Introduction

Most centralized exchanges follow a first-in-first-out (FIFO) rule when matching orders, and as a result, traders have a lot to gain by making their orders arrive a few microseconds earlier. This wasteful speed competition is called latency arbitrage, and very often leads to a winner-takes-all competition in which the fastest player makes all the arbitrage profits. Billions of dollars are spent every year in a technological arms race that includes submarine cables, microwave towers, and hollow-core fibers.

Such profits come at the expense of liquidity providers, who suffer increasing adverse selection. They will increase their spreads unless they are subsidized by exchanges. Because higher "taker fees" are needed to pay for these subsidies, the final exchange users pay the bill with increased transaction costs either way.

Essentially, users who are not optimizing for speed end up paying for a wasteful arms race between high frequency traders. That’s bad! This creates deadweight loss as many otherwise profitable strategies are no longer viable. Deadweight loss can be significant.

Let us first understand how liquidity is often provided on exchanges, in order to understand how matching rules at FIFO exchanges hurt liquidity for all and generate billions of dollars in latency arbitrage every year.

Then we’ll see how traditional regulated exchanges, centralized crypto exchanges and existing decentralized exchanges (DEXes) all fall short in very important ways.