Dark Pool Reference Price Latency Arbitrage∗ Matteo Aquilina,y Sean Foley,z Peter O'Neillx and Thomas Ruf{ May 10, 2017 Abstract Using proprietary order book data with participant-level message traffic and matching engine time stamps, we investigate the nature of stale reference pricing in dark pools. We document a sizeable proportion of stale trading which imposes large adverse selection on the passive side in dark pools. We are the first to document that HFTs almost never provide liquidity and instead frequently take liquidity in the dark, in particular in order to take advantage of stale quotes in the dark. Finally, we examine several market design inter- ventions to mitigate stale trades, showing that only mechanisms to protect passive dark liquidity, such as random uncrossings, are effective. Keywords: high-frequency trading, dark pools, latency arbitrage, reference prices ∗We would like to thank Michael Aitken, Peter Andrews, Hao Ming Chen, Brian Eyles, Simon Hargreaves, Edwin Schooling Latter, Ted Macdonald, Albert Menkveld, Richard Payne, Talis Put- nins, Jia Shao, Patrick Spens, Felix Suntheim, Martin Taylor, Carla Ysusi and Bart Z. Yueshen. We would also like to thank our colleagues at the FCA. We are also grateful to participants of the FCA/LSE conference on financial regulation for their comments. Any errors and omissions are our own. This article is an extension of the FCA Occasional Paper 21 'Asymmetries in Dark Pool Reference Prices.' yFinancial Conduct Authority (UK). zUniversity of Sydney. xFinancial Conduct Authority (UK) and University of New South Wales. e-mail:[email protected] Peter O'Neill thanks the Capital Markets Cooperative Research Cen- ter for funding a period as a visiting researcher at the FCA during this study. {University of New South Wales. 1 1 Introduction Financial markets have been subject to increasing competition on speed, which now governs investor trading costs and liquidity. In this new world, fast traders impose adverse selection costs on slower ones by acting on information signals faster than their competitors. These signals are not always clear, resulting in competition on interpreting information, as well as reacting to it (Budish et al., 2015). Where these signals are symmetrically interpretable, a race occurs on reaction times alone. These have been labeled `toxic arbitrage' (Foucault et al., 2016) and `latency arbi- trage' (Bartlett and McCrary, 2016) and are argued to be harmful to liquidity in financial markets by increasing adverse selection to liquidity providers. Dark pools are uniquely susceptible to latency arbitrage by relying on feeds from lit markets to price trades. Changes in lit prices create opportunities for fast par- ticipants to pick off stale quotes before they can update. Reference pricing creates a mechanical relationship, resulting in an `old price' and a `new price', a situation which does not exist on lit venues. While prices may vary between venues, there is a degree of uncertainty in their convergence or reversal. Dark pool reference prices thus create an ideal setting to observe latency arbitrage as signals have very low uncertainty. Dark pools aim to lower the trading costs of institutional investors. The reliance on reference pricing can create latency derived adverse selection costs. We character- ize the extent of stale trades in dark pools, and the impact it has on execution quality. We link this with the liquidity provision strategies of participants in dark pools, as the first study to provide orderbook information in dark pools using matching engine timestamps. Finally, we examine the effectiveness of several existing market design solutions that aim to address the problem of reference price latency arbitrage, finding batch auctions and random uncrossings are effective at reducing such conduct. This paper has important implications for the design of modern markets in rela- tion to the merits of `slowing down' markets, such as the controversial IEX `speed- bump', batch auctions and minimum resting times. We confirm the predictions of theoretical models of high frequency arms races (Foucault et al., 2016). We show 2 that HFT participants impose adverse selection on slower participants and market design interventions, which obstruct the speed race, reduce this adverse selection. Dark pools differ from `lit' markets in offering no pre-trade transparency, match- ing orders using reference prices from lit markets data feeds.1 Two forms of delay or latency in referencing this primary market exist, resulting in potential costs to in- vestors; processing latency and transmission latency. Where markets are in the same physical location or data center, a delay exists between the hardware and software responsible for calculating and disseminating the market data (processing latency).2 When these two markets are in different physical locations, the time it takes to transmit price date creates an additional delay (transmission latency).3 These two sources of latency engender differences in speed amongst participants. To eliminate these, innovations have been proposed in modern markets.4In the US, the exchange and dark pool IEX has designed an `inbound speed-bump' to prevent latency arbitrage arising from latency in its reference price calculation. The popular- ity of such innovations is evidenced by their recent introduction by other exchanges, such as the Chicago Stock Exchange, the Alpha Exchange in Canada5 and recently, NYSE. IEX's speed-bump delays inbound and outbound orders by 350 microseconds (IEX, 2015). Importantly, it does not apply to the repricing of dark orders. Conse- quently, as long as the reference price feed is not stale by more than 350 microseconds, reference price latency arbitrage is prevented.6 1This refers to the vast majority of dark pools and dark pool trades by value which is not `Large In Scale' so must rely on the `Reference Price Waiver' and external pricing sources, to enable dark trading. 2Bartlett and McCrary (2016) find that the NYSE and NASDAQ SIPs take 450 and 750 mi- croseconds on average, respectively, to process incoming quote updates from US exchanges. 3Bartlett and McCrary (2016) compare proprietary co-located feeds at the exchanges to the US NBBO consolidated tape (SIP) finding that the NYSE SIP takes 9 microseconds on average to receive quote updates from its own exchange, despite being in the same building. Quotes from BATS take 999 microseconds on average to travel 16 miles, a comparable distance to LSE and BATS in the UK. This significantly exceeds their `theoretical minimum time' of 86 microseconds. 4Latency and high-frequency concepts are embedded in new regulation such as microsecond timestamp precision requirements in MiFID II and the SEC's recent proposal on one millisecond tolerances for Reg. NMS quote dissemination (File No. S7-03-16) 5See Chen et al. (2016) for an examination of the implementation of Alpha's speed-bump. 6This is acknowledged in competing exchange BATS' submission to the SEC regarding IEX's application to become an exchange: `this 350 microsecond delay provides IEX the ability to update 3 The LSE has recently introduced a new Field Programmable Gate Array (FPGA)7 product to reduce processing latency to ‘sub-five microseconds'.8 Sev- eral microwave networks now carry data between national and global exchanges, significantly reducing transmission latency compared with fiber optic networks. While some latency (both processing and transmission) is unavoidable, in well- functioning markets both types of latency should be reduced to a minimum as latency can give rise to arbitrage opportunities. Foucault et al. (2016) model these `asyn- chronous price adjustments which give rise to toxic arbitrage opportunities'. They show that dealer adverse selection risk, and thus liquidity, is a function of the `ar- bitrage mix', the proportion of toxic vs non-toxic arbitrages, and the arbitrager or sniper's speed relative to the liquidity provider's. We show that the proportion of stale/toxic trades is significant, with aggressive snipers being predominantly HFT participants. This has an adverse impact on liquidity provision; we show that HFTs almost never provide marketable liquidity in dark pools. According to publicly available information, the transmission latency between LSE's data center in central London and BATS's in Slough is about 320 microsec- onds and between the LSE and Turquoise (60 microseconds).9 There is additional time to process incoming order messages, quoted by exchanges to be about 25 mi- croseconds.10 The latency of pre-trade risk checks, which must be performed on incoming orders, is also often quoted. A competitive market exists in minimizing this latency. LSE quotes a reduction of 2{3 microseconds to below 0.5 microseconds in a recent exchange upgrade (LSEG, 2013, p. 6). When messages spike, as is com- mon within a millisecond, this infrastructure hits bandwidth/throughput constraints, the prices of resting orders that are pegged. before market participants with faster access to market data can access those now stale prices on IEX' (Swanson, 2015, p. 1). 7FPGAs are a type of computer architecture in which the programming is in the hardware chip rather than the software, reducing processing latency significantly (LSEG, 2016). 8This reduces the processing time to disseminate market data by the exchange. HFT and other latency sensitive participants have also used FPGAs in their co-location servers for many years, and more recently, in their microwave networks. 9This is according to one market data vendorm Standard and Poors Capital IQ (2015). These figures will vary across providers, and technologies used. Microwave connections are reported to be 30 to 40% faster than fiber. 10LSEG (2013). 4 and messages get queued. This can increase latency by many multiples.11 The importance of speed in governing how financial markets operate has been demonstrated by recent actions by regulators and practitioners as well as academics. Latency in Goldman Sachs's US dark pool was significant enough to justify a fine of $800k levied by FINRA in 2014 (FINRA, 2014).