Tradebot founder Dave Cummings had more tricks up his sleeve. Around 2004, he began to develop a strategy to make money trading in dark pools, a rising force in the early 2000s. While institutional traders were running from the lit markets, such as Nasdaq (NDAQ), into dark pools, in order to get away from the new breed of high-speed traders, like Tradebot, the speed traders devised methods to swim in the dark as well. Known as “latency arbitrage,” the strategy involved gaming the difference between the price of stock in a dark pool and its price in the lit markets, such as Nasdaq and the NYSE (NYX). Tradebot was effectively exploiting the “latency” of the system, a measurement of the time it takes for information to move from place to place in a closed system, such as a market.
Behind the difference: Dark pools that priced stocks based on an electronic feed called the Securities Information Processor, or SIP. If the price of Intel rose to $20.02 from $20 on Nasdaq, many dark pools would get that price through the SIP feed. The trouble with the SIP was that compared to the microsecond speeds of Tradebot’s world, it was punishingly slow. For firms practicing latency arb, that amounted to a gold mine. Trades that occurred on Nasdaq would occur a split second before the information reached the dark pools.