Michael Brolley and Marius Zoican

Southern Finance Association
November 19, 2020

Liquid speed:

a congestion fee for low-latency exchanges

Who really needs to trade at warp speed?

  • HFTs provide price discovery as both makers and takers
  • However, they also to capture latency arbitrage rents.
  • Speed inequality can adversely effect liquidity          (Shkilko & Sokolov, 2020).
  • Should we tinker with or overhaul our market design? (Baldauf & Mollner 2020; Brolley & Cimon  2020; Haas,Khapko, & Zoican 2020).
  • Exchanges charge HFTs for "co-location": revenues between $874M-$1024M in 2018
  • Co-location revenue on par with trading fees revenue.

How much speed do we really need?

Our paper

  • Main idea: Surge pricing of speed (à la Uber).
  • How? Implement a congestion fee on liquidity taking orders.
  • Charge a uniform fee to each liquidity-taking order message whenever there are multiple take orders in a short time interval.
  • Fee level     the number of take orders, surging during micro-bursts.
  • Latency arbitrage externalities are (partially) priced in.
  • A system that is incentive-compatible for exchanges.
\uparrow

Status quo: Latency arbitrage rent-sharing

Ideal world: No latency arbitrage rents

Our idea: Incentive-compatible rent transfer from HFTs to investors

Asset

  • One risky asset, for which news arrives with probability   .
  • It pays off:
\delta
\tilde{v}=\begin{cases} v+\sigma, & \text{if ``good news'' arrives} \\ v-\sigma, & \text{if ``bad news'' arrives} \\ v, & \text{if no news arrives}. \end{cases}

Traders

  •            risk-neutral high-frequency traders (HFT) who submit market or limit orders.
  • Liquidity investors (also risk neutral), arrive at the market with probability          .
  • Liquidity investors only submit market orders are equally likely to buy/sell.
H\geq 3
1-\delta

Congestion fee

If           HFT "snipers'' submit a marketable order simultaneously, each is charged a fee

k\geq 2
f\left(k\right)=\begin{cases} \phi \left(k-1\right) & \text{ if } k\geq 2 \\ 0 & \text{ if } k=1. \end{cases}
  • Congestion fee    number of liquidity-taking orders received by the exchange in a short time interval (100  s to 10 ms).
  • Single marketable order arrives        congestion fee is zero. 
  • Congestion fees are computed from intraday, but charged daily (or monthly, even).
  • Unlikely that liquidity traders pay congestion fees.      Estimated total duration of HFT races in FTSE100 stocks: 
\propto
\mu
\Rightarrow
537 \text{ races/day} \times 81 \text{ $\mu$s/race} = 0.043 \text{ seconds/day}.

Impact of fee on liquidity and race intensity

A larger congestion fee leads to:

  1. Narrower spreads;
  2. Lower sniping probability

What about fee revenues?

  • Direct effect:          implies higher revenues for each trade;
  • Indirect effect:          reduces HFT incentives to snipe         less intense races.
\phi \nearrow
\phi \nearrow
\Longrightarrow

A regulator’s optimal fee choice

  • Implement a "surge pricing of speed'' (a la Uber) on liquidity taking orders. 
  • Charge HFTs a fee whenever there are multiple liquidity-taking orders in a short time interval.
  • Quick calibration indicates fee in the range of 15%-35% relative to the average arbitrage opportunity.                          (using Aquilina, Budish, and O'Neill, 2020).
  • Latency arbitrage externalities are (partially) priced in.
  • Incentive-compatible for exchanges                                    (i.e., competition-proof vs. co-location fees).

Conclusions