DP9925 Toxic Arbitrage

Author(s): Thierry Foucault, Roman Kozhan, Wing Wah Tham
Publication Date: April 2014
Keyword(s): Adverse Selection, Arbitrage, High Frequency Trading, Liquidity
JEL(s): D50, F31, G10
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9925

High frequency arbitrage opportunities sometimes arise when the price of one asset follows, with a lag, changes in the value of another related asset due to information arrival. These opportunities are toxic because they expose liquidity suppliers to the risk of being picked off by arbitrageurs. Hence, more frequent toxic arbitrage opportunities and a faster arbitrageurs' response to these opportunities impair liquidity. We find support for these predictions using high frequency triangular arbitrage opportunities in the FX market. In our sample, a 1% increase in the likelihood that a toxic arbitrage terminates with an arbitrageur's trade (rather than a quote update) raises bid-ask spreads by about 4%.