Toxic Arbitrage

High frequency arbitrage opportunities 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. The authors find support for these predictions using high frequency triangular arbitrage opportunities in the FX market. In their 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%.