicago market will only slow down traders who take liquidity -- that is, those who trade against standing orders posted by market makers.

For years, the U.S. stock market’s rallying cry has been to get trades executed faster and faster. Spread Networks cored through mountains to build a straighter -- and quicker -- fiber-optic line for traders. Microwave towers sprung up to convey trades even faster. Now, there’s a move to slow things down amid allegations that some traders have an unfair advantage, and as high-frequency traders realize the costs to go even faster outweigh the potential profits.

Even the New York Stock Exchange and Nasdaq Stock Market are getting into the game. They both blasted IEX when it was seeking regulatory approval, and they are now copying features of the Investors Exchange.

The Chicago Stock Exchange echoed the harshest critics of modern trading when describing the new system, saying it’s “designed to neutralize microsecond speed advantages exploited by low-latency market participants engaged in latency arbitrage strategies that diminish displayed liquidity and impair price discovery,” according to its regulatory filing Monday. Low-latency market participants are those who try to trade the fastest.

The goal is to prevent speedy traders from picking off stale price quotes. U.S. stock trading is spread across 13 exchanges and dozens of other markets including dark pools. Market makers often post standing orders on many of them at once, and either update the prices or cancel them when the stock price starts moving. But if they’re not fast enough, traders can hit those now out-of-date quotes, losing money for the market makers.

“High-frequency firms are really modern-day market makers and specialists,” John Kerin, chief executive officer of the Chicago Stock Exchange, said in a phone interview. “Just like anything else, you have some that really add to the market and provide good and public benefit and others that do not.”

One of the biggest market makers endorsed Chicago’s change.

“We applaud CHX for this important innovation that will slow down traders intent only on picking off stale passive quotes and enable market making firms like Virtu to provide more liquidity,” Virtu Financial Inc. Chief Executive Officer Doug Cifu said. “This change will benefit institutional investors.”

The exchange said it’s losing business because of “latency arbitrage,” which it defined as “the practice of exploiting disparities in the price of a security or related securities that are being traded in different markets by taking advantage of the time it takes to access and respond to market information.”

Specifically, the company said since January it’s observed latency arbitrage in the SPDR S&P 500 ETF Trust, a $198 billion fund known as the SPY that tracks the benchmark index for U.S. stock prices.

“SPY latency arbitrage has caused CHX liquidity providers to dramatically reduce displayed liquidity in SPY (and at times withdraw from the market altogether), which, given CHX’s significant contribution to overall volume and liquidity in SPY prior to the declines, materially decreased liquidity in SPY marketwide,” according to the regulatory filing.

The Chicago Stock Exchange is one of the smallest U.S. stock exchanges, handling less than 0.5 percent of nationwide volume during the past 30 days, according to data compiled by Bloomberg. A China-based company called Chongqing Casin Enterprise Group is trying to buy the exchange.

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