Trading at the Speed of Light

Joe Grundfest
Joe Grundfest, JD ’78, W.A. Franke Professor of law and business (Photo by Jennifer Paschal)

What does Einstein’s Theory of Relativity have to do with securities law? According to Joe Grundfest, JD ’78, potentially quite a lot. In collaboration with two University of California physicists, he’s intent on figuring out how it impacts the timing of information dissemination in today’s era of high-frequency trading (HFT).

“We’re exploring the legal definition of time in light of Einstein’s theory,” says Grundfest, the W. A. Franke Professor of Law and Business at Stanford Law School and a powerful former commissioner at the U.S. Securities and Exchange Commission (SEC). His colleagues in this effort are Gregory Laughlin, professor of physics at the University of California, Santa Cruz, and Anthony Aguirre, associate professor of physics at the University of California, Santa Cruz. Together, they have already published a paper, “Information Transmission Between Financial Markets in Chicago and New York,” and are currently engaged in research they hope will throw additional light on this uncharted legal territory. 

“Historically, the Theory of Relativity has been entirely irrelevant to the law and for good reason: Information and markets have moved slowly enough so that factors related to the speed of light are irrelevant to the ability to make a profit,” says Grundfest. But with the advent of HFT, “considerations related to the ability to communicate at the speed of light are relevant,” he says. “Suddenly, milliseconds matter.”

High-frequency trading is a relatively new phenomenon, but one with important implications for markets. As a computerized way of trading large numbers of orders at extremely fast speeds, HFT uses complex algorithms to help traders analyze markets and execute orders much faster than was previously possible. Today, between 50 percent and 80 percent of trades on global exchanges are executed using HFT. 

Grundfest has a long history of involvement in the laws regarding markets and trading. His most recent brief for the U.S. Supreme Court argued that shareholder fraud class-action suits were invalid unless investors could prove they were directly injured because they relied on corporate misstatements. Case law to date held that when a widely traded corporation misstated facts, it committed “fraud on the market” and individual shareholders were thus relieved of the burden of proof of showing that they were personally affected.

With his new research, Grundfest’s mind turned in an unusual direction for business law—to physics. Light travels at approximately 186,000 miles per second. With communications technologies improving all the time, information is getting close to traveling at the speed of light. That, coupled with the fact that much critical market-impacting information is released in Washington, D.C., by government agencies, means that traders located closer to Washington have an advantage. 

A case in point: New York is 204 miles from Washington, D.C., which means that if the technology isn’t a barrier to transmission speed, it takes a little more than a millisecond for information to travel from Washington to New York (1.095 milliseconds to be exact). Chicago, on the other hand, is 595 miles from Washington, D.C. That represents 3.194 milliseconds at the speed of light. “If you measure in milliseconds rather than miles, then New York is 2.099 milliseconds closer to Washington than Chicago,” says Grundfest. “Previously, that wouldn’t have mattered, but 2.099 milliseconds can be forever in high-frequency trading, giving traders in New York a distinct advantage.”

Legally, this raises an interesting ambiguity. If critical information relating to markets is released at noon Washington, D.C., time—which is typically how lawyers define time—traders located at the Chicago Mercantile Exchange get the information later and are disadvantaged by the delay.

Grundfest and his physicist collaborators, Laughlin and Aguirre, have come up with three different ways that time could be legally defined. 

The first is the traditional way—“transmission time.” The information is released from a single point in Washington at noon and the news, traveling by fiber optic or microwave technology, effectively reaches New York before Chicago.

The second way is to measure time based on “universal time.” Under that definition, the information would be pre-positioned on computers located in Chicago and New York and when it is noon in Washington, the news is simultaneously released in Washington, New York, and Chicago. Because there is no distance to travel, all traders receive the information at the same time. “In effect, you have the simultaneous receipt of information,” says Grundfest. 

The final way to think about time would be to take Einstein’s Theory of Relativity at face value and assume that information travels at the speed of light. A way to ensure parity among traders would be to calculate releases at different times from a single point so that everyone receives it at the same time. Thus information bound from Washington to Chicago would be released earlier than that same information bound for New York. 

“In the vast majority of situations, people shouldn’t care if the definition of time is No. 1, No. 2, or No. 3,” says Grundfest. “But in a small, important, and increasingly common group of cases involving high-frequency trading, lawyers and traders need to think about Einstein’s Theory of Relativity.”

This actually has already proved to be a point of contention. In 2013, it was suspected—although never proved—that critical Federal Reserve information, embargoed for release at noon on a particular day, was released in Chicago at the same time it was released in Washington, D.C. “Now, it wasn’t before noon Washington time, so it could be argued that technically it didn’t violate the embargo,” says Grundfest. “But nevertheless it put traders in New York at a disadvantage.” 

Other cases like this will undoubtedly emerge as stakes continue to rise due to HFT. “The government needs to be clear about what the rules are, so it can be clear when information can be disclosed. In the world of high-frequency trading, people need to be utterly transparent,” says Grundfest. 

Grundfest, who says that HFT is an “extraordinarily interesting area,” has been following the subject for several years. He is also the founder of the award-winning Stanford Securities Class Action Clearinghouse, which provides detailed online information about the prosecution, defense, and settlement of federal class-action securities fraud litigation. He also co-directs Directors’ College, the nation’s leading venue for the continuing professional education of directors of publicly traded corporations, and he is a senior faculty member with the Arthur and Toni Rembe Rock Center for Corporate Governance. 

“As high-frequency trading becomes more prevalent—especially when HFT traders begin to depend on semantic search techniques—we’ll become even more sensitive to the fact that milliseconds faster or slower can make a difference in whether you profit or not from a trade,” says Grundfest. 

Next steps for Grundfest and his associates—to publish the paper and see if regulators or the business community picks up on the ideas in it. “That’s our standard practice in academia: Get the idea out there and see if anyone salutes,” says Grundfest.  SL