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Article by Jake and Stake | Edited by Kornekt | Cover Art by Chamelon
Flash Boys, a book by Michael Lewis on high-frequency trading (HFT), documents how trading firms created a method to front-run orders placed by investors. HFT had existed in some form since the 1930s when the telegraph was used to communicate positions across exchanges. However, it didn’t gain momentum until 1983 when the Nasdaq introduced purely electronic trading. HFT, as we know it today, was developed and popularized in the mid-2000s as the markets began to modernize. As a result, cross-market trading began to take off.
Today, small arbitrage opportunities occur all the time in traditional finance. These opportunities arise in milliseconds and are imperceptible to humans, but are perceptible by computers. One company, known as Spread Networks, spent $300 million constructing a fiber optic cable 827 miles long from Chicago to the Nasdaq data center in New Jersey.
Before the project, trades on the Chicago Mercantile Exchange were transmitted in just 17 milliseconds. After the project, transmission time was reduced to 13 milliseconds — compare that to the average human blink, which lasts 100 milliseconds.
This 4-millisecond difference — $300 million for a 23.5% speed increase — allows HFT firms to see orders to buy a stock, buy the stock before the orders can be executed, and sell the stock to the original purchaser at a slightly higher price.
Everyday retail investors purchasing stock don’t have access to these systems and are constantly getting front-run by HFT firms. These trading firms, therefore, profit off of retail investors, earning billions of dollars every year. According to the Financial Times, HFT accounted for 65% of the US stock market volume in 2008. Some estimate HFT to have accounted for as much as 78% of total trading volume in 2009.
Breakdown of US Stock trading volume between 1996 and 2016. Source: Credit Suisse
Arbitrage increases liquidity across markets and closes the difference between the bid and ask spreads — leading to better prices — and HFT firms skim the difference.
In an effort to make their systems as fast as possible, banks and trading firms go as far as placing their servers inside stock exchange buildings in a strategy called colocation. One HFT firm was able to secure a spot “[…] a few feet nearer to an exchange computer that had previously been occupied by machines owned by Toys ‘R’ Us.” The firm got a slight advantage of just inches, but this was quite significant as it is a competition for microseconds and nanoseconds. This advantage increased the firm’s profits, but if competitors knew about the computers they would have responded in kind. The HFT firm with the Toys ‘R’ Us machines was so paranoid about hiding this slight advantage — they insisted the Toys ‘R’ Us logo was not changed after they had moved in.
Brad Katsuyama was the global head of electronic sales and trading at the Royal Bank of Canada when he noticed that scalpers were taking advantage of large trades, resulting in worse prices. After digging deeper, he discovered that these fiber optic cables and colocation agreements allowed HFT firms to take advantage of retail traders.
As a result, he founded IEX, an exchange designed to provide a fairer stock trading avenue by creating an alternative system. Exchanges like IEX are trying to reduce the effects of HFTs through design.
IEX:
has published its order-matching rules
refuses to pay for order flow
charges fixed fees on large orders and a flat percentage rate on small ones
avoids colocation
ensures market pricing data arrives at external points of presence (internet exchange points along your packet’s path) simultaneously.
IEX has even created a “Magic Shoebox”, designed to slow down traffic coming in and out of the exchange.
IEX Magic Shoebox. Source: IEX Exchange
This box contains 61km of fiber optic cable that’s designed to add a 350-microsecond delay, creating a speed bump for all network traffic.
IEX is an alternative trading system (ATS). These ATSs exist outside of traditional securities markets. They are regulated, but many have problems with insider trading and predatory behaviors, especially when trades are anonymous and have no specific order information before they occur. These anonymous ATSs are called Dark Pools.
Dark pools are private exchanges for trading securities. These exchanges are pools of liquidity not accessible by the investing public hence the name dark pool. They allow hedge funds and institutional investors to make privately negotiated trades, called “block trades”.
Some institutions use these pools to avoid large price impacts, and orders can be broken up into smaller forms executed across various exchanges to hide trading activity (see more). Learn more about slippage and liquidity in the DeFi Download’s AMM Edition (part I).
Dark pools are categorized as “Alternative Trading Systems (ATSs)” by the SEC. They allow large entities to trade anonymously, without revealing the order price or size to other dark pool participants. These dark pools exclude HFT firms, providing a refuge from front-running.
Source: Nasdaq
The problem for Dark Pools is attracting sufficient liquidity to execute trades at reasonable prices. To increase liquidity, Dark Pools give their own proprietary trading desks access to the markets. They move the information from large national exchanges to private exchanges, but the same arbitrage opportunities existed. This information advantage is too profitable to ignore because several dark pool operators would have given their own trading desks information to improve their trades, front-running their customers. One dark pool operator’s compliance department warned that this was illegal, but they did it anyway.
Another dark pool operator (Pipeline Trading Systems) was caught operating an undisclosed proprietary trading desk (a division of the company that places trades) which composed the overwhelming majority of volume within the dark pool. Not only did their “Affiliates” — aka the Pipeline Trading desk — get information about trades, they also got better access to the system (colocation) and information about the Pipeline’s order-matching engine (the system’s rules) so they could more effectively front-run other dark pool subscribers.
Still yet, another large dark pool operator gave HFT funds access to their pools with special order types, allowing them to get an unfair advantage over regular subscribers. They even let some preferred subscribers avoid trading against the HFT funds. In other words, the dark pool gave HFT coyotes access to the henhouse, armed these coyotes with forks and knives, and created a “VIP” section where special hens could order omelets and watch the mayhem below.
Payment for order flow is another way to capitalize on this price information. Market makers will pay stockbrokers to route users’ trades to them for fulfillment. Robinhood made huge waves as one of the first broker-dealers to offer free trades and zero fees on account maintenance or any fund transfers. How did they afford to do this? Famously, market maker Citadel Securities buys Robinhood’s order flow for $2.6 billion a year.
Bernie Madoff, infamous for running the largest Ponzi scheme in history, said this of payment for order flow:
“[…] It was characterized as this bribe and kickback and something sinister, which was very easy to do. But if your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated.” — Bernie Madoff
How Payment for Order Flow Works. Source: Bloomberg
Broker-dealers are obligated by law to provide a “best execution” price — no worse than the National Best Bid and Offer (NBBO) — to their customers, but these prices, notoriously, do not provide enough information for customers to verify them. Additionally, NBBO prices often go unrecorded, making it extremely difficult to determine whether traders got the right price or not.
Even if the prices were recorded, HFTs could take advantage of the latency between the NBBO’s calculation time and its publication. Because HFTs can access market information (prices) faster than the NBBO price can be published, HFTs will pre-calculate future NBBOs, front-run trades, and pocket a small but assured profit. Payment for order flow (PFOF) allows brokerages to share in some of these profits.
The SEC has said about PFOF:
While the fierce competition brought on by increased multiple-listing produced immediate economic benefits to investors in the form of narrower quotes and effective spreads, by some measures these improvements have been muted with the spread of payment for order flow and internalization.
All of these TradFi (traditional finance) examples of arbitrage come from one thing: having access to information. Intuitively, buying something and selling it for more than you bought it for is not a new concept. It’s not always bad either. In fact, arbitrage is a crucial part of these systems because it improves market efficiency. It’s seen in traditional finance and in Amazon retailers. Amazon reselling has gained huge traction among the Zoomer cohort — purchasing products in stores, then marking up the prices and selling them on Amazon.
Now, crypto is speed-running the history of finance. MakerDAO created the first decentralized lending project in 2014, Uniswap launched in 2018, and Compound set web3 on fire with yield farming in 2020. With DeFi comes opportunity.
There’s a new kind of arbitrage in finance: Maximum Extractable Value (MEV). Formerly referred to as Miner Extractable Value, MEV includes DEX (decentralized exchange) arbitrage, liquidations, and NFT sniping; all these are possible through crypto-economic protocols like Ethereum and it is very valuable. There are bots constantly searching for these opportunities throughout the mempool, but ultimately, the entity that has final control over these arbitrage opportunities is the block producer.
In proof-of-work systems, miners are the block producers, and in proof-of-stake systems, stakers are the block producers. Because these entities produce the last set of transactions to finalize, they can add, remove, or replace transactions as they see fit without intervention from others. Only block producers can guarantee the execution of MEV transactions, so if they find an arbitrage opportunity, they can capture it. As a result, block producers in web3 have “god mode”.
A version of this article initially appeared in BanklessDAO’s DeFi Download newsletter on October 27, 2022.
Author Bio
Jake and Stake is a writer and editor at BanklessDAO. He is the creator of and contributor to the DeFi Download, with a background in software engineering and cybersecurity.
Editor Bio
Kornekt is a writer and editor with strong conviction in the world web3 creates.
Designer Bio
Chameleon is a designer and creator in the web3 space.
BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.
This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.
Bankless Publishing is always accepting submissions for publication. We’d love to read your work, so please submit your article here!
More Like This
The Evolution of Money by Frank America
7 Etherscan Basics by Hiro Kennelly
The Byzantine Generals Problem, 51% Attacks, and Proof-of-Work by Jake and Stake
Article by Jake and Stake | Edited by Kornekt | Cover Art by Chamelon
Flash Boys, a book by Michael Lewis on high-frequency trading (HFT), documents how trading firms created a method to front-run orders placed by investors. HFT had existed in some form since the 1930s when the telegraph was used to communicate positions across exchanges. However, it didn’t gain momentum until 1983 when the Nasdaq introduced purely electronic trading. HFT, as we know it today, was developed and popularized in the mid-2000s as the markets began to modernize. As a result, cross-market trading began to take off.
Today, small arbitrage opportunities occur all the time in traditional finance. These opportunities arise in milliseconds and are imperceptible to humans, but are perceptible by computers. One company, known as Spread Networks, spent $300 million constructing a fiber optic cable 827 miles long from Chicago to the Nasdaq data center in New Jersey.
Before the project, trades on the Chicago Mercantile Exchange were transmitted in just 17 milliseconds. After the project, transmission time was reduced to 13 milliseconds — compare that to the average human blink, which lasts 100 milliseconds.
This 4-millisecond difference — $300 million for a 23.5% speed increase — allows HFT firms to see orders to buy a stock, buy the stock before the orders can be executed, and sell the stock to the original purchaser at a slightly higher price.
Everyday retail investors purchasing stock don’t have access to these systems and are constantly getting front-run by HFT firms. These trading firms, therefore, profit off of retail investors, earning billions of dollars every year. According to the Financial Times, HFT accounted for 65% of the US stock market volume in 2008. Some estimate HFT to have accounted for as much as 78% of total trading volume in 2009.
Breakdown of US Stock trading volume between 1996 and 2016. Source: Credit Suisse
Arbitrage increases liquidity across markets and closes the difference between the bid and ask spreads — leading to better prices — and HFT firms skim the difference.
In an effort to make their systems as fast as possible, banks and trading firms go as far as placing their servers inside stock exchange buildings in a strategy called colocation. One HFT firm was able to secure a spot “[…] a few feet nearer to an exchange computer that had previously been occupied by machines owned by Toys ‘R’ Us.” The firm got a slight advantage of just inches, but this was quite significant as it is a competition for microseconds and nanoseconds. This advantage increased the firm’s profits, but if competitors knew about the computers they would have responded in kind. The HFT firm with the Toys ‘R’ Us machines was so paranoid about hiding this slight advantage — they insisted the Toys ‘R’ Us logo was not changed after they had moved in.
Brad Katsuyama was the global head of electronic sales and trading at the Royal Bank of Canada when he noticed that scalpers were taking advantage of large trades, resulting in worse prices. After digging deeper, he discovered that these fiber optic cables and colocation agreements allowed HFT firms to take advantage of retail traders.
As a result, he founded IEX, an exchange designed to provide a fairer stock trading avenue by creating an alternative system. Exchanges like IEX are trying to reduce the effects of HFTs through design.
IEX:
has published its order-matching rules
refuses to pay for order flow
charges fixed fees on large orders and a flat percentage rate on small ones
avoids colocation
ensures market pricing data arrives at external points of presence (internet exchange points along your packet’s path) simultaneously.
IEX has even created a “Magic Shoebox”, designed to slow down traffic coming in and out of the exchange.
IEX Magic Shoebox. Source: IEX Exchange
This box contains 61km of fiber optic cable that’s designed to add a 350-microsecond delay, creating a speed bump for all network traffic.
IEX is an alternative trading system (ATS). These ATSs exist outside of traditional securities markets. They are regulated, but many have problems with insider trading and predatory behaviors, especially when trades are anonymous and have no specific order information before they occur. These anonymous ATSs are called Dark Pools.
Dark pools are private exchanges for trading securities. These exchanges are pools of liquidity not accessible by the investing public hence the name dark pool. They allow hedge funds and institutional investors to make privately negotiated trades, called “block trades”.
Some institutions use these pools to avoid large price impacts, and orders can be broken up into smaller forms executed across various exchanges to hide trading activity (see more). Learn more about slippage and liquidity in the DeFi Download’s AMM Edition (part I).
Dark pools are categorized as “Alternative Trading Systems (ATSs)” by the SEC. They allow large entities to trade anonymously, without revealing the order price or size to other dark pool participants. These dark pools exclude HFT firms, providing a refuge from front-running.
Source: Nasdaq
The problem for Dark Pools is attracting sufficient liquidity to execute trades at reasonable prices. To increase liquidity, Dark Pools give their own proprietary trading desks access to the markets. They move the information from large national exchanges to private exchanges, but the same arbitrage opportunities existed. This information advantage is too profitable to ignore because several dark pool operators would have given their own trading desks information to improve their trades, front-running their customers. One dark pool operator’s compliance department warned that this was illegal, but they did it anyway.
Another dark pool operator (Pipeline Trading Systems) was caught operating an undisclosed proprietary trading desk (a division of the company that places trades) which composed the overwhelming majority of volume within the dark pool. Not only did their “Affiliates” — aka the Pipeline Trading desk — get information about trades, they also got better access to the system (colocation) and information about the Pipeline’s order-matching engine (the system’s rules) so they could more effectively front-run other dark pool subscribers.
Still yet, another large dark pool operator gave HFT funds access to their pools with special order types, allowing them to get an unfair advantage over regular subscribers. They even let some preferred subscribers avoid trading against the HFT funds. In other words, the dark pool gave HFT coyotes access to the henhouse, armed these coyotes with forks and knives, and created a “VIP” section where special hens could order omelets and watch the mayhem below.
Payment for order flow is another way to capitalize on this price information. Market makers will pay stockbrokers to route users’ trades to them for fulfillment. Robinhood made huge waves as one of the first broker-dealers to offer free trades and zero fees on account maintenance or any fund transfers. How did they afford to do this? Famously, market maker Citadel Securities buys Robinhood’s order flow for $2.6 billion a year.
Bernie Madoff, infamous for running the largest Ponzi scheme in history, said this of payment for order flow:
“[…] It was characterized as this bribe and kickback and something sinister, which was very easy to do. But if your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated.” — Bernie Madoff
How Payment for Order Flow Works. Source: Bloomberg
Broker-dealers are obligated by law to provide a “best execution” price — no worse than the National Best Bid and Offer (NBBO) — to their customers, but these prices, notoriously, do not provide enough information for customers to verify them. Additionally, NBBO prices often go unrecorded, making it extremely difficult to determine whether traders got the right price or not.
Even if the prices were recorded, HFTs could take advantage of the latency between the NBBO’s calculation time and its publication. Because HFTs can access market information (prices) faster than the NBBO price can be published, HFTs will pre-calculate future NBBOs, front-run trades, and pocket a small but assured profit. Payment for order flow (PFOF) allows brokerages to share in some of these profits.
The SEC has said about PFOF:
While the fierce competition brought on by increased multiple-listing produced immediate economic benefits to investors in the form of narrower quotes and effective spreads, by some measures these improvements have been muted with the spread of payment for order flow and internalization.
All of these TradFi (traditional finance) examples of arbitrage come from one thing: having access to information. Intuitively, buying something and selling it for more than you bought it for is not a new concept. It’s not always bad either. In fact, arbitrage is a crucial part of these systems because it improves market efficiency. It’s seen in traditional finance and in Amazon retailers. Amazon reselling has gained huge traction among the Zoomer cohort — purchasing products in stores, then marking up the prices and selling them on Amazon.
Now, crypto is speed-running the history of finance. MakerDAO created the first decentralized lending project in 2014, Uniswap launched in 2018, and Compound set web3 on fire with yield farming in 2020. With DeFi comes opportunity.
There’s a new kind of arbitrage in finance: Maximum Extractable Value (MEV). Formerly referred to as Miner Extractable Value, MEV includes DEX (decentralized exchange) arbitrage, liquidations, and NFT sniping; all these are possible through crypto-economic protocols like Ethereum and it is very valuable. There are bots constantly searching for these opportunities throughout the mempool, but ultimately, the entity that has final control over these arbitrage opportunities is the block producer.
In proof-of-work systems, miners are the block producers, and in proof-of-stake systems, stakers are the block producers. Because these entities produce the last set of transactions to finalize, they can add, remove, or replace transactions as they see fit without intervention from others. Only block producers can guarantee the execution of MEV transactions, so if they find an arbitrage opportunity, they can capture it. As a result, block producers in web3 have “god mode”.
A version of this article initially appeared in BanklessDAO’s DeFi Download newsletter on October 27, 2022.
Author Bio
Jake and Stake is a writer and editor at BanklessDAO. He is the creator of and contributor to the DeFi Download, with a background in software engineering and cybersecurity.
Editor Bio
Kornekt is a writer and editor with strong conviction in the world web3 creates.
Designer Bio
Chameleon is a designer and creator in the web3 space.
BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.
This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.
Bankless Publishing is always accepting submissions for publication. We’d love to read your work, so please submit your article here!
More Like This
The Evolution of Money by Frank America
7 Etherscan Basics by Hiro Kennelly
The Byzantine Generals Problem, 51% Attacks, and Proof-of-Work by Jake and Stake
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