Modern physics teaches that objects behave differently as they reach the speed of light. This has become relevant for financial market execution. While prices pretend to be global, in reality they depend on location. Liquidity at any given price is uncertain. And physical location becomes critical for the success of certain trading styles. Moreover, quantum physics suggest that ‘freak events’ that destabilize the markets are likely to occur.
“When Finance Meets Physics: The Impact of the Speed of Light on Financial Markets and their Regulation”, James J. Angel, The Financial Review, Forthcoming, May 2014 · Volume 49 · No. 2
The below are excerpts from the paper. Cursive line and emphasis has been added.
High frequency trading and the speed of light
“So-called ‘high frequency’ traders are often implementing some very old and fairly low-tech strategies. Examples of high-frequency strategies include arbitrage, market making, and reacting to news. Because these traditional trading strategies are rather simple and easy to duplicate, traders face intense competition in their implementation. They race to snap up profitable trading opportunities before they disappear. An arbitrageur who comes in second in the race for a profitable trade still loses, whether by one minute, one second, or one nanosecond. For this reason, such traders invest heavily to make sure that their trading systems respond as fast as possible to market conditions. Exchanges have sped up their response times and major exchanges now have ‘latencies’ of less than one millisecond (one thousandth of a second). Exchanges and practitioners now routinely time stamp their messages to the millisecond or nanosecond.”
“The famous Michelson and Morley (1887) experiments demonstrated that the speed of light is a constant, regardless of whether the light source is moving towards the observer or away from the observer. This invariance of the speed of light has some important implications, as shown by Einstein (1905) in his famous paper showing the equivalence of mass and energy…Because nothing can move significantly faster than light in a vacuum, the speed of light thus becomes a speed limit on the transmission of information as well.”
“In one millisecond, light travels about 300 km, roughly the distance between Boston and New York. (In real computer networks, the signal travels a little slower because of the delay in going through a solid and because of switching delays in the network.) one microsecond (one millionth of a second), light travels about 300 meters, or just over 3 (American) football fields. In one nanosecond (one billionth of a second), light travels about 30 cm, or about a foot. In a very close race between two computerized traders, that nanosecond just might make the difference between catching a profitable trade and missing it.”
What changes for trading at the speed of light?
“Matter and time behave differently as speed approaches the velocity of light. We can use the insights of physics to see what pitfalls may occur in the understanding and regulation of high-speed markets…
- The United States’ “trade through” rule of Regulation NMS requires exchanges to not “trade through” the quotes of another exchange…If two exchanges are geographically separated, the information that one exchange has a better price may not have reached the other exchange before it executes a trade…Syncing to a standard time source such as an atomic clock sounds simple in theory, but there are limits to the practical accuracy of what can be implemented.
- A market participant does not really know if a published ‘firm’ quote is actually alive (can be traded upon) or dead without actually submitting an order to trade against it. Only once they submit an order will they find out whether their order is filled or whether someone else beat them to it or the quote was cancelled before their order arrived.
- This proximity to the exchange matching engines allows them to receive market data faster and to submit orders faster than other participants located farther away…For centuries brokerage firms have located offices as close as possible to the exchange so that they could get their orders into the exchange faster. The only difference is that the orders are now submitted via electrons and not runners.”
“One of the primary ‘places’ where the limitation due to the speed of light can be seen is in the information transmission between the futures market in Chicago and the equity markets in the New York/New Jersey area. These locations are about 730 miles apart and even in a vacuum it would take light (and therefore information) just under 4 milliseconds to go from one market to the other…Laughlin, Aguirre, and Grundfest (2014) show the proliferation of microwave networks and their effects on reducing the transmission time between these markets to close to the theoretical speed of light limit of 3.93 milliseconds. They also show that changes in the limit order book quotes at the CME in Chicago result in trades on the equity markets in New Jersey near the theoretical limits of the speed of light and these microwave arrays.”
Quantum tunneling and freak events
“One of the lessons of quantum physics is that occasionally extreme events can and do occur. Particles can ‘quantum tunnel’ through a solid barrier even when they do not have enough energy to get through it by classical calculations. There is a nonzero probability that a particle such as an electron or even a basketball can get through a solid barrier no matter how high or solid the barrier. Quantum physics therefore suggests that “freak events” will occur.”
“In our highly complex and nonlinear market network, ‘freak events’ will also occur. For example, freak events can be triggered from programming glitches in which seemingly innocuous minor changes lead to a major catastrophe, which has already happened: on August 1, 2012, Knight Capital Group (2012) nearly failed following a $440 million software glitch. Such catastrophic freak failures would have been caught earlier when every order passed through human hands.”
“Under the right combination of events, the complex market network of interconnected exchanges and off-exchange participants can become unstable, as demonstrated by the US experience of the ‘Flash Crash’ on May 6, 2010. On a day of heavy trading volume and generally falling prices, a large investment firm placed a large sell order on futures contracts tied to the S&P 500 and the price of the contract plummeted. There were reports of data problems at several firms. Several high frequency trading firms withdrew from trading, citing ‘data integrity’ problems.”