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Trading at the Speed of Light

Posted by Josh Rothman  August 24, 2011 03:23 PM

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You may have heard of "high-frequency trading" -- it's a new way for financial firms to make money by trading securities ultra-fast. Instead of holding securities for the long term, as ordinary investors do, high-frequency traders program computers to buy and sell them rapidly, sometimes several times a second, generating small, steadily accruing profits. Today's computers and networks are so fast, in fact, that automated algorithms now exploit advantages measured in microseconds. Firms must locate their servers strategically, with the goal of reducing "trade latency" -- the delay introduced, inevitably, as electronic signals wend their way through the circuits.

Two young, absurdly talented computer scientists, Alexander Wissner-Gross and Cameron Freer, have taken this networked arms race to its logical extreme. Writing in the Physical Review, they aim to find out what financial markets will look like once trades are executed millions of times per second and at the speed of light. In their paper, "Relatavistic Statistical Arbitrage," they offer a glimpse of a possible financial future. In addition to the familiar trading floors we all see on TV, they think we'll find trading stations spread around the globe, precisely placed to take advantage of "light propagation delays" between financial centers.

Semaphore was also limited by the speed of light.

How does "trading at the speed of light" work? Imagine two stocks whose prices are tightly correlated: Whenever A goes up, B goes up, too. It just so happens that A is traded in Tokyo, while B is traded in New York. To make money, all you have to do is notice when A has gone up, and then buy B -- but you have to do it before everyone at the New York exchange does the same thing. You must, in short, get the information from Tokyo as fast as possible, and then put in an order in New York immediately.

For years, traders have continuously optimized these kinds of "arbitrage" trades, in part by building high-tech data networks which transmit pricing information as quickly as possible. Now that most networks are fiber-optic, though, network speed is meeting an immovable barrier: the speed of light. In years to come, the only way to gain an advantage over your competitors will be to place your order from the best possible location -- an " intermediate node" which, in this case, lies exactly between New York and Tokyo. A specialized trading facility, in short, will have to be built for each arbitrage trade.

Freer and Wissner-Gross have calculated the optimum locations for these nodes for a number of securities exchanges. Some of them are clustered around today's big trading floors. But many are scattered all over the world, from the North Pole to the middle of the Pacific. The future of finance, or at least of high-frequency arbitrage, will be decentralized -- reversing a long-standing trend. "Historically," they point out, "technologies for transportation and communication have resulted in the consolidation of financial markets":

For example, in the nineteenth century, more than 200 stock exchanges were formed in the United States, but most were eliminated as the telegraph spread. The growth of electronic markets has led to further consolidation in recent years. Although there are advantages to centralization for many types of transactions, we have described a type of arbitrage that is just beginning to become relevant, and for which the trend is, surprisingly, in the direction of decentralization. In fact, our calculations suggest that this type of arbitrage may already be technologically feasible for the most distant pairs of exchanges, and may soon be feasible at the fastest relevant time scales for closer pairs.

This reality is already arriving: Firms are already building specialized infrastructure set aside especially for high-frequency trades. (One firm is building an 825-mile fiber-optic cable between New York and Chicago in order to provide three millisecond advantage). Even if the nightly news shows someone ringing the bell at the NYSE, nearly 70% of the trades on that exchange are super-fast, high-frequency trades executed by computers. Soon enough, Freer and Wissner-Gross argue, the NYSE will be enmeshed in a network of "relativistic statistical arbitrage trading nodes [spread] across the Earth’s surface."

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About brainiac Brainiac is the daily blog of the Globe's Sunday Ideas section, covering news and delights from the worlds of art, science, literature, history, design, and more. You can follow us on Twitter @GlobeIdeas.
Brainiac blogger Kevin Hartnett is a writer in Columbia, South Carolina. He can be reached here.

Leon Neyfakh is the staff writer for Ideas. Amanda Katz is the deputy Ideas editor. Stephen Heuser is the Ideas editor.

Guest blogger Simon Waxman is Managing Editor of Boston Review and has written for WBUR, Alternet, McSweeney's, Jacobin, and others.

Guest blogger Elizabeth Manus is a writer living in New York City. She has been a book review editor at the Boston Phoenix, and a columnist for The New York Observer and Metro.

Guest blogger Sarah Laskow is a freelance writer and editor in New York City. She edits Smithsonian's SmartNews blog and has contributed to Salon, Good, The American Prospect, Bloomberg News, and other publications.

Guest blogger Joshua Glenn is a Boston-based writer, publisher, and freelance semiotician. He was the original Brainiac blogger, and is currently editor of the blog HiLobrow, publisher of a series of Radium Age science fiction novels, and co-author/co-editor of several books, including the story collection "Significant Objects" and the kids' field guide to life "Unbored."

Guest blogger Ruth Graham is a freelance journalist in New Hampshire, and a frequent Ideas contributor. She is a former features editor for the New York Sun, and has written for publications including Slate and the Wall Street Journal.

Joshua Rothman is a graduate student and Teaching Fellow in the Harvard English department, and an Instructor in Public Policy at the Harvard Kennedy School of Government. He teaches novels and political writing.


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