Flash Boys raises the question but fails to explain why knowledge of speed is more important than speed itself in modern electronic trading.
While the general public may only be gaining awareness of HFT’s existence with the recent launch of Flash Boys by Michael Lewis, there are still many who participate in the capital markets industry struggling to understand the real role of speed in electronic trading. What follows is not "yet another blog post" on HFT - good or bad. Nor is it an opinion on the contents of Flash Boys. Instead, I will discuss a perspective we developed about the role of speed as a result of the past several years monitoring electronic trading networks.
In 2009, we presented a view to the marketplace that "speed is good, transparency is better". At this time the electronic trading industry was in the middle of what seemed to be an endless latency arms race. At that time we felt that this arms race would inevitably come to a halt as electronic trading advantage is a function of relative latency, not absolute latency. This is often hard for non-technical people to fully understand. However, improving relative latency at the same point in time is exponentially proportional to technology cost. Also, specific reductions in latency do not necessarily improve trading performance in proportion to investment cost. The relationship is much more complex. This fact is sometimes forgotten and not fully understood by IT professionals supporting the trading business.
What has happened in the past five years is the mass adoption of high speed IT systems for electronic trading. Everybody is fast today. To be more precise, everybody is "fast enough". Fast enough is often good enough for most organizations. The trading mantra has shifted from "I must be fast" to "I can't be slow". In essence, the industry has found its center of gravity balancing the cost of achieving latency advantage versus the economic return from improved trading performance.
So how do you compete in world when everyone is “fast enough”. The answer is that you have to be smarter. To be smarter, you need to have better knowledge of speed than your competitor. Imagine if you were a professional athlete and your speciality was the 100 metre sprint. How would you prepare for the next big race. You would analyze the race and identify the following key metrics:
Based on these metrics you would devise a training plan and strategy. If you execute your plan and prepare well, you would know quantitatively your chances of winning the race. At that point you could decide whether or not you would enter the race, travel to the destination and compete. The critical observation is that the athlete is able to devise a more predictable plan and strategy for winning the race based on a superior knowledge and analysis of all key metrics associated with the race, the competitors and the environment. A champion athlete does this for every race. A champion athlete does not just win one race. The champion athlete wins the majority of races he/she decides to enter. It is not a surprise when they win. It is not luck.
In electronic trading, thousands of races happen every minute. Traders that win the most have a better strategy and a better plan based on superior knowledge and understanding of the IT systems that support execution of trading transactions. In particular, these traders have superior knowledge of all aspects relating to speed. Basic parameters include:
If you can answer these precisely then you have an advantage as it relates to the predictability of trade execution and outcome. But real competitive insight comes from much deeper analytics relating to speed and operations of the IT systems. Examples of these analytics cover more complex questions like:
The emergent field of latency analytics and broader IT operational analytics (ITOA) provide algo traders with these answers in real-time. We see latency as an essential real-time analytic that should be used to weight the trade execution decision. Latency is an analytic, which qualifies the level of risk that you might not get the price advertised. If viewed this way, it acknowledges the reality of IT systems, i.e. it is impossible to provide a perfectly consistent level of latency. Latency will always vary, just like the weather. As traffic levels change, so will latency. Trading strategies need to be able to cope with this reality. If traders were able to receive a latency analytics feed showing the real-time state of the IT systems then the algorithm would be able to take account of the latency variation in the IT systems to achieve better trading performance. This reality is not too far away as people realise that knowledge of speed is now more important than speed itself.