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HFT capitalizes on a kind of time arbitrage. They take the data from one market, and then transport that data using specialized, custom built networks that move the data from one place to another a tiny fraction of a second quicker than other networks. They then capitalize on having that data earlier to eek out small profits at scale.

Imagine two investors sitting at a restaurant table discussing trades they are about to make. The trades they are making will be significant, in the sense that their trades will then impact the value of the stocks they're trading. Meanwhile, a waiter at the restaurant makes a habit of eavesdropping on the conversations of these investors. When he gets the information, he runs to the phone and effects his own, smaller trade.

It's not that the waiter happened to overhear something. The waiter makes it his business to "overhear." The waiter adds no real value. He's a parasite on the people who do add value. The HFT traders are likewise.

What they do is documented in Michael Lewis's Flashboys.

https://www.amazon.com/Flash-Boys-Wall-Street-Revolt/dp/0393...




I work in the industry, have read Flash Boys, and am aware of how misleading and occasionally false the book is. It's always disheartening to see someone be so sure of themselves while also being incorrect.

Your metaphor is inaccurate. Your metaphor describes actual front running, which is indeed illegal. It does not describe the sort of latency arbitrage that HFTs do, which Michael Lewis has unfortunately also dubbed "front running" (and succeeded at changing the lay population's definition of the term).

I would try to adjust your metaphor to be correct but it isn't really possible. There is no eavesdropping. HFTs do not know anything about trades before they happen. If they see a large trade, they adjust their prices after the trade happens (possibly on another exchange). This isn't eavesdropping, they are operating on public information, just very quickly. It's the foundation of all market making: adjusting prices according to order flow.


I'm going by memory of what I read in the book and would be happy to have any misunderstanding on my part clarified. Put simply, I think the book described things this way. (I'll use all convenient numbers and fanciful descriptions.)

A buy is tendered from Timbuktu. The offer will need to travel from Timbuktu to the NYSE. The Flash Boys find out about this buy offer before the sellers using the NYSE system do, so they insert themselves.

The buyer in Timbuktu sees a price of 100 dollars. As are all prices, this 100 dollar quote is "historical." The price will be what it is when the trade is actually effected. The buyer offers 101 dollars. The Flash Boys get ahead of the game, buy the stock at 100.50 and resell it for 101.

That's boiling it down to the essentials. I could be wrong about what the book says. The book could be wrong in its characterization of what goes on. Please, you tell me.


I haven't read Flash Boys since it came out, but I'm pretty sure it doesn't actually inaccurately describe how latency arbitrage works the way you just did, it just blurs together similar concepts enough to create confusion about the details, which results in outrage.

The key part that you're missing is that latency arbitrage works only when there are multiple exchanges, and there is only one exchange in your example. Your example suggests that HFTs somehow see the buy order before it reaches the NYSE, but that is not possible. In reality it would be something like this:

- Buyer wants to buy 100,000 shares at $100, but no single stock exchange (there are 13 in the US I believe, soon to be 14) has that many shares available at that price. - But there are 50,000 shares each available at NYSE and NASDAQ each, so they send orders to each. - Their NYSE order arrives first, and the trade happens at $100 for all 50,000 shares - The HFT notices, and seeing that demand is high for the stock, increases their price on NASDAQ to $100.01 for those remaining 50,000 shares. - The buyer's order on NASDAQ does not trade, because the $100 is no longer available

The "information leakage" is from public information only - that a trade happened on another exchange.

Note also that no part of this example discusses the HFT buying a certain price, then selling back immediately at a higher price.


Sorry I can't edit, I reformatted the bullets below:

- Buyer wants to buy 100,000 shares at $100, but no single stock exchange (there are 13 in the US I believe, soon to be 14) has that many shares available at that price.

- But there are 50,000 shares each available at NYSE and NASDAQ each, so they send orders to each.

- Their NYSE order arrives first, and the trade happens at $100 for all 50,000 shares

- The HFT notices, and seeing that demand is high for the stock, increases their price on NASDAQ to $100.01 for those remaining 50,000 shares.

- The buyer's order on NASDAQ does not trade, because the $100 is no longer available




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