Toxic Arbitrage

Abstract

Short-lived arbitrage opportunities arise when prices adjust with a lag to new information. They are toxic because they expose dealers to the risk of trading at stale quotes. Hence, theory implies that more frequent toxic arbitrage opportunities and faster responses to these opportunities should impair liquidity. We provide supporting evidence using data on triangular arbitrage. As predicted, illiquidity is higher on days when the fraction of toxic arbitrage opportunities and arbitrageurs’ relative speed are higher. Overall, our findings suggest that the price efficiency gain of high-frequency arbitrage comes at the cost of increased adverse selection risk. Received March 25, 2015; editorial decision September 21, 2016 by Editor Andrew Karolyi.