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A High Frequency Trader's Apologia, Part 1 (chrisstucchio.com)
375 points by yummyfajitas on Apr 17, 2012 | hide | past | favorite | 317 comments



Huh, I'm glad this was posted!

1) Didn't realize when I read this it was by yummyfajitas, whose comments I always respect.

2) Do I understand correctly that the order book is public (albeit anonymized)? That surprised me -- it seems like this would lead to meta-games and jockeying for position and such, as opposed to different parties just submitting into a black box what some security is worth to them.

3) Are there any good papers/articles modeling different market set-ups? For instance my black box one above. Or one where orders are matched randomly rather than chronologically. Or one where trades happen in one batch once per day. I can't say I'm opposed to HFT, it just seems to sap a very large amount of engineering brainpower for not that much societal marginal benefit anymore. If I could snap my fingers and give up a bit of the liquidity and get all those engineers back I probably would.

4) I once worked in a sell-side equity research shop which traded stocks the old fashioned way (based on fundamentals) and had a non high-frequency trading desk, etc. That type of company is getting hurt by the lower spreads offered by HFT. But I never did quite comprehend why it made sense to pay for our product (research) with trading commissions. Seemed to cross two unrelated services, although that kind of business model seemed deeply entrenched in the market.


Do I understand correctly that the order book is public (albeit anonymized)?

Yes.

...submitting into a black box what some security is worth to them.

These are Dark Pools. https://en.wikipedia.org/wiki/Dark_liquidity

Are there any good papers/articles modeling different market set-ups?

These are often called Crossing Networks. https://en.wikipedia.org/wiki/Crossing_network


Wow, that's exactly what I was asking about. Thanks for the interesting links.


there are several books including a "public book" that all exchanges publish and an "internal book" that each exchange has.

in case of the "internal book", it is always ahead of the "public book", as changes to it "published" after events occur internally and this "internal book" is updated.

this is important bit, as an individual exchange "knows better/earlier" than the "public".


Regarding 2: You're correct, the main order book is public and usually anonymous. There are also non-public books called dark pools where you cannot see what other people are bidding. You are also correct in supposing that a lot of meta-games go on, but dark pools don't remove this entirely; they just change the rules. For instance you could, if it is allowed, submit a tiny orders in increasing price until it gets filled; then you know something about the price in the pool.


> For instance you could, if it is allowed, submit a tiny orders in increasing price until it gets filled.

Ha, that's clever. I suppose any system that people come up with will always have ways to game it. Reminds me of Arrow's Impossibility Theorem[1] which basically proved that there's no possible perfect voting system. Ah well.

[1] https://en.wikipedia.org/wiki/Arrow%27s_impossibility_theore...


The way the system is set up makes it a tax on global efficiency. All of these resources (crazy smart people, money, equipment) are needlessly wasted on getting lower latency when really it adds no systematic value.

Instead, just as the system disallows fractional penny bids, it could discretize order times to the nearest e.g. 5 seconds. Boom. Suddenly you have more MIT/etc grads solving better problems for the world.


Some exchanges already do that. But the issue is also liquidity not latency. When you disallow fractional penny bids and match trades at set time-interval, this causes market-makers to widen their bid/ask spread because of the inventory risk. Ideally, as a dealer you'd like to buy low and sell high and move the merchandise on your lot before the prevailing market condition moves against you.

The spread even at highly liquid stocks used to be 0.10+/cents before the introduction of penny pricing and HFT; this saves money for retail investors.

Also, introduction of set-time matching also means that algo's will just be tweaked to new market conditions. New arbitrage algo's will be introduced to exploit how some exchanges will be slower to react to price-actions. Predatory algo's will exploit how some institutional VWAP orders cannot be canceled quickly against volatile conditions. It's anti-virus vs. the virus writers. Oh not to mention the exchanges are in on this game, more trades mean more revenue for them. Exchanges make money by volume of trades, not by P&L of their customers; and like affiliate marketers, they actually offer liquidity rebates to any traders that offer trades that get taken at market price to boost their volume.


The spread even at highly liquid stocks used to be 0.10+/cents before the introduction of penny pricing and HFT; this saves money for retail investors.

----

It saves money for retail traders (i.e. fools). It has negligible effects on investors in well diversified passively managed funds.


For institutional investors, this is a very complicated question. There's always been ways that they are front-runed by more nimble traders.

Currently, the state-of-art for institutional investors are to use buy-side algorithmic tools to slice and dice their orders into 100 lots and obfuscate their huge lot order (> 100,000 shares). Algo's include iceberg which continuously monitors the quotebook throughout the day and execute a portion of customer's orders when the market turns in favor of direction of the order and with an order size not to disrupt the current momentum of the stock's price action; also special darkpools are used at mutual funds such as Liquidnet where no official quotebook are maintained, instead it's more of an instant messenger tool that is limited to only mutual fund managers who chit-chat and close large block deals. Any participants who are suspected of front-running are banned.

As for your original concern, yes spread of a few cents per share is very important for institutional investors when you have to execute a order for 100,000+ shares; and there's actually a whole technology vendor space in finance called transaction cost analysis that fund managers look at to see what the hidden cost of their trades are. As whether HFT actually help institutional investors, it's analogous to saying whether defense contractors help the federal government; some say it's symbiotic relationship, some say it's a parasitic relationship for all and symbiotic for some. Meaning most relationships on Wall Street like on Capital Hill, revolves around wine & dine & shifting allegiances. Quite a few HFT firms have tried to open a new line of revenue by opening up their high-speed infrastructure to institutions to execute their iceberg orders. Yet some of the HFT algorithms' intentions are to sniff out iceberg orders and front-run them.


How do you not love the idea that large institutional investors exploit covert channels to place orders?

As crazy as this sounds, this isn't an HFT thing or a modern markets thing: execution of large block trades is one of the fundamental basic problems in trading. It's just that now we're solving it with a system of dueling robots.


[deleted]


I'm not sure what you're arguing for exactly, but nothing you're saying weighs against the parent statement without some serious broken window fallacy.


Unfortunately, I can't figure out how to make the point any clearer, so I've removed it. My apologies.


Whenever HFT comes up on HN, someone asks why we don't just remove the incentive for low latencies by matching orders less frequently. It's a fair question, but I think there are good reasons not to do this.

Let's say we discretize the exchange to, say, 1 Hz, so all the orders are queued up and then executed simultaneously at the next clock tick. Now, on a given tick, there will almost always be a mismatch between the number of buy orders and the number of sell orders, so some orders will go unfilled. How do we choose which ones? (For this discussion I am ignoring price. Obviously we will fill more aggressively-priced orders first; the question is how to prioritize orders of equal price.)

We could give priority to the ones that arrived first, but of course then we're back to traders racing each other. The only other scheme I can think of [1] is to fill every order in proportion to its size. So if Alice wants to sell 200 shares, Bob wants to buy 100 shares, and Charlie wants to buy 300 shares, we give 50 shares to Bob and 150 shares to Charlie.

Well, this scheme has its own problems -- arguably worse ones than the current system! If Bob really wants to buy 100 shares, and expects to be competing with Charlie, he has an incentive to place a much bigger order: in this case, if he knew Charlie's bid size, he would also ask for 300 shares, expecting to get 100. Of course, Charlie will be playing the same game and inflating his own bid size. The equilibrium is that everyone asks for way more size than they actually want.

There are two things wrong here:

1. Traders are spending mental energy trying second-guess each other's order size; those who don't are crowded out of the most competitive (and, typically, profitable) trades.

2. Since traders can't guess correctly every time, they will sometimes end up buying or selling much more than they want, which means they have to turn around and do the opposite trade, paying the spread in the process. If this happens during during a large price movement, these traders can lose even more money, and in their haste to reverse their trades, they will drive the market even further in the same direction.

And by the way, this is not just speculation. While I'm not familiar with any exchanges that discretize their clocks this way, there is a product with a similar system: the CME Eurodollar contract [2]. In this contract, unlike the other futures products traded on the CME, resting orders do not execute on a first-come-first-served basis; instead they are allocated "pro rata", or in proportion to their size, much as I described above. Based on my conversations with several people who trade them (including HFTers), the results are also as I described: traders routinely over-order and suffer the consequences.

Hopefully this sheds some light on why this seemingly obvious solution is not widely implemented.

[1] Of course I can think of many other schemes, but they either have obvious problems or basically reduce to this one.

[2] There are other products matched this way, but I'm not as familiar with them.


Why not use a random order for order fulfillment at each tick? No skewed incentives with that rule.

If that creates too many concerns over security of the RNG, then use deterministic rotating ranks. Traders may be able to predict who they will be able to beat out on the next tick, but the high ranks rotate throughout the herd, so everybody gets a fair shot at beating out others at the same price.


Hmm. So let's say we assign every trader a unique ID and randomly (or not) prioritize the IDs every tick. (I'm assuming you're shuffling the IDs and not the individual orders; otherwise, as jsnell points out, it averages out to the pro rata case.) The main problem I can see is that if someone can get their hands on multiple IDs, they can duplicate their orders across all their IDs and we're back to the pro rata system.

Even if you make sure to assign just one ID per trading firm, firms could coordinate to share their IDs. For example, if you're not using your ID this tick, you might place an order on my behalf for a small fee. And I'll also have sent some of my orders through an independent broker to take advantage of their ID. (Of course, if that broker places many such orders, and only some of those fill, they'll need some policy for which of their customers get the trades... maybe they could use time priority?)

It's conceivable (if unlikely) that the SEC could enact and enforce a ban on such collusion. Even then I think there would be other perverse incentives, but I'll need to think more about it.


A random ordering will create an incentive to split orders into smaller pieces. Which at the limit is going to devolve to the the proportional fulfillment case once everyone submits only orders of the minimum size.


Weight the orders by size.


That's exactly what pro rata does.


I was gonna post a comment saying what they meant was obvious, but then I just went "ohhhh." * That's actually quite an annoying little problem there.

One work-around might be to add rules to the exchange forbidding the placing of multiple bids by the same entity at the same price, and then allocating randomly.

This is also reminding me of the Talmud's descriptions of how to pay off debtors when there isn't enough money to go around: http://mindyourdecisions.com/blog/2008/06/10/how-game-theory... Such a system could work for exchanges too, although it still encourages over-bidding.

Surely also over-bidding has its own risk/reward curve so it would be reasonable to allocate pro-rata and let people work out how much to over-allocate.

* And realised what the implications were.


What you see as "an annoying little problem", I see as a sign that the system is consistent and robust. It's a good thing that the system doesn't distinguish between a hundred one-share orders and a single hundred-share order; such a distinction would be totally arbitrary. (By contrast, ranking orders by time is not arbitrary. All else being equal, it's better for things to get resolved faster; the only question is whether we're giving too much of a reward for too little of an improvement.)

Elsewhere in this thread (http://news.ycombinator.com/item?id=3856015) I argue against treating orders differently based on the "entity" that placed them.

In general, we want traders to spend their time thinking about asset prices and risk, not market structure and game theory. The price-time priority system is a very simple one that rewards traders for deciding what they want and then announcing it right away. All the modifications that have been proposed in this thread encourage traders to play games, second-guess one another, or otherwise work around the system.

There are definitely tradeoffs, but personally I think it's better to use the cleaner system and accept the latency arms race than to add a layer of artificial incentives -- and for what it's worth, it appears that nearly every major electronic market has come to the same conclusion.

Finally, thanks for the link to the Talmud article: it was a very cool application of game theory to history. (Of course, I don't see any indication in the article that the Talmudic system would be an improvement over pro rata.)


Just referring back to this from the comments on the second part, and just wanted to mention I meant "annoying little problem" in the sense that it seems a shame there can't be other solutions, like how Arrow's Impossibility Theorem prevents achieving a perfect voting system (http://en.wikipedia.org/wiki/Arrow%27s_impossibility_theorem). I definitely see what you mean about this being the most optimal solution from the point of view of actual pricing and risk. The downside though is there is profit to be made in slicing time every quicker which can't be prevented without breaking something else, but the money spent on this time-slicing is broadly wasted because it is just an arms race.

So I don't think the current solution is necessarily wrong; just annoying we can't get all the benefits and also avoid the arms race.

No problem, I very much like the Talmud article and how simple the explanation works out to being.


Yeah, that and SEC Rule 612 (no subpenny prices, as the article mentions) both make bucketing sensible. Have a (1s,$0.01) granularity and HFT pretty much goes away, the National Best Bid/Offer makes sense again, and flash crashes only happen once a decade. If regulators actually cared about about market stability, they'd be pushing for something like that...

The London Metals Exchange - being an outlier as always - has gone for a different approach: they throttle traffic to 40 actions/client/second and smooth it out over as many seconds as necessary - so a 10,000 quote burst will be smeared over 4 minutes... good luck trying to manipulate the market with that, HFT boys.


How about the following variant?

Every market has a book, and a price. If a sell comes in at under the price, and there are unfulfilled buy orders anywhere above the price, the sell executes at that price for the order that has been above that price the longest. Conversely if a buy comes in above the price and there are unfulfilled sell orders below that price, the trade executes at that price for the sell order that has been below that price.

The price itself drifts upwards or downwards at a set rate depending on whether there are currently an excess of buy or sell orders that would execute at the current price.

What downside do you see in such a scheme?


the scheme you're describing is no different than the continuous case. whoever came in first gets filled first. it doesn't matter if matching happens at a set interval, getting into the book first still matters, and HFT continuous as usual


You can do it based on time. Yes it there will still be some incentive to be faster, but the incentive will not be that great. And you can remove all incentive to be faster by simply increasing your buy price by a penny. This means that all the incentive for speed is less than one penny per stock.

This would result in much smaller incentive for speed and less money and energy spent on being faster, and more fair markets, etc.


Why do you think there will be less incentive for speed in the discretized case? The reward for being first in line will be exactly the same.

And traders already have the option of advancing their price by a penny. The issue is that they are competing over hundredths of a penny.


Tokyo Stock Exchange uses the "itayose" method for its opening auction:

http://www.tse.or.jp/english/faq/list/stockprice/p_b.html

But yeah, it wouldn't be a good method for an every-N-seconds auction.


Why wouldn't it?


Sorry, I meant to say "the every-N-seconds auction is not a good idea, even with the itayose method". The reasons are basically the ones traversal mentioned above.


A very well-reasoned comment. I wonder if anyone has done simulations of the various scenarios.


no.

that would only work if every traded product on the planet was in a single matching engine.


If Adam Smith says so. Totally agreed.


A few notes:

(a) Orders for stocks priced below $1.00 are permitted to display in sub-penny increments. Not that this is really relevant to HFT, but it is often a point of confusion.

(b) Orders may rest on the book and display at a price but execute at a separate price. For example, if a market is 20.01 / 20.02 and I believe true value is 20.017 I can bid 20.01 but tell the matching engine that I'm willing to accept 20.015. That you are willing to trade at the midpoint also places you at a higher priority in the queue, above those only willing to buy at 20.01.


Regarding b), I believe it's the MPL order you are referring to.

http://usequities.nyx.com/markets/nyse-arca-equities/order-t...

Some dark pools also allow trades at subpenny increments, although of course (being a darkpool) the orders are not displayed.


Transactions that occur in dark pools (over half the liquidity on NYSE listed stocks these days) typically get posted to the exchange after the fact. This used to cause anonymous hedge fund I used to work for all kinds of problems in the leas liquid markets as half the daily volume would suddenly post dive minutes


This seems inaccurate. Dark pools make up 15% of market volume.


Midpoint orders exist on all the venues. All but EDGA/EDGX provide some rebate for resting a midpoint order. DirectEdge charges both sides for what they refer to as "midpoint match".


So basically you don't know the actual midpoint where the market is trading.

Doesn't that mean people can get an advantage by guessing where that point is and bidding just below it? (Not too far below, because then you're wasting money.) And if so, do they use strategies to try to determine where the midpoint is? (e.g. offer a very small number of shares at many different points, see which ones execute)


There is no need to guess the midpoint. The midpoint is simply: (best_bid + best_ask) / 2.


What the linked article doesn't discuss is that it is possible to get a real-time notification when a trade occurs. The price of the last trade is the mid-point that you are referring to. Algo trading/HFT shops are listening for trades as well as quotes - this is how they know the price that trades are actually happening at.


So what you're saying is that the subpenny price that the trades are actually executing at is publicly available?


Yes. Every trade is publicly available. The price, venue, size, etc.


Yep. Here's an example:

http://www.google.com/finance?q=ABIO

When I checked this page, the last displayed trade was $0.737.


But isn't this just the aggregate? How is every trade visible? Why, if its all free and public, do you have to pay so much for live data feeds?


All trades are made publicly avaiable eventually. The lower latency you want the more you have to pay. And some trades aren't avaiable at low latency for any price.


the midpoint doesn't matter at all. There is no "price" only a price available for a certain volume.


Note (b) is surprising and I'm not sure I understand. Can you add more details to your example?

If someone sells at 20.01, and I'm higher in the queue because I told the matching engine that I'm willing to accept 20.015, why would I ever not bid 20.0199...? Can someone sell at 20.02 but tell the matching engine they're willing to accept 20.015? Do we match? What does it execute at?


They are only accepted at the midpoint.

EDIT:

It's just a feature of the matching engine. It's not really that complicated. The venue, let's say BZX, accepts an order from you to display a BID for 100 at 20.01 and you flag the order and tell the matching engine you'll accept 20.015.

When someone comes along and wants to sell, let's say Grandma Sue, she might say: Sell 100 at MARKET. The displayed market is 20.01 / .02. With your bid in the market Grandma will get matched at 20.015, a .005 price improvement over the displayed bid of 20.01. This is a good thing.


It looks like MPL orders are undisplayed. Then how can they "display at a price but execute at a separate price"? Or, what does it mean when I read "The MPL order is an undisplayed limit order that is priced at the midpoint of the Protected Best Bid and Offer (PBBO)" if it doesn't actually mean undisplayed.

edit: ah the above edit helps. thanks.


There is confusing terminology amongst venues. The key points are: you can execute at the midpoint or at any discretionary offset from the primary or market.


It sounds like they display at a lower accuracy than what you may actually specify, and there's a bit of jiggering to allow the displayed request and true request to both be 'accurate'.


To add to (b) Midpoint orders have to be hidden though because lit markets cannot allow displayable sub-penny orders.


That's correct. They display at a whole penny price but execute at the midpoint. They may also execute at an offset for the market or primary.


What I don't understand about HFT is why its efficiency does not seem to be limited by transaction fees. I've tried a bit in the past to play with some algorithms that buy and sell (on paper) and it seems like the faster you go, the more you need the market to move in order to scrape a few pennies of profit, because the movement has to be sufficient to cover the spread, the transaction fees, _and_ provide some profit. Of course with a simple example like "buy at $20, sell at $20.10", it seems simple enough to extract some profit, but in fact it would need to be enough profit that it covers the transaction fees, which seem to be a kind "friction" that limits the smallest change in price that is useful. From what I can tell this kind of movement just doesn't generally occur in the sub-millisecond time frame, so how does it work? Or is it just that they are trading so much $$ in one shot that a very tiny change in price covers the transaction fee without issue? (Meaning they are taking very large risks..)


They don't pay "transaction fees" in the way you think about them. The way it generally works is you pay when you "remove liquidity" from the book and you get paid when you "add liquidity" to the book.

What does that mean? Suppose the bid/ask is 20.00/20.10 as in the example given. The order book will show a bunch of people willing to pay 20.00, 19.99, 19.98, etc, and a bunch of people willing to sell for 20.10, 20.11, 20.12, and so on. All of those people have added "liquidity" to the book by making orders which have not yet been placed. The idea is that a huge buyer could come in and try to buy 1 million shares at 20.25, and that order could get immediately executed because of the backlog of non-executed orders.

If you bid 20.10 (i.e. offer to buy the stock at 20.10) the seller at the top of the book will have his order executed (with you) and you will have removed a tiny bit of liquidity from the book. On the other hand, if you bid 19.95, your order just gets added to the system, and you have added a bit of liquidity.

The exchanges will charge you slightly more for removing liquidity (say .05 / share) than they pay you for adding liquidity (say .04 /share) and so make a spread. However, high frequency strategies can be clever about the way they add and remove orders to the book in order to minimize their net transaction costs, and so they end up being rather low.

On the other hand, when a retail investor purchases a stock through Schwab or something, Schwab (or in many cases some other larger bank) is dealing with exchange fees directly, and simply charging their customer a flat commission on top of your trade.


Your numbers are too high. Actual rates are sub-penny or free. Some markets give a rebate for taking, others for posting.


Thank you, I haven't heard that explanation before, it makes a lot of sense. So the normal transaction fee that you or I would pay is an additional fee by the broker, rather than a direct market fee?


The sub-millisecond timeframe is part of a race to be at the top of the book or a race to pull orders. Very few HFT's literally trade a single security repeatedly on a sub-millisecond timeframe.

The general strategy is "our signal changed - move fast, get to the top of the book in milliseconds". Then you wait, and seconds to minutes later someone will fill your order sitting at the top of the book. Then you play the same game on the opposite side to unload your position.

The game of shaving milliseconds is solely about beating other HFT's to the punch, it's not about actual market movements.


Thanks for the article. It seems to me like a missing piece is a discussion of volatility. That is, I get it that HFT drives spreads lower, but spreads are the wrong direction to make money, even in volume. That is, if pre-HFT spread is that the best buy price is $10.00 and best sell price is $10.05, and post-HFT best buy = $10.03 and best sell = $10.04, you still lose a penny on every trade instead of a nickel -- you can't make that up on volume! :-)

It seems to me that volatility is required for any market maker to make money, and that's a fundamental conflict, isn't it? That is, "outside" traders would prefer the market to be smooth, whereas "inside" traders want it to fluctuate.

I can see the argument that, in actuality, HFT on the whole needs less fluctuation to extract enough profit to provide liquidity, so in theory, it would be expected to be a more stable market maker than human operators. Is that basically equivalent to what you're saying in the article? (And is there any data on that hypothesis?)


"Then you play the same game on the opposite side to unload your position."

Don't you have to play the game at both sides of the book simultaneously? Otherwise, you would risk adverse selection.


Great article. I'm curious what your thoughts are on the Sub-Penny Rule.


The transaction fees large players pay are negotiated to nothing. The exchanges want liquidity, especially in the derivatives markets. HFT does provide a ton of that, so they can negotiate away the transaction fees (in exchange to agreeing to maintain some minimum volume.


Yep. Most large market makers enter into obligations with exchanges to make markets in a wide spectrum of funds. Even those which are not that profitable. In exchange, the market maker gets much lower fees.


Minor point, but actual market makers are required by law to make markets. In fact, the market makers basically are the exchange.

This is different from hedge funds which act as market makers by earning rebates by providing liquidity. These guys (and gals) are have no regulatory requirements to make markets.


The two do overlap though - some large hedge funds do become market makers in the legal sense on particular exchanges.


In fact, some traders have a negative fee--huge providers of liquidity are paid to always be there in the market.


Transaction fees for most brokers are pretty high. Even "discount" brokers like Scottrade charge $7 for every stock trade.

There are other brokers that charge $0.01/share traded or less.[1][2] A $0.10 spread becomes easy profit if the buy/sell only costs $0.02.

The linked broker below requires you to be an "expert" before you can sign up -- you have to have made at least 100 trades -- but otherwise just about anyone can sign up.

I have NOT tried to use them for day trading (or at all, for that matter), so please don't consider this a full recommendation. Just trying to show that there ARE other options that are cheaper.

[1] http://interactivebrokers.com/en/general/education/comparebr... [2] http://interactivebrokers.com/en/accounts/fees/stocksPricing...


Yes, their trades are for much bigger amounts, and they also don't pay the hefty brokerage fees that casual investors like us pay. One example, http://en.wikipedia.org/wiki/Direct_access_brokers which cost around $0.004 per share. And maybe HFTers don't even pay that much.


I've also looked at this before, and with transaction fees of 3% of the total traded, I can't see how they make money. Unless they have a deal with brokers for lower transaction fees or something.


The OP provides a good technical explanation. Unfortunately he fails to mention another closely related term to high frequency which is what makes this type of trading highly lucrative: 'Front running'. See http://en.wikipedia.org/wiki/Front_running .

Front running is illegal, but if you look for successful cases of high frequency trading they are generally tied-to/accused-of front running. And as you might imagine, in order to do front running you need to be high-up on the food chain (i.e. be a market maker)

The missing key about front running in the article is the 'anonymous' bid-ask: "The matching engine takes his order and displays it (anonymized) to all other traders with a data feed." and "She places her orders, and it is again displayed to the world (anonymously) and stored.".

If you have forehand knowledge of the bid-ask (i.e. non-anonymous) the market maker can front-run and with high-frequency make a considerable profit.


Frontrunners have knowledge of specific trades that are about to occur. You frontrun a specific block trade. The definition you imply here suggests that all market makers are "frontrunners".


HFT is not front running. Search comments for my remarks on latency arb - that may seem like front running, but it's entirely different. Latency arb involves information that is publicly available. Front running does not.


My understanding is that front running has been around as long as there have been market makers - and there have been market makers as long as there have been markets.


The practice of placing a large order and canceling milliseconds later to induce an exploitable price movement accomplishes this, sanctimonious protest to the contrary notwithstanding.


Thanks, this is a very clear article on the most important ingredients of HFT. I am curious to hear the apology but I am not sure there is anything to apologize for. The market marker is taking on substantial risk of adverse selection and is being compensated for it. As long as legal means are used to achieve that end, this is not really different from any other business strategy. Causal implied benefits to society from any business are subjective and the most important consequences are usually latent.

Anyways, I am curious to know if elaborate prediction models are used here or it is mostly a game of adjusting prices based on correlated instruments? Also, how does one build a simulator for such strategies?


Apology in the sense explained in comment in another thread: http://news.ycombinator.com/item?id=3852595


This offers no insight into HFT and is not an apology. Why is it here?

For people interested in HFT, start your exploring with a google search for "latency arbitrage".


It's an apology in the second sense of the word apology:

"2. a defense, excuse, or justification in speech or writing, as for a cause or doctrine."

Basically, apology as "explanation and defense of an idea".


The word "apology" almost always means saying sorry, even to people who know the other meaning.

The author might consider the word "apologia", which does not obviously mean saying sorry and has the additional benefit of sounding Greek, stirring up memories of Socrates' famous defense at his trial. But again, there isn't even a defense in the author's post, just the promise of one forthcoming.


I was alluding to Hardy's book, "A Mathematician's Apology", not the ancient greek one. I've updated the title on HN as per your suggestion.


It isn't an apology in that sense of the word either. There is no defense here. Just a not so technical explanation.

Though, the article promises a defense in a later post, so perhaps it will turn into an apology then.


That's coming in part 2, but an explanation of the mechanics is necessary before reaching that point. Since a discussion of the mechanics are useful by themselves, I didn't wait to polish part 2 before posting this one.

My apologies (in the sense of definition 1) to those who feel misled. I'll polish up the actual apology (in the sense of Hardy) post-haste.


"an intro to limit order books"

Without looking, as it has been years since I did this professionally: is latency arbitrage looking at price moves out of sync with different ECNs and liquidity providers?


Sorry for the lack of guidance in my original response.

Latency arb was born out of the fragmentation that was introduced when the SEC passed Reg ATS.

For those unfamiliar with trading, there are many exchanges, not just one. All of those exchanges are obligated to trade at the same prices. To ensure this, Reg ATS establishes the NBBO: National Best Bid/Offer. If you're buying, and one exchange has an offer at $10.00 and another has an offer at $9.00, $9.00 is the best offer. If you send an order to the exchange that has a $10.00 offer, they are legally obligated to send that order to the exchange with the best price.

Latency arb is the process of keeping quotes/prices in sync by trading when a specific exchange's prices don't match NBBO. Many of the largest HFT players work on a very simple principle: they subscribe to all of the exchange feeds and construct their own NBBO that is faster than the best commercially available NBBO feed. With this, you know what direction stocks are moving as it happens.

Keep in mind that a "price movement" rarely occurs at a specific instance in time. It occurs over the horizon that it takes for the market to synchronize -- which happens as fast as possible and is based on the infrastructure investments of high frequency traders. If you can do it faster and you build the infrastructure the world is yours. Like Vanderbilt with railroads.


From my understanding of this, HFT basically makes it impossible for a non-HFT trader to buy at anything but his maximum buying price and to sell at anything but his lowest selling price. This seems like it would significantly undermine the profitability of the market for non-HFT traders.


HFT makes things very bad for day traders. It makes things marginally better for people who want to take or sell a long-term position. It doesn't change limit orders.


Can you please explain what you mean by 'It doesn't change limit orders'?


I guess a lot of anti hft literature comes from traders? Yes?


And the former middlemen who lived on the $0.10 spread that existed before hft.


What I would love to hear in the follow up to this post is what are the typical technical challenges which a typical HFT encounters? If someone wants to be an HFT what are the core skills one must have? (Strong in algorithms, good c++ skills?). How much math should one know and what kind of math?


I think to be successful your team needs to be strong in four key areas:

- Trading (Strategy) - Software - IT - Research

There isn't necessarily one of the four that trumps the rest, and different players have different relative strengths across those four disciplines. (Which are as you would imagine, not terribly specific to HFT)

I imagine the question is developer-focused, so on the software side, I think I value most highly:

- Don't fuck up. This is obvious, and the trading adage of "Don't lose money" is overdone...but essential. Assume you will fuck up and have nets in place to catch you. Doing safeties well isn't sexy and doesn't add any edge, but I've witnessed "unlikely" safeties save trading systems.

- Understand the hardware. Undestand the strategy. You cannot write fast "generic" code. Have a sense for how fast you could optimally be on the hardware and network stack you're using. This requires interfacing with IT and, sometimes, trading, as some "strategies" traders come up with aren't easy to do FAST; you might be able to suggest something similar that is potentially much quicker on the critical path.

- If you really want to compete in low-latency, C++. If you just want to be pretty fast and your strategies aren't competing for specific orders with the other market makers, I don't think it matters. You can probably do a lot of strategies in 100us in any language. GUI can be done in anything, but it should be able to scale. Most of the GUI pieces are pre-existing. Sortable tables for fills. Ladders for displaying markets, etc. I've used Java/C#/C++ GUIs -- C++ has always worked best for me, but I wouldn't be opposed to doing the front-end in JS/HTML honestly.

- Understand the critical path. This and, to some degree, only this, has to be FAST. Obsessing about how to optimally build a theoretical value cache more quickly etc etc is often not that big of a deal. (It's not on the path)

- Linux kernel and TCP/UDP stack DETAILED understanding. (Or verilog I guess...)

- Locks. When does a mutex really need to be locked? Obviously depends on system architecture. And can often dictate architecture.

I think almost anything else I'd say would be either vague or generic. I think there's a lot of niches one can carve out in HFT and, while I personally value generalists who can holistically understand the goal (make $), there's a ton of people doing really well by just being the most badass at X/Y/Z.


C++? Everyone is now building their own hardware instead.


A pretty small subset of HFTs are building their own hardware from my perspective; there's a lot of people claiming to be doing awesome stuff on FPGAs.


There have been a couple of HN discussion threads regarding your last two questions.

1. http://news.ycombinator.com/item?id=3177815

2. http://news.ycombinator.com/item?id=966716


I've seen so many news articles full of hyperbole about HFT, and this is the first legitimate explanation I've seen. Thank you.


The astute reader will probably ask this straightforward question: -- "Jubal, does that seem right to you?"


The concept of a market maker? Market makers are not an HFT "innovation"; they're kind of central to the whole concept of a trading exchange.

He hasn't yet explained anything more than what a market maker is or where HFTs fit into them. This post is the first in a series. It's background material. It would be a little weird if anything in this particular post got your hackles up.


Mal, Inara, Jayne, Kaylee, River, Simon and Wash are all characters from the television series "FireFly." Jubal Early (Richard Brooks) is the bounty hunter in the last episode who ultimately ends up as an object in space.

Throughout the episode, his hypothetical situations always end with the rhetorical question, "Does that seem right to you?"

My comment was a tip of the hat back to Chris Stucchio. I enjoyed the article and also look forward to more.


D'oh!


Kinda an obvious introduction to order books. Later I hope he gets into the rebate mechanism:

http://www.interactivebrokers.com/en/accounts/fees/NYSEstkfe...

Note that you get PAID for placing certain types of orders.


Will the following installations address the role of high frequency trading in flash crashes? Although high frequency trading seems like a very good strategy when arrayed against human opponents I have to wonder what happens when all the inputs and outputs are controlled by HFT algorithms trading against each other. How do you debug a HFT algorithm?


What caused the flash crash is a poor implementation of stop and market orders.

Essentially, the exchanges do not natively have a concept of "market orders" -- filling now. Instead, some brokers implement them by selling at a penny or buying at some enormous price, essentially hitting the bid or offer. Under normal circumstances this is not a problem, as the prices are reasonable. However, during periods of extreme dislocation, when traders pull out their limit orders, all that are left are stub quotes at a penny. And because those brokers used algos that would trade at a penny, those trades happened.

You debug an algorithm like you debug any other piece of software :) I "debug" by using a regression against a pure python implementation, which was implemented in the most obvious and correct way. I discussed it here: http://veyronb.wordpress.com/2011/11/02/prototyping-with-pyt...


The rapidity of recovery from the flash crash can be credited to HFT.


Lets all rejoice in how fast those who created the disaster fixed it. rolls eyes


It was a fat fingered mutual fund who created the flash crash, not HFT's. It was HFT's who prevented it from being a disaster.

http://www.sec.gov/news/studies/2010/marketevents-report.pdf


How is the price of a stock market plummeting a "disaster"? For those who own the stock it's of course not advantageous, to those who wish to buy it, it is.

I'd like the HFT traders to get into milk and apples. Maybe they can crash the price of these too so I can get some cheap groceries.


Groceries do have huge variations (at least here in Uruguay), and there is a futures market in them.

There's definitely talk of fruit futures :)

http://www.goodfruit.com/Good-Fruit-Grower/October-2011/Futu...

"The status of the long-awaited futures trading contract in apple-juice concentrate hasn’t changed. It’s still coming “soon.” "

Milk doesn't only because it's regulated (here at least).


Testing/Debugging can be achieved by running your own mock exchange with historical or generated data. Also, most exchanges provide a simulated environment where you can do fake trades and make/loose fake money.


I am also interested in the debugging part.


as I understand it, the flash crash of may 2010 was by a bug in the algo that said "in order to allow the market to absorb a large order, simply divide it into X chunks and put them on the market one at a time". The bug was that this algorithm worked if your total shares T were small enough that T/X didn't affect the market. But on that day, T was so big that T/X still moved the market, and the algo didn't take that into consideration. You could protect against this by having sanity post-checks, but once something hits the market there's basically no CTRL-Z button.

One interesting thing about the flash crash was that the original "stock" wasn't a stock at all, but S&P e-minis, which are tied to a whole cross-section of stocks but are on an exchange that is mostly traded by pros. We have circuit-breakers now on individual stocks that halt trading if a single stock moves too much too fast, but that won't be effective if the whole index gets pushed down like it did that day.


Can you say how feasible it is to build an HFT startup - the operating costs of execution/connectivity/colocation(!) aside - do you think regulatory authorities make the barrier-to-entry too high?

SEC/FINRA have Series 7/56 requirements for employees, UK has FSA-related principal investment regulations - both require a company to sponsor a person to trade. Also, the MiFiD regulations in EU require an "adequate capital" of 700k euros - is it really possible to get venture/seed capital covering these bare costs so that you just remain "legal", let alone operate?


Thanks to sponsored access and the large trader rule, you really just need the blessing of a clearing firm and pay some colocation fees. As a one time cost anyone can get in with 200K deposit (on a 6:1 levered setup) and about 50K in startup expenses, with a 25k/mo recurring charge.

P.S.: that is what I am doing now :)


That's useful to know - thanks!


Men buy, women sell, and also if women are sad you can feed them strawberries and get off on it. Got it. Now I understand HFT perfectly.


It's a firefly reference.


That much was obvious. When you build your examples around a sexist experience of sexist media, your examples will themselves end up sexist. I mean, why isn't Zoe buying, too? What is it that Inara's selling? I think we know, and from the heternormative misogyny rises the situation in which a cheeky description of market making has exclusively men buying and exclusively women selling.


What is it that Inara's selling?

Shares of Blue Sun. http://firefly.wikia.com/wiki/Blue_Sun_Corporation

I'll be sure to have Zoe and Book make an appearance in part 2. Sorry that my fanfic missed your favorite character.


For the record, I made no connection between Inara's occupation on the show, and her "selling" in this example. I doubt Chris intended such a connection.


I'll believe that HFT adds liquidity to the market when the typical start of employment to retirement period is 15 milliseconds.


An expected and uneducated statement. It's simple really: any participant who rests an order on the book is adding liquidity. Period. Many HFT strategies are largely passive (market making, for example) and therefore entirely rely on resting orders (as Chris' article points out). Therefore, they add liquidity.

Now, if you want to get into a discussion as to the quality of that liquidity then you have to go educate yourself a bit more. Once you do you'll find that the liquidity being added is not toxic nor fleeting. However, what you and most others don't understand is that it is also significantly more informed passive liquidity than it used to be.

This may lead folks to believe that the liquidity is fleeting because they can cancel away before you can execute. However, that simply means they are better and faster than you, not that they are doing anything wrong.

Why, then, don't we simply require them to rest their orders for a longer period of time? Simple: you want tight spreads. As spreads shrink market making becomes less profitable. When market making is less profitable market makers have to be more risk averse to avoid getting adversely selected and losing money. More intelligent models (they become more informed) and less latency (they can leverage that informedness to avoid being selected) is how market makers stay profitable in a market where the average spread is 1 penny.


How about rather than adding regulations, just discretize the market's clock? Would a market that performed a trade-resolution tick once every 100ms lose anything important? I believe arbitrage improves efficiency, but I'm less clear on the benefits of extremely high temporal resolution. Currently that's what the incentives encourage optimizing for, among other things. If you predict a market movement 10ms ahead of time, you can profit from that brief 10ms temporal-arbitrage window. And like any arbitrage, that does indeed improve the pricing signal in an absolute sense, in this case by taking a price change that was 10ms later than it "should've been", and moving it up in time via your trading. But it's not clear that 10ms-level pricing inefficiencies are actually something particularly important to smooth out via arbitrage, when you can just define them out of existence by going to a discrete-time market (which are fairly well-studied in the mathematical literature).


I think if you consult the literature you'll find that the prevailing trend is for markets to become more continuous rather than more discrete. Continuous markets help with true price discovery. Our markets are continuous in time right now and we've pretty much squeezed the spreads to their maximum, so while prices aren't continuous they are about as close as we can get w/o eliminating the profitability of the primary market participant (market makers) that make it function.

You can scheme up any number of possible microstructures that sound interesting on the surface. There's a reason why none exist. Remember, there is nothing to stop you from implementing a time-discretized market place. Current regulations (Reg-ATS) allow for you to do so. You'll find it hard to compete. Some markets do perform large scale discretization for block orders. Read up on POSIT and related ATSs and dark pools.


FYI - I wrote the successor to posit. Point in time matching goes out of fad when volatility increases. Why take on the risk of executing a block at a single point in time when you can spread that risk out over the day?


I read somewhere that non-hft tend to trade much more at the "second" tick. This may have been b/c they were dumb (hard to believe) or because converging at the same time (15:30:10 instead of 15:30:10.175) gives them better chances to finding a match to their sell/buy position


what exactly is 'true price discovery' ?

can a price be false?


With insufficient trades, you cannot know if a certain price is really what the 'market' wants to pay, just what that one person at one point in time wanted to pay. Overgeneralized, the more trades, the more accurate the price gets.


Evidently you have childlike trust in the capacity of the second-tier Russian mathematicians and physicists to get the boundary conditions right.


Discretization often leads to instability, particularly if not done carefully. The prototypical example is naive discretizations of stable ODEs. Of course, all we have are toy models and speculation. The only real way to know is to try it.

If I remember right, a couple of Asian equities markets have some sort of "auction on clock tick" mechanism, so we might be able to look to their experiences.


> Discretization often leads to instability ...

> Of course, all we have are toy models and speculation

These two statements could be construed to be in conflict, especially as I haven't the faintest idea what naive discretizations of stable ODE's is, and Google isn't of much assistance in providing an explanation that I can digest.


I didn't intend them to be in conflict - I listed a toy model, and acknowledged the limitations of it.

An explanation of ODEs and instability (some math background is obviously required): https://en.wikipedia.org/wiki/Stiff_equation


You lead with a fairly strong statement presented as a known fact and then later indicate it's just a model.

To me the idea of slowing things down sounds vaguely sensible, but I also know that I don't know enough to really judge. So it sounds like no one else really knows either, but the entrenched players like things the way they are, which makes sense, because the ones who have the money to be at the table running things are probably also the ones who have the money to throw at HFT and come out ahead.


It is a well known fact about dynamical systems in general.

I.e., if you ask me about the stock market, a flight control system, an electric circuit, a biological system and a computer network, I'll tell you that continuity gives you a better shot at stability than discretization in most of them.

I.e., if you don't know what you are talking about, lean towards continuity. If you do understand things, then explain the mechanics and back it up with empirics.


The hypothesis being advanced by people proposing point-in-time clearances is not necessarily that it will make the market smoother. It's that it will free up a lot of resources for other purposes.


For what it's worth - and not to distract from your real point - Exponential (or the more general Lyapunov) stability are a better explanation of instability. Stiffness is more a property of the method used to solve the ODE, rather than of the ODE itself.


Stiffness is a property of certain dynamical systems, which certain ODE solvers are better suited for. That said, "stability" is an ugly word in numerical methods, particularly for differential equations, as it could mean a number of things. I think this is the source of the confusion here.


It seems that investors trading on an exchange operating at discrete time intervals would be at a arbitrage disadvantage if other exchanges offered continuous trading in the same shares.

So a demand for markets that are liquid and efficient rewards trading that is continuous in time over time-discrete trading, and firms are competing hard to shave milliseconds from latency with co-located hardware and faster trans-oceanic cables.

On the other hand, pricing is limited by regulation to penny increments, with some pressure to telegraph smaller increments.

Are we likely to see a push for trading with offers and trades denominated in milli-cents or micro-cents? Would smaller pricing increments be welcomed by traders or regulators or neither?

Are any markets in the world trading at tiny denominations? (NB: assumes pricing in integer quantities of tiny denominations)


I don't see a reason that "normal" investors would be at an arbitrage disadvantage if trading on an exchange that was discretized to, say, 100ms. Arbitrageurs would still have an incentive to keep the prices on the "slower" exchange in line with the "continuous" exchange's prices, trading at the discrete ticks to exploit price differences. So, price differences past an epsilon shouldn't persist for more than a few ticks, which is more than fast enough for most non-HFT investors, who don't typically make trading decisions with anything close to sub-second precision anyway.

I think a bigger question mark with my admittedly offhand proposal is whether discretizing might actually increase gaming opportunities, since the change could do non-obvious things to the strategy space. On the other hand, it might also remove existing market-gaming opportunities (which are fairly poorly understood, and axiomatically assumed not to exist by the idealized equilibrium analysis economists typically use). Alas, current game-theory solvers don't scale up anywhere close to well enough to give solid answers in either direction (real markets are a bit more complex than 4-participant games iterated over 10 timesteps...).


>I don't see a reason that "normal" investors would be at an arbitrage disadvantage if trading on an exchange that was discretized to, say, 100ms. Arbitrageurs would still have an incentive to keep the prices on the "slower" exchange in line with the "continuous" exchange's prices, trading at the discrete ticks to exploit price differences. So, price differences past an epsilon shouldn't persist for more than a few ticks, which is more than fast enough for most non-HFT investors, who don't typically make trading decisions with anything close to sub-second precision anyway.

Sure, but what you're missing is that the slow exchange's prices are always going to be worse. Not a lot worse - probably only a penny either way on some ticks, and zero on other ticks - but a little. So why would any investor with the choice ever choose to trade on the slow exchange rather than the continuous one?


"Worse" in what sense? Won't the prices deviate pretty randomly around the true price, sometimes behind a penny higher than the continuous exchange, and sometimes a penny lower, making it basically a wash?


No. If the discrete exchange makes it possible to withdraw an offer in between ticks, then the HFT guys would do that every tick - so you actually wouldn't get a price (or you'd get a very wide spread), and it would basically fail to be an exchange. So let's assume any order you have on the book stays there until the next tick's auction. In that case the HFTers are going to give a much higher spread, because if new information comes in at 3.2s and the stock is suddenly worth more than it was at 3s, but they can't withdraw their sell order until 4s, then obviously they lose money. So occasionally you'd get a better price on the discrete exchange (when the market moves further than the spread in the space of one tick) - but the HFTers would be terrified of this situation, and make their spreads wide enough that they think it's impossible. So 99% of the time, you'd get a worse price.


SecondMarket is a start up pushing in this direction. The company whose shares are trading set the trade frequency. Sometimes once per quarter, once per day, whatever they want. Obviously, this is much less liquid.


Yep. One daily cross would be in some ways more fair. But it would also wound price discovery significantly.


> It's simple really: any participant who rests an order on the book is adding liquidity. Period.

If a stock is trading at $100.00, and I put a buy order on the book at $0.01, how have I added liquidity?

> This may lead folks to believe that the liquidity is fleeting because they can cancel away before you can execute. However, that simply means they are better and faster than you, not that they are doing anything wrong.

The question is not whether it's right or wrong, but whether it is beneficial. I don't buy that HFT is intrinsically evil, but there seems to be little convincing evidence that it's actually beneficial, either. The system as you've described it basically involves scraping pennies off transactions that would have occurred anyway. That's not intrinsically evil, but it doesn't seem to actually benefit anyone except the HF trader.

> Why, then, don't we simply require them to rest their orders for a longer period of time? Simple: you want tight spreads. As spreads shrink market making becomes less profitable. When market making is less profitable market makers have to be more risk averse to avoid getting adversely selected and losing money. More intelligent models (they become more informed) and less latency (they can leverage that informedness to avoid being selected) is how market makers stay profitable in a market where the average spread is 1 penny.

What's missing here is an explanation of why we should build a system that enables HFT to be profitable. That's not something I care about. If lower profits for HFT means a better market overall, that's fine with me.

Frankly, in markets where the spread is 1 penny, it seems like there's enough liquidity already.


It should be obvious how it is beneficial. HFTs are in competition with themselves, not with investors like you and I. Prior to HFT market making, manual market makers (brokers on the floor) were making huge profits on large spreads. This means worse prices for the average investor.

Without HFT there would be no "1 penny" spread.


> why we should build a system that enables HFT to be profitable.

because HFT's are more efficient. paying a guy to make a market in one stock is expensive. paying for a computer to do it is cheap. when the market maker's costs are lower, they can afford to quote tighter spreads and still be profitable. lower spreads => lower tcosts for "normal" (low frequency) market participants


The system as you've described it basically involves scraping pennies off transactions that would have occurred anyway.

Could you explain how to "scrape pennies" (as in specific mechanics, your explanation should involve limit orders or whatever), and why this strategy doesn't benefit the speculators the HFT is trading with?


> Could you explain how to "scrape pennies" (as in specific mechanics, your explanation should involve limit orders or whatever),

Are you under the impression that you're assigning homework to students? This comes off as really rude.

And no, I'm not going to write up a treatise on HFT for you. I don't pretend that this is an area of expertise for me. FTA:

Most HFTs run a market making strategy. What this means is they play both sides of the table - they take no position on whether a stock will go up or down. Instead, they try to offer securities both to buy and sell. If you want to buy, they will sell to you at $20.10. If you want to sell, they’ll buy from you at $20. As long as their buys and sells match don’t get too out of whack, the HFT will collect $0.10 = $20.10 - 20.00.

What is that if not "scraping pennies"? The entire goal is to jump between a buy and sell in order to skim a bit from the transaction.

e.g. Alice wants to sell at $10.00. Bob wants to buy at $10.05. They could simply trade with each other, but if Eve gets her way, Eve will buy from Alice at $10.00, and then sell to Bob for $10.05, making $0.05 on each share that would otherwise have gone to Alice.

Engaging in this is not evil, but I fail to see how it benefits anyone else.

> and why this strategy doesn't benefit the speculators the HFT is trading with?

Because when a HFT makes money, other parties involved make a little bit less. HFTs don't print money. They extract it from the market.

Also, because stock markets are not exclusively limited to speculators and HFTs.


Are you under the impression that you're assigning homework to students?

I'm asking for an explanation that goes beyond "they make money, and I don't understand how, they must be ripping people off!"

e.g. Alice wants to sell at $10.00. Bob wants to buy at $10.05. They could simply trade with each other, but if Eve gets her way, Eve will buy from Alice at $10.00, and then sell to Bob for $10.05, making $0.05 on each share that would otherwise have gone to Alice

What's missing from your explanation is time. If you actually wrote out a specific explanation involving limit orders (like I suggested), you would immediately have seen that.

If Alice wanted to sell at $10.00 and Bob wanted to buy at $10.05, they would have already traded. The millisecond Bob's order hit the market, he would have filled Alice's order (or she would have filled his, depending on which was bigger). Eve never had any ability to participate.

If Eve played any role, there was a time delay. At 12:20, Eve put an order BUY(price=$10.00, quantity=100, time=12:20) onto the market. Alice chose to sell to her at 12:30 because she wanted to trade immediately, with no risk of her order being unfilled. After buying her stocks, Eve turned around and placed a SELL(price=$10.05, quantity=100, time=12:30:01) order. At 12:40, Bob comes along and places an order BUY($10.05, quantity=100, time=12:40), which is filled by Eve's order.

If Alice wanted to hold out for $10.05 she could have. She chose not to, because she didn't want to run the risk of Bob never showing up. Eve didn't "scrape pennies" from Alice and Bob, Alice paid her $0.05 to take the risk of Bob never showing up.


Here's the thing though: ostensibly, financial markets aid in allocating capital for real world investment.

Real world investment doesn't work on a millisecond basis. It doesn't even work on a per-minute basis - at best, it works on a daily basis.

So if we were talking about how the financial markets benefit the real economy, we would say that Alice wants to sell at price X on Tuesday, and Bob wants to buy at price Y on Tuesday. And in that case, the go-between is unnecessary.

Nobody in the real economy needs instant order fulfillment when even regular bank transfers take a day to clear.

I get that more frequent dealings can help with finding "right" prices. It certainly reduces the spread. The problem is that HFT makes market access unequal.

You claim that Alice could have held out for $10.05 if she had wanted to. This is incorrect. Alice most likely does not have the infrastructure in place, and the fixed costs would be far too high for her to participate in that game. So in fact Eve did not provide any kind of useful service to Alice. Eve exploited unequal access to the market for her personal gain.

From a libertarian perspective you may say that's fine, granted. But the argument that Eve provided a service to the real economy is not as clear as you make it seem.

So there is a tradeoff there. HFT reduces spreads and perhaps helps price finding. However, for most market participants form the real economy, intra-day fluctuations dominate the spreads by orders of magnitude anyway, so reducing the spread isn't even that much of a useful service to the real economy - at least not to the extent it happens today. On the other hand, HFT makes access to the market unequal, limiting market competition.

It seems unlikely to me that the current situation is a proper balance within this tradeoff.


Real world grocery shopping happens on perhaps a bi-weekly basis. But I want to be able to check out soon after I get to the register; I don't want to have to wait for hours or days for a cashier to decide that they're ready to execute the other side of my purchase.

Investment happens on a timescale of months or years. But when I make the decision to exchange one investment for another (I include "cash" as an investment) I want to be able to make that exchange rapidly. If someone wants to jump on my offer in mere milliseconds, I'll take it. Maybe I could've gotten a few more cents by waiting for an offer minutes or hours later, but that's not the game I'm playing. If I cared about those last few cents I'd price my asset a little higher and wait for a better deal. Since I don't think it's worth the wait, I'll let the HFT have those few cents for the convenience of letting me clear my trade immediately so I can move on with my day.


I see your point in theory, but in practice it doesn't seem to apply.

Even regular bank transfers, i.e. transferring money from one checking account to another checking account, usually take a day to clear over here. I am talking about regular bank accounts in Germany, by the way. The economy manages to run just fine with this system.

As long as something as basic and fundamental as simply moving money from point A to point B is that slow, I really don't buy the argument that the real economy needs transactions on financial markets to clear that quickly. What's the point of having a trade clear in milliseconds if it takes me a day to transfer the money to a different account?


Trades don't clear in milliseconds. Trades are agreed to in milliseconds, just as bank transfers are. I.e., once you push the "make transfer" button, the wheels are in motion, it just takes a day for the money to actually move.

The same applies to equities - once the trade is made, the wheels are in motion. But actually transferring the securities takes up to 3 days.


> "Trades are agreed to in milliseconds"

One might ask "why is this important if the transfer itself takes days?"

The main reason is that it gives you certainty and closure. You try to make a trade for + or - X shares of Y at $Z and you get an essentially instant response. You don't have to wait around all day just to know if you've got a deal; you don't have to poke around looking for a slightly better price; you just make the offer and see it accepted immediately, and can move on to other things. (This is the sense in which I meant the word "clear" a few posts up: the trade is cleared from your to-do list, even if the securities take some time to actually move.)

There is a cost for the service of being able to move on: the HFT will likely capture a tiny bit of profit which could have gone to you with more effort. You've traded money for time and effort.


Question of understanding: If what you say is true, and it actually does take up to three days to transfer the securities, how can you immediately sell an asset that you just bought a few minutes ago? My understanding of HFT (including from your description) was that this type of thing, i.e. holding an asset for only a few minutes, happens all the time. How can that be possible if the transfer takes as long as you claim it does?


You don't actually have to have the securities physically in hand in order to enter into a contract to transfer them.


But then yummyfajitas' comparison doesn't apply after all. When transferring money, the recipient has to wait a day until he can order the next transfer. This is not the case with trading, so this whole "three days" claim seems spurious to me.


I think his point was that the time it takes to be agreed to and the time it takes for the trade to clear are two different things, and that it's OK for those to happen on different timescales.

Having the trade agreed to quickly is a big deal even if it could take days to have any tangible assets to show for it.


> financial markets aid in allocating capital for real world investment.

this is only one purpose of financial markets. the other purpose is to transfer risk. any capital that you hold is subject to risks, and as a capital owner, you really only want to be subject to the risks that you know about and can compute well. you'd like to transfer other types of risk to other parties.

> It doesn't even work on a per-minute basis - at best, it works on a daily basis

is this a joke? if AAPL releases earnings at 10am and they come in 20 cents under expectations, i can guarantee you that regardless of the presence of computers, by 10:01am, AAPL is going to trade down a lot.

> It certainly reduces the spread. The problem is that HFT makes market access unequal.

lower spreads mean that less profitable strategies can survive in the marketplace. there will actually be more market participants in this type of scenario

> You claim that Alice could have held out for $10.05 if she had wanted to. This is incorrect

what you're describing here is a limit order, the most basic type of order that everyone has access to. she puts in 10.05 in etrade, and gets filled if the market moves up to 10.05 (but not if the market moves down towards 9.95 and does not come back up).

> for most market participants form the real economy, intra-day fluctuations dominate the spreads by orders of magnitude anyway

this is exactly why latency is important (and also contradicts your earlier statements). you want your orders filled now, before the market moves away from you.


You claim that Alice could have held out for $10.05 if she had wanted to. This is incorrect.

Unless the "5" key on her keyboard is broken, she could have typed 10.05 into eTrade instead of 10.00.


At the point of IPO the capital for a company has already typically been allocated. The financial markets allow the owners of a company to sell their shares to the public and realize profits on their prior investments. After that markets are about betting whether the price of the company will go up or down and people trade accordingly.

The need to trade instantly is very important for risk mitigation. If unexpected news comes out today that a company is the target of an adverse event like a DOJ lawsuit many market participants will want to react as fast as possible to the news. Say it takes 30 seconds for the price to fall by $10. If you could trade at the 15 second mark you would only lose $5. To an investment firm (non Market Maker or other HFT) this can be crucially important and many firms have automated systems of their own to trade.

A key point of the article that most people miss is that someone has always fulfilled the role that HFTs currently occupy. In the old days floor traders occupied this role as pointed out by the article. Floor trading was a club where you had to buy a seat to be allowed in. Depending on the market the cost of the seat might be hundreds of thousands of dollars. The traders controlled access to the markets and for some markets like Oil the only way to trade was through these floor traders. Now these floor traders took full advantage of this and kept the spreads on the instruments they traded much wider than they are today. In the early 90s you could easily pay $.20 per share to the market maker to get a fill on a liquid stock.

The realization (as pointed out by the article) that computers could do this better and faster is just like any other industry. The people most hurt by this development were the floor traders themselves. There is a movie called The Pit that explores the effect that computerized trading had on floor traders in Chicago. Today if I want to trade MSFT the spread on BATS's BZX exchange was just $0.01. To me, another market participant I consider it to be much better to pay a penny to Getco rather than $.20 to a floor trader.

The colocation business as it has evolved has made market access more equal, not less. Today anyone can pay to colocate a server at NASDAQ, NYSE, BATS, etc... I know longer have to buy a floor seat to be able to trade there. Now there are real market barriers to entry but they are not structural. Just as you can't go build a Google competitor given that you don't have all the historical search traffic data and the infrastructure to compete with them, HFT firms have made significant investments in infrastructure of their own. If you had sufficient capital for technology development you could compete with any other HFT firm.

Yes there are people hurt by HFT, just like anything else when new players with greater efficiency emerge. However the average investor who is not competing with these firms is not harmed. The floor traders were, just like telephone operators before them.


The need to trade instantly is very important for risk mitigation. If unexpected news comes out today that a company is the target of an adverse event like a DOJ lawsuit many market participants will want to react as fast as possible to the news. Say it takes 30 seconds for the price to fall by $10. If you could trade at the 15 second mark you would only lose $5.

This type of risk mitigation is important to whom, exactly? When the type of unexpected news you mention comes in, somebody is going to take a hit, yes. Who should take that hit? What are the criteria according to which you make that decision in the first place?

In the scenario you outline, say the price falls by $10, somebody is going to take that loss no matter what. Without rapid trade, the original holder of the paper is probably going to take the full loss. In your scenario with rapid trade, they found some "fool" who was prepared to buy the paper at an intermediate price, and so the original owner lost less. So from the perspective of the original owner that is certainly a benefit. But is it a benefit for society? That is an entirely different question.

One could argue that the only reason they lost less is that they were faster in reacting to a certain piece of news, on a timescale of minutes, which is entirely irrelevant to the real economy.

Your point about HFT replacing floor trading is a valid point, but all it really proves is that barriers to entry into the market must be low. There is nothing inherent requiring high frequency trading. The job could just as well be done by lower frequency algorithmic trading, with a matching algorithm that runs on e.g. a 5 minute heartbeat.

Yes, the spreads are going to be bigger. Then again, intraday movements dominate spreads by orders of magnitude anyway, so from the perspective of the real economy, why should I care about how small the spreads are?


What you are really proposing here is to take away competition from the market. This would mean that you need another way of assigning the winner(buyer or seller, in case there are multiple ones wanting to buy the same stock); Some ways of doing it: randomly, alphabetically, shoe size, networth etc. You get the drift... The question is, will it be fair?

In capitalist systems winners are assigned based on open and fair competition, but then again there are other political views and systems.


Arms races are fair, but they waste resources. Splitting money randomly may be better for society than encouraging an arms race.


I think this is the important point and one that seems to be lost on a lot of traders: Yes, what you are talking about is logical, but we as a society have the right to say: No, this is not beneficial to everybody.

The way many traders argue, they seem to have little shame saying that they want the system to give them a hand when they have made a bad decision.

> If unexpected news comes out today that a company is the target of an adverse event like a DOJ lawsuit many market participants will want to react as fast as possible to the news.

No, I think the first thing you want to do is kick yourself in the butt for investing in a company that went down like this. If you invest in an oil company and it has a huge spill, the stock will go down and you will lose money. Don't like that? Don't invest in oil companies with a lousy safety record. Or invest yourself in making sure that the company that you gave your precious liquidity doesn't mess it up.

I would further claim that there are very few truly "unexpected" news. Traders are just a little too much in love with not really caring about what they invest in. At least not as much as they are in love with the money they make or the image that they are the "market makers" who provide the liquidity that we all need.

A DOJ lawsuit happens for a reason. Oil spills happen for a reason. If you have made a bet, you are the one who has to provide reasons for your bet. I cannot believe there are that many people who argue they should be able to rip off as many people as possible once their bet has gone sour. That the one thing they really need is to be able to rip others off as fast as possible. And that all this is somehow reasonable and useful.

I understand nobody really likes being the loser, but that's how capitalism works - filtering out the bad apples by having them go down in flames. Well, that's what it's supposed to be like, anyways.

> Arms races are fair, but they waste resources.

Amen.


Arms races are fair, but they waste resources.

Thank you for making my point in such an awesomely succinct way. This is exactly what I was trying to get at.


Capitalist competition is inherently wasteful - advertising, lawsuits etc. - but overall it allocates resources more efficiently than any alternative that's been tried.


Speaking as a software developer at one of the exchanges, I thought these comments were accurate and insightful. A lot of people think that colocation is inherently unfair, but they don't realize what a huge improvement this is over the old system of a limited number of floor traders.

One slight correction: I think the movie about floor traders in Chicago is called "Floored". There is another another movie about floor traders in NY called "The Pit".


You're fighting a losing battle. These people are personally involved in HFT or the financial industry in general, so naturally they'll try to justify what they're doing with whatever distraction-bullshit they happen to think of.

Sure, I can't know this, but it's a safe assumption. Whatever. Feel free to downvote and flag my post to bury it again, HN. Stay classy.

The army of PhDs from elite schools working for the financial industry are too smart not to realize that it's full of shit. How could they not see the relentless greed, and the sociopath douchebags in charge for what they are?

They'll be aware of bad/immoral/illegal things being done all around them, but hey, the salaries in finance are pretty fucking ridiculous and they get to work on challenging problems.

http://www.zerohedge.com/news/high-frequency-minutes-hft-exp...

Just like you said, in the real world, someone trading in the real economy does not make trades thousands of times per second. And I bet HFT bringing spreads down to $0.05 doesn't help anyone without a HFT machinery of their own.

But here they are, on Hacker News, bullshitting/distracting us convincingly time and time again.


One thing that hasn't been mentioned is the practice of placing a large block order and then canceling it milliseconds later to take advantage of the price movement this causes. So placing a large order does not automatically create liquidity--it can create the momentary illusion of it. (This observation has to be pompously dismissed in gratuitously insulting terms--professional rational discourse will not suffice to explain indefensible practice. I must have touched a nerve.)


> I'm asking for an explanation that goes beyond "they make money, and I don't understand how, they must be ripping people off!"

I didn't say that anyone was ripped off. There's nothing inherently wrong with being a middle-man in a transaction. I just don't see that HFTs are adding any real value.

> What's missing from your explanation is time.

You're pretending that Alice and Bob placed their orders 20 minutes apart. That's not the game HFTs play. HFTs are playing games of milliseconds. It's not 12:20 and 12:40. It's 12:20:00.200 and 12:20:00.450. If Eve had taken the day off, Alice would have traded with Bob, and it would have looked just as immediate to both of them. And if there were a high risk that the market would tank immediately after Alice's sell order were placed, then Eve wouldn't have left her buy order on the book anyway.

If your 20-minute wait scenario were realistic, then sure, HFT would be adding meaningful liquidity. But then, it wouldn't be called high-frequency trading, and you wouldn't have written about how "speed matters".


If Eve had taken the day off, Alice would have traded with Bob, and it would have looked just as immediate to both of them.

This comment makes sense only in the context of a message board hypothetical, because it presumes foreknowledge on Alice and Bob's part. Here, Bob showed up. Eve looks like a genius. But it was equally likely that he wasn't going to show up.

A lot of the discussions about liquidity and HFT here seem a little innumerate. They appear to work from a scale where the hypothetical Alice's ask price is "absolute zero". That's not the real scale. Obviously, instead of Bob showing up at $10.05, you're equally likely to end up with Chuck at $9.95.

If you're not equally likely to get Chuck instead of Bob, why are you selling?


> This comment makes sense only in the context of a message board hypothetical, because it presumes foreknowledge on Alice and Bob's part. Here, Bob showed up. Eve looks like a genius. But it was equally likely that he wasn't going to show up.

Equally likely? So HFTs are flipping coins blindly and just happen to make a lot of money because they can flip quickly?

> If you're not equally likely to get Chuck instead of Bob, why are you selling?

I don't understand this question at all. I'm selling because I want to sell my stock. Maybe I'm liquidating assets to buy a house. Maybe I'm speculating that the market is going to tank. Maybe I'm just adjusting my asset allocation. I could be selling for any number of reasons, and I don't care about Bob or Chuck. I just want to sell and get the market price.


If you need liquidity but want to retain your upside exposure, there's a whole class of tradable instruments that does that for you.

If you need liquidity and aren't confident enough in your upside to want to be exposed to the downside, you're happy to have Eve.

Note well: your hypothesis is that Alice should get something for nothing. Alice wants liquidity (ie: no downside exposure) and immediate access to the next significantly better price to hit the market. It must be nice to be Alice! :)

As for your first question: HFTs do not have crystal balls. If they did, Chris Stucchio would be a billionaire.


For sure, HFTs don't have crystal balls. They certainly are able to leverage their market access to give them an advantage, though.

I feel like I need to reiterate that I don't think HFT is evil. I'm just not sure that HFTs really add that much liquidity to the market, and there is evidence that they contribute to volatility (such as the flash crash).


The "Flash Crash" was caused by a single, manually-initiated large block trade:

At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 EMini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.

(From the SEC link Chris posted earlier).

I don't know whether I believe Chris that HFTs caused the market to correct much faster, but it seems clear that HFT didn't cause the crash.


The SEC seems to disagree, and says that HFTs added to the drop. HFTs also apparently burned through about half of the trading volume just trading with each other.

> The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini S&P 500 down approximately 3% in just four minutes from the beginning of 2:41 pm through the end of 2:44 pm. During this same time cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY (an exchange-traded fund which represents the S&P 500 index) also down approximately 3%.

> Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.[9]


The SEC paper doesn't even use the word "liquidity" properly, and the authors appear to be biased.

http://www.nanex.net/aqck/2977.html


HFT didn't cause the flash crash, but neither did that mutual fund manager.

The primary cause was a delay in when incoming orders were time-stamped by the NYSE. Instead of stamping the orders when they arrived at the queue just before entering the market, the NYSE servers time-stamped them when they _left_ the queue and were placed in the book.

Since the queue was delayed by extreme volume (NYSE has always lagged on technology), stale prices were posted to the NYSE feed. However, it was impossible to tell that they were stale from the timestamps.

Since the market was falling rapidly, this resulted in the NYSE quoting higher prices than every other market.

Since the NYSE was quoting higher prices than every other market, arbitrageurs massively sold at the NYSE and bought on other exchanges.

Since the queue was delayed, however, the sell orders at the NYSE took a while to actually show up in the book. Meanwhile, more sell orders were placed.

Want to see something scary? Here's the result: http://www.nanex.net/20100506/FlashCrashAnalysis_Part3-1.htm...


HFTs are playing games of milliseconds. It's not 12:20 and 12:40. It's 12:20:00.200 and 12:20:00.450.

Or it could be 12:20:00.200 and never. You are assuming Bob will show up, but at 12:20:00.200, neither Alice nor Eve know if he will or not.

If Bob shows up, Eve makes $0.05. If Bob never shows up and the price drops to $9.50, Eve loses money. Alice paid Eve $0.05 to take that risk because she felt it was worthwhile.

If Alice didn't feel this risk was worthwhile, she would have placed an order at $10.05.

But then, it wouldn't be called high-frequency trading, and you wouldn't have written about how "speed matters".

Please go reread the section on why speed matters. As I said, speed matters to Eve and Eddie (both HFT's) - because Eve placed her order at 12:20:00.000, and Eddie placed his at 12:20:00.030, Eve trades before Eddie. Alice's timing is irrelevant in this part of the game.


> Or it could be 12:20:00.200 and never. You are assuming Bob will show up, but at 12:20:00.200, neither Alice nor Eve know if he will or not.

Sure. It could be never. But it's not 50/50 or Eve wouldn't be playing. Eve buys from Alice because she expects to immediately sell at a higher price.

> Please go reread the section on why speed matters. As I said, speed matters to Eve and Eddie (both HFT's) - because Eve placed her order at 12:20:00.000, and Eddie placed his at 12:20:00.030, Eve trades before Eddie. Alice's timing is irrelevant in this part of the game.

It's not irrelevant. A price-increasing event occurs and Eve jumps on Alice's sell order before Bob's buy comes into the system. Bob pays the same, Alice gets her asking price, and Eve pockets the difference. This is just exploiting unequal market access.


But it's not 50/50 or Eve wouldn't be playing.

Of course it's not. Alice has a lower appetite for liquidity risk - that's why Alice chooses to pay Eve to take on this risk.

A price-increasing event occurs and Eve jumps on Alice's sell order...

First of all, there was probably no event. It's most likely that Eve had passive orders - buy at $10.00, sell at $10.05 out in the market (HFT's usually don't take liquidity, that costs too much money). Alice came along and chose to fill Eve's order.

Ignoring that, you also haven't explained how Eve's "unequal market access" plays any role in this. Why does Eve have to be a machine in this process? While being a machine helps Eve beat Eddie (another machine), if no machines were in the game then Eve could easily be a human. In fact, Eve was a human until fairly recently.


From what I can see, the "best price" rule basically becomes meaningless in the face of HFT. Alice is pretty much always going to get her min only, right? This prevents Alice from setting her min lower to manage risk. e.g. In a world where matches are executed immediately, but market makers are competing without an advantage, Alice could set her min at $9.50. If Bob comes along and buys at $10.05, great. If Chuck comes along at $9.55, not as great, but okay. But in a world where HFT will pop up and buy at the lowest possible price, setting a low min stops being a reasonable option, because you're basically capping your sales price at that point. So maybe HFT helps Alice get $10 instead of risking $9.55, but it also stops her from getting $10.05.

I know that market making could theoretically do this anyway, but it's a different situation when market makers have such a speed advantage. If you've got to sit on your position as long as the typical eTrade user, leaving a passive buy for $0.10 under market price picks up more risk, because you might not be able to cancel if the market shifts downward by $0.30.


You're using terms like "best price rule" but asking questions like "if Alice sets her 'min' at 9.50 she can sell to Bob at 10.05". This doesn't make sense. Alice has a limit order on the book that says she's prepared to sell at 10.00. When Bob comes along saying he'll buy at 10.05, the market fills the order at 10.00.


There are some things I'm not entirely clear about here. I'm not sure how the best execution rule (best price rule is apparently a bit different) plays out when there's a spread. When someone bids 10.10 and someone else asks 10.00, how should that be resolved. Either someone takes the whole spread or it's split between them, and I'm not sure what the SEC says should happen. A "minimum" price doesn't make any sense if it's the only price, but then neither does a "maximum" price.

In any case, though, the spread would theoretically go to the existing participants, rather that an HFT. The "market making" of the HFT still results in extracting money from the market. This could be a beneficial thing in illiquid markets, but I'm not sure it's beneficial in markets that already have high liquidity.


You're not clear on how order books work, which, respectfully, suggests that your reasoning on this stuff is a bit suspect. The standing limit order prices the trade.

I can understand how upsetting HFT must have sounded to you (although to be fair, we're still shifting the good outcome from Bob to Alice in your best case) given that misunderstanding, but, no: to capture the 5 cents (more likely: 1 cent) between Alice and Bob, the HFT had to accept Alice's downside risk exposure. There was no (simple) outcome where Alice could have it both ways, scalping Bob for 5 cents in the best case but getting out at 10 cents in the worst.

I came to my understanding of this topic in a weird way (see downthread) but one resource I found extremely helpful was Larry Harris' _Trading And Exchanges: Market Microstructure For Practitioners_. It is the TCP/IP Illustrated of markets. Very well written, and well written in a way easily appreciated by programmers. Highly recommended. When I first started reading it, I literally didn't want to put the book down.


Respectfully, I never claimed to be an expert of any sort, and I said so earlier. A large part of why I participate in these kinds of discussions is so I can learn.

I still get the feeling that you think I'm attacking HFT. It's not "upsetting" to me. The only questions for me are whether there's more value in HFT than cost, and whether the same value could be had with lower cost. It's good to know that my Alice scenario is invalid, though. That means HFT isn't breaking what I thought was a useful scenario for sellers.

Thanks for the book recommendation. I've added it to my list.


The last sentence of your second graf is what I was trying to capture with my "upsetting" sentence; sorry for the poor choice of words.

It's a great book.


Alice wants to sell at $10.00. Bob wants to buy at $10.05. They could simply trade with each other, but if Eve gets her way, Eve will buy from Alice at $10.00, and then sell to Bob for $10.05, making $0.05 on each share that would otherwise have gone to Alice.

If this is what HFTs were doing, it would be understandable why they were so upsetting. But of course, HFTs can't do this, because Alice and Bob's trade is executed instantaneously in the match engine.


Obviously HFTs can't wait until the match occurs before jumping in the middle, but they can and do jump in the middle of a match separated by milliseconds. Granted, they're assuming risk by doing this, but the risk is low, especially given that they can also cancel in milliseconds if the market shifts.


I can't understand the point you're making here. Earlier, you suggested ALICE SELL @ $10, BOB BUY @ $10.05. Those orders can't rest in the book; the match engine will evict them immediately by executing the trade. The is no time interval between Bob's order and the trade execution.

Could you perhaps explain the specific scenario you're talking about here? Alice, Bob, and Mallory perhaps?


I know that they won't sit on the book. The entire point of HFT is to jump between BUY and SELL orders as they arrive, though. e.g. This could be the sequence.

12:00:00.000 - Alice - SELL $10.00

12:00:00.100 - Eve - BUY $10.00

12:00:00.200 - Eve - SELL $10.01

12:00:00.300 - Bob - BUY $10.05

(Eve could have issued her BUY order before Alice's order arrived, SELL after Bob's BUY, etc.)

If Eve stayed home for the day, Alice and Bob would have happily traded with each other and Alice probably wouldn't have minded the extra 200ms delay but would have appreciated the extra $0.05 per share. But instead Eve decided to jump in and extract a bit of money from the transaction. And again, there's nothing wrong with that. But I fail to see how Eve is adding any value to the market here. There was no lack of liquidity.


    12:00:00.000 - Alice - SELL $10.00
    12:00:00.100 - Eve - BUY $10.00
    12:00:00.200 - Eve - SELL $10.01
    12:00:00.300 - Chuck - BUY $9.95
    12:00:00.400 - Chris - BUY $9.90
    12:00:00.500 - Charlise - BUY $9.80
Oops. Compare:

    12:00:00.000 - Alice - SELL $10.00
    12:00:00.300 - Chuck - BUY $9.95
    12:00:00.400 - Chris - BUY $9.90
    12:00:00.500 - Charlise - BUY $9.80
Eve took the day off. Alice is screwed.


It may be helpful to think of Alice trying to unload ten different stocks each at $10, every day M-F.

With HFT, some trades will go according to your first scenario; others will go according to the scenario you responded to. On net, Alice sells all her stocks to Eve and gathers in $100 every day.

If Eve stays home, instead Alice unloads perhaps six of her stocks to Bob at $10.05 each, and is still holding on to four of them. She doesn't want to end the day with $60.30 and four stocks she doesn't want, so she unloads the remaining stocks to Chuck and nets $100.10. Except that Chuck takes Mondays off, so on Monday she might end up selling to Chris and only finish with $99.90.

So what Eve (HFT) really accomplishes here is she grabs 10 cents of Alice's potential profit on most days or 10 cents of Alice's loss on Monday. Alice is happy with this arrangement because she gets the certainty of getting her $100 each day for the minimum effort. Eve is happy because she's grabbed an average profit of 6 cents per day (40 cents for T-F, -10 cents for M) in exchange for taking on a little bit of risk.

The real loser in this scenario is Freida, who is trying to do the same thing as Eve but is a little bit slower.


If Eve stays home, and Alice places a standing limit sell order at $10.00, and Bob comes along with a limit buy at $10.05, Alice's is the standing order and will set the price of the trade. The trade will fill at $10.00, not $10.05.


Alice isn't screwed in the second case. She just gets lucky in the first case.


Alice is holding a security that is decreasing in value, and her book order isn't going to clear.


Assuming no HFTs, maybe Alice could set min_price=9.9$, and still sell for $10.05 in the better scenario? It seems that HFT's kill alice's sell spread option, forcing her to sell at min_price?


Huh? If Alice places a limit sell at $9.90, Bob's limit buy at $10.05 order will execute at $9.90. The limit price of the standing order is the one that prices the trade.


Oh, thanks for correcting my misunderstanding. So in general, sell "min_price" really just means sell "price"? Or are there circumstances that it would sell above that price?


As explained above, if Bob's $10.05 buy order was in the order book first, then Alice's $9.90 sell order would trade with Bob's buy order at $10.05.


This comment demonstrated the fundamental point of your misunderstanding. Your ordering of events is not how it works. Eve doesn't "jump in the middle" What actually happens is this:

  12:00:00.000 - Eve - BUY $10.00
  12:00:00.000 - Eve - SELL $10.01
  12:00:00.200 - Alice - SELL $10.00
  12:00:00.300 - Bob - BUY $10.01
Eve was there before Alice & Bob. This is KEY to understanding what is going on here. Even is NOT jumping in the middle. Eve provided a service to both Alice & Bob and got paid for it.

Here's another way to think about it:

Alice wants the ability to sell her stock whenever she wants for a "correct" price. Right? That doesn't come for free. Someone has to figure out what the correct price is. That takes effort and costs money. Humans used to do this (they were called market makers). Now computers do it because they're better/faster/cheaper at it (just like they're better at a lot of things humans used to do).

They're also cheaper at it. The cost to Alice of getting to sell whenever she wants at a good/correct price has actually gone down from what it used to be. You can see this in the shrinking spreads. It used to be we only had price accuracy to a dime or a quarter. Now it's generally down to only a penny! Even though Eve is making money Alice is getting a way better deal than she used to before someone figured out how to program Eve to do it instead of the slow and expensive Harry the Human.


It's like in Superman III.


There's no counter argument here nor does this come across as informed or educated. All you've done is talk about the process with as many technical words as you could without actually saying why 15ms liquidity gives us anything.

Apart from mini-crashes. And massive profits for companies that create nothing and actually were the cause of the recent financial meltdown.

Which is why many of us sit here scratching our heads or make sarcastic comments like the op.


I read his comment without any trouble. I don't work in finance but I'm perhaps a little more familiar with it than the typical HN reader. It certainly didn't come across as an attempt to snow the thread with jargon.

A careful reread generates this list of domain-specific terms:

resting orders, liquidity, HFT, passive trading, cancel, execute, spread, market making.

Most of these mean what they sound like they mean. If "liquidity" is complicated, it's also the topic of the whole thread. "Passive trading" is probably the closest thing to jargon in the whole comment.

It would be better if nobody made sarcastic comments, wouldn't it?


His complaint was that the post failed to explain why 15ms liquidity has any value, not the terminology. I didn't detect any sarcasm there.


I think if you read his comment just a little more carefully you'll see what I was responding to. I don't have a "side" in this particular debate.


I totally don't understand what you're on about, sorry. Paul summed up my point perfectly.

You seem to be forming a habit of ascribing things to me I didn't say. It's getting a little embarrassing/annoying.


> Apart from mini-crashes.

The Flash Crash was caused by the NYSE's faulty time-stamping system. It essentially broadcast false information that caused traders to think there was an arbitrage opportunity. This was entirely the NYSE's fault. See here for details: http://www.nanex.net/20100506/FlashCrashAnalysis_Part3-1.htm...

> And massive profits for companies that create nothing

They prevent you from paying even more to corrupt exchange specialists. This creates billions of dollars a year in value. They also have a neat ability to help the market recover from irrational crashes in 20 minutes, instead of lingering there for days or months while everyone is too scared to provide liquidity.

> and actually were the cause of the recent financial meltdown.

HFT is completely unrelated to the financial meltdown. The financial meltdown was caused by a housing bubble. HFT market makers don't even trade mortgage-backed securities. Those were traded over-the-counter (basically via phone calls) by investment banks.

If you don't know what these words mean, then look them up instead of complaining about it. If you want to make a point, it is your obligation to understand the subject matter. Don't argue about things you don't understand.


"All you've done is talk about the process with as many technical words as you could"


Apart from mini-crashes. And massive profits for companies that create nothing and actually were the cause of the recent financial meltdown.

Could you explain how low latency trading caused either of these things?

I'm particularly curious what relation you see between low latency trading in various computerized exchanges, and a financial meltdown primarily involving OTC trading in heterogeneous derivative-like equities.

By the way, to answer the question, 15ms of liquidity is just as good as 100ms or 1 sec of liquidity. The ordinary trader doesn't care about latency, latency is purely a game between HFT's to see who will receive the profits from selling liquidity.


"By the way, to answer the question, 15ms of liquidity is just as good as 100ms or 1 sec of liquidity. The ordinary trader doesn't care about latency, latency is purely a game between HFT's to see who will receive the profits from selling liquidity."

I think this is the crux of why people think HFT is a net harm to the economy. They're devoting many millions or maybe billions of dollars to this stuff, and presumably making a hefty profit for it to be worth it, and it actually makes zero useful impact on the market? Yeah, that pisses me off.

I have no problem with the financial sector being overpaid if they actually provide value to the economy. Capital allocation is a necessity and nobody's claiming that soviet-style planning would be superior. But HFT looks to me like they're just sucking little pieces out of everyone else's trades, while providing no value to society.


Without getting into whether we're paying too much of a premium to the financial industry to make the economy more efficient (for instance, by enabling you to get a 15 year mortgage on a house with 20% down instead of a 5-year mortgage with a balloon payment):

HFT makes a profit off the trading spread. The spread is "friction" in the market. It's the gap between what one person wants to spend and another wants to take in for the same good. Every time you make a trade, you cross the spread and thus pay a fee; you're "buying liquidity".

HFTs compete with everyone else trying to make a profit from the spread. The people being harmed most directly by HFTs are themselves trying to extract a fee from normal market participants. Moreover, by competing very effectively, the HFTs are narrowing the spread. They are effectively bidding the price of liquidity down.

It would make sense to be mad at HFTs if the participants they were replacing were mom's and pop's just trying to make a reasonable living while looking out for the good of the whole market. But that's not who HFTs are displacing. The human traders who profited from spreads in the 1980s were often crooked as a carton full of fish hooks. The markets before automation (and the OTC markets today) are riven with people running strategies to skim money off real buyers and sellers.

The more you know about how the markets work and what the incentives of all the players are, the harder it becomes to feel any outrage about HFT.


Yeah, but you'll notice the quote at the top of my post was basically saying that that friction doesn't matter at small enough intervals.

I get that you don't want too much friction in the market, you definitely don't want excessive surpluses or shortages of actual goods and to some extent that applies to securities.

But I see zero reason to care about the price of IBM in even a 1-minute interval. A little friction? Who cares, we're not impeding shipments of goods here, and even if we were, the 1-minute spread on a 6 month lumber future is similarly unimportant, to me at least. That's without even getting into seconds and milliseconds.

Basically, I'm saying that "but, liquidity!" gets less and less convincing as an argument as the time intervals shrink. At a certain point, we're just funding a very expensive and stupid zero-sum game with pennies out of all of our 401k accounts.


Doesn't it make more sense to make a firm argument for "why not liquidity"?

Who exactly is funding this expensive and stupid zero-sum game? Exactly what effect does this game have on your 401k? Isn't your 401k invested in index funds? Don't they trade infrequently and in huge, huge blocks? A no-load S&P 500 tracking fund is not HFT'ing the components of the S&P 500.


Doesn't it make more sense to make a firm argument for "why not liquidity"?

Sure. Why not strip clubs? And blackjack? I acknowledged that liquidity has value it's not an end -- it only has value in as much as it provides value.

I don't fully understand who's funding it, but I know the money comes from trade volume, and a big chunk if not the majority of the money on the market is there from institutional funds, 401ks, pensions, etc. Those that are actively managed get nibbled away at. Those that hold for longer (index funds do rebalance) get nibbled away at less frequently.

What's your hypothesis for where the trade volume that they make money from originates? They're just taking money from the rest of the financial industry?


I don't know where to start. I'm not saying you're wrong, just, I don't know where to start responding. And please feel free to mentally append "as I understand it" to each of these.

1. Funds of actively traded securities are nibbling away at you with or without HFTs. Actively traded funds are evil.

2. HFT market makers aren't nibbling at actively-traded funds. They're nibbling at other market makers. Like I said previously: an HFT market maker is bidding the price of liquidity down, not up.

3. Your 401k is almost certainly not invested in a fund whose strategy is passive trading and selling liquidity. Your funds have positions in the market. Passive traders do not take positions. Your 401k benefits (very marginally) from the tightened spreads created by HFTs. The people who don't benefit are day traders.

4. I have no idea what "strip clubs" and "blackjack" have to do with any of this.


Mostly agree, except:

> Actively traded funds are evil.

Actively traded funds are not "evil." Actively traded funds are the only reason you can buy an index fund and actually expect a decent return. Without active traders, the market would be inefficient, i.e. things would not be fairly priced.


"We" aren't funding anything. We (401k owners) benefit minutely from the reduced friction, but it doesn't cost us anything; if hedge fund A gets their latency down to 1ms and so they get our buy/sell rather than hedge fund B that's running at 5ms, so what? It's not like A charges us any more than B did, and why should I care whether A or B gets the profit?

What's happening is commoditization, which you should be happy about - the only value the HFTs are destroying is their own profits. It's just like if PC maker A can sell hard drives 5 cents cheaper than PC maker B by building a faster robot - sure, I didn't really care whether my hard drive was $120 or $120.05, but I don't lose anything - why do I care whether A or B gets the profit?


"But HFT looks to me like they're just sucking little pieces out of everyone else's trades, while providing no value to society."

This suggests that market participants of any type provide "value to society". Their is only one reason any entity participates in the market, and it has nothing to do altruism, and everything to do with making money for themselves or their clients. Capitol allocation to companies going public is over once the shares are issued via the IPO auction. No transaction on the secondary market results in any money going back to the company that issued the shares. So how does the length of time a firm holds onto a stock before attempting to realize profits define whether or not they provide value?


He's not imputing a direct connection between HFT and the derivatives meltdown. He's implying guilt by association, since HFT systems were deployed by the big investment banks. Of course, so was Powerpoint, which itself probably played a bigger role in the meltdown, so maybe we should ban that too.


For mini crashes, I think an argument can be made about HFT potentially making the stock prices, etc… less normal and more fat-tailed, and thus less well handled by statistical models (e.g. http://www.bankofengland.co.uk/publications/Documents/speech...). Quantifying how much, of course, is another matter.


The financial meltdown was just caused by a deviation slightly larger than the one regulators had accounted for.

Regulators were trying to juggle lots of different policies... relaxing underwriting and reserve capital requirements while pumping up mortgages to help make joe sixpack feel rich so he'd support the war on terror. Such widespread regulatory corruption is unprecedented in the first world.

It is/was a horrible mess, but HFT has nothing to do with it. The bizarre indignation people feel about HFT shows just how gullible people can be to "news" stories.


> However, that simply means they are better and faster than you, not that they are doing anything wrong.

So it sounds like "the only winning move is not to play" if you are a small fish, because you're going to get screwed by people who invest a lot in this stuff?

At least that's what I'm reading in that sort of message. I'm quite willing to be proven wrong, given I don't know much about the subject.


By "not play", let's be clear that with respect to HFT, the game is "active speculative trading". If your intent towards the market is to buy and hold a position, or to liquidate a long-term holding, the fact that there's a billion dollar game of Core Wars happening at the match engines is irrelevant to you except that you will probably pay a little less to execute your trade.


So where's all that cash being thrown at HFT coming from and going then?

Also, just out of curiosity, you seem fairly defensive of HFT - any particular reason? I feel fairly ambivalent about it. I don't like the idea of trying to regulate stuff like that away, but it also appears to be fairly worthless / zero sum after a certain point, to the untrained eye. I'll freely admit I don't know a great deal either, though.


Presumably from many of the same places GETCO's (significant) revenue comes from: by selling liquidity services. Market makers aren't a new concept.

I find financial tech fascinating, have had a lot of projects that involved attacking them (sometimes at a financial-domain level; ie, constructing technology-centric frontrunning schemes by leveraging software bugs), and so have had a chance to learn a bit about the field. Not as much as others on this thread.

I am defensive, it's true, but not about HFT (if exchanges adopted technical countermeasures to prohibit HFT, that'd actually be a win for me: one more thing for my team to test!) What bugs me is the knee-jerk comments, often from people with severely broken mental models of how trading markets work, piling on with "HFT flash-crashed the CDO meltdown" stuff.


The strategic and technical games that go on in the markets are engaging to watch, but they're basically ways of winning the most money (from the investor's/speculator's viewpoint). The more complex they get, and the higher the bid prices for talent which can win these games, the more the talent and energy is diverted from fields that could advance society more (say, basic research, or new product/tech development). So you get more smart kids going to biz school with an eye towards a place on Wall Street, instead of a broader distribution. That's my view on why financial jobs, and possibly large-scale investment, in general should be less profitable - though how to achieve that is a very open question (not sure how well capital gains taxes would work).


The cash comes from traders/investors who are impatient. If you want to trade immediately instead of waiting and hoping for someone else to hit your order, you have to pay the spread. Market-makers make money by allowing impatient traders to transact with them, and then holding the inventory until other impatient traders want to buy/sell it.

This requires the market-maker to take a risk. The spread compensates them for the risk. The size of the spread is (currently, with HFT) set by competition between market-makers. Before HFT, there was much less competition between market-makers, and spreads were hence much wider. Back then, this resulted in the transfer of significant wealth from investors to exchange specialists. In modern markets with HFT market-makers instead of specialists, these transaction costs are much lower, which saves you and your pension fund money.

Example:

Suppose the national best bid on stock ABCDE is $15.17 and the best offer is $15.18. The "spread" is $0.01. (These limit orders were almost certainly placed by market-makers using HFT.)

If you want to buy ABCDE, you can do one of two things: - You can place a limit order to buy at 15.17 and wait and hope that someone sells some to you. - Alternately, you can place a market order that will cross the spread and buy at 15.18 instantly.

The market order protects you from the roughly 50-50 chance that ABCDE prices start increasing and your order never gets filled. It costs $0.01 per share, which is basically paying the HFT market-maker for liquidity (the ability to trade immediately).

Before HFT, the spread might have been $0.05 or even $0.10. You would still have the same two choices, but instead of $0.01, you would have to pay some human specialist $0.05-0.10+ if you wanted immediacy. His father and grandfather would have also been specialists, and his bonus would have been several million dollars that year. HFT market-makers simply out-competed these parasites. There is no longer a monopoly on market-making, so liquidity has gotten cheaper.

Correspondingly, it is cheaper for you to trade (ditto for mutual funds, pension funds, hedge funds, etc.). This allows you to keep more of your investment profits.


If you cancel faster than the market, you can stand first in line for everything and leave the line for those occasions where the trade isn't profitable. I don't see the difference between jumping to the head of the line for Good and standing in every line but jumping out for Bad. And I don't see how line-jumping adds liquidity. A bid I can never hit because it will be gone any time I'd actually want to hit it isn't much of a bid, at least as far as I'm concerned. If it's gone before anyone can hit it, then I think there's a definitional question of whether that's really a 'bid' for the intents and purposes of liquidity provision.

Now I'm not saying such bids are Bad. They could be helpful in all sorts of ways. But I'm not sure that provision of liquidity is one of those.


>"A bid I can never hit because it will be gone any time I'd actually want to hit it..."

Why should they let you hit them when they expect to lose? The HFT firms have some pretty decent traders. They're not going to sit there idle and let you pick them off. If you want to win this game, you have to be better than the competition.


They shouldn't, and I don't expect them too. The point is that someone who is effectively jumping to the head of the line for profitable trades isn't really "providing liquidity".

When I think of liquidity providers, I'm thinking of market makers who post prices at which they either buy or sell, offered long enough to allow other traders to hit either.


I'd like to get a better understanding of this liquidity.

Assume the subset of market participants whose holding period is always > 1 day ("slow"). Assume another subset of market participants whose holding period is always < 1 minute ("fast"). Ignore everyone else in the market.

Do these "slow" participants see any practical liquidity benefit from the "fast" participants? I don't see how.

Financial guys envision these "slow" traders as grandmothers, but remember that most entrepreneurs have holding periods of > 5 years.


The entire point is that there are intermediate holding periods. Think about intraday speculators and statistical arbitrage funds who trade on scales of minutes to hours. They bridge the gap. Further out you have fundamental hedge funds, individual traders, pension funds, etc.


Thanks for the comment - this was the question I most wanted to understand. I realize that durations are on a continuous scale. I personally know people who operate across the full range of durations.

But it's still far from clear to me that grandmothers (aka entrepreneurs) see any liquidity benefit from folks with short holding periods. I'm not saying it's a problem if grandmothers like me dont see a liquidity benefit from HFT. I'm just asking if it exists.


I'll believe that Amazon's network engineers (and whoever else is involved in making their page fast) add value when it takes 200ms to ship products to my home.


So if you remove the restriction on subpenny increments, you remove the need for HFT?


HFT would still serve a role with subpenny increments. Nonetheless, the subpenny rule is a very important mechanic in the construction of HFT.


I agree. I think there is currently a balance to be struck between accuracy of the price determined by the algorithm and the speed at which it obtains that price. I think removing the subpenny rule would just reduce the importance of speed and increase the importance of accuracy. I'd imagine trades would still happen extremely fast though.


Do HFTers pay any sort of commission or transaction fee (to the exchange)?


The common way transaction fees are handled in US equity markets is called the "maker/taker" model. When a participant adds liquidity to the exchange order book, AND that order is executed, they are given a very small rebate per share (they are the "maker"). The other side of the order, the firm who "removed" liquidity from the order book, is charged a very small fee. The difference between the rebate and the fee is the spread the exchange earns for executing the trade.

Note that not all orders that add liquidity qualify for rebates, the rebate may depend on particular order properties as well as the way in which the trade executes.


(not a trader but I've researched it a bit) Yes, often per share traded. A lot of traders use Interactive Brokers which has a few different pricing structures[1].

[1]: http://www.interactivebrokers.com/en/p.php?f=commission


Sub-pennies, negotiated directly with exchanges. They do the same negotiation that Interactive brokers does, except unlike interactive brokers, HFT players can trade 10% of market volume which give them significant leverage.


Last week, Bloomberg published this op-ed defending HFT: http://www.bloomberg.com/news/2012-04-10/high-speed-trading-...

The piece is largely propaganda. A nice rebuttal is found here: http://www.ritholtz.com/blog/2012/04/hft-pirates-and-their-a...

Can anyone explain why multiple exchanges exist (besides for historical or political reasons)? It seems anti-competitive that exchanges can be private at all, let alone that exchanges can be allowed to operate as monopolies in a market or country.


It seems anti-competitive that exchanges can be private at all

"Anti-competitive" is a false (i.e. nonsensical) concept. I mean, if I am a really good golf player, and I just keep getting more and more competitive, do I suddenly cross a bright red line that makes me "anti-competitive" because I'm just too competitive?

It's just a made-up term used to attack business that lots of people have unknowingly bought into.

If it were to actually mean something, it would mean using the government to grant a monopoly. That's the opposite of any kind of private business where two or more parties are voluntarily agreeing to trade. Like, for example, a private exchange.


Anti-competitive behavior would be literally cheating at golf.

In both cases, it has been observed over time that allowing individuals to do whatever they want has a negative effect on the game. You are not required to believe that the rules are necessary, in either business or golf, for them to exist.


Anti-competitive behavior would be literally cheating at golf.

Right, and "cheating" in the real world is defined by fraud and physical violence and their myriad manifestations, not mututal trade to mutual benefit (as on a proprietary exchange, for example). Or offering the best product at the lowest price.

But, that's not at all the meaning of "anti-competitive" as people use it.


It is the position of the United States government, among others, that cheating includes the use of monopoly or oligopoly to unfairly restrict competition in any of several ways which are neither violent nor fraudulent.

You're welcome to argue that that position is misguided, but it is certainly not nonsensical.


You're welcome to argue that that position is misguided, but it is certainly not nonsensical.

I think it's a very commonly held position, and it's understandable that people hold that position.

I think monopolies are impossible or next to impossible except when granted by the government. BTW, I think (not sure) that that's actually the origin of the word "monopoly."

So, yes, monopolists are cheating, and the government is cheating. Of course, if the government permits cheating, it's "dog eat dog," so you have to cheat and/or might as well in some cases. (That, in fact, is what makes the Occupy Wall Street protests so inane, IMHO.)

I believe that in a truly capitalist system, oligarchies would be unable to weild undue influences for the same reasons I think monpolies would be unable to.


> I believe that in a truly capitalist system, oligarchies would be unable to weild undue influences for the same reasons I think monpolies would be unable to.

"Truly capitalist system" is not an economic term, it's a political term. As such it's not very useful in this discussion. It is important to distinguish "free markets" in the theoretical sense from "unregulated markets" in the political sense. Conflating the two just results in confusion.

Monopolies and oligarchies and all sorts of anti-competitive structures arise naturally in unregulated economies. For example, monopolies arise in any market where the marginal cost of providing a good or service continues to decrease without hitting a floor. Natural monopolies also arise in situations with significant network effects. Telecoms are the pedagogical natural monopoly.


Conflating the two just results in confusion.

Completely disagree with you here. I use "capitalism" to refer to an economic and political system, and I think people who use the terms the way you are are the ones introducing confusion. There are economists on both sides of this, as well as philosophers, so having clarified, we should stop this kind of discussion. What I mean is, if you are already so convinced of the rightness of this many things that I disagree with, I don't think HN is going to be a productive place for further discussion.

Monopolies and oligarchies and all sorts of anti-competitive structures arise naturally in unregulated economies.

I completely disgree, but I think we disagree on which usage of most of the words in that sentence is proper and which is invalid. (All the ones that aren't just glue words.)

I know you've read this stuff in economics textbooks. I'm already aware that I disagree with those particular textbooks.


You can have that opinion, of course -- although I'm very skeptical of any such absolute statement about such a complex system, and I feel it's willfully ignorant of the history of antitrust law -- but it's not really relevant.

Monopolies are not illegal; if I make the best widget, I can be the only person selling widgets. It's illegal when I use my monopoly to stop competitors from selling their own widgets.

If you believe that this situation is impossible, then the law is irrelevant, and it shouldn't bother you any more than laws against walking your elephant without a leash.


I feel it's willfully ignorant of the history of antitrust law

FWIW, I've spent a huge chunk of time studying ethics on my own. It's true that I can't claim to know a LOT of history about antitrust law. But the reason it's possible to make sense of "complex systems" is the use of (correct) principles about how they work, not examining every concrete example ad infinitum and saying, for example, "well, but maybe the ball will fall up next time". Anyway, putting aside the philosophisizing, I have more specific comments below.

It's illegal when I use my monopoly to stop competitors from selling their own widgets

My point is that your only means to do that is to use government force, i.e., laws. (Now there's a principle for you!)

Now, I might obfuscate the design of my widgets so that only I can make other widgets that interface with them. But that's not the same thing. For example, that doesn't stop others from making their own entirely separate system of interconnecting widgets. Similarly, Apple controlling what's in the App Store doesn't stop Google from creating it's own app store and controlling it's content. One might say that Apple "has a monopoly on content of the App Store," but that's using the term "monopoly" disingenuously.

This is not supposed to be a complete proof of anything, but it's supposed to suggest my line of thinking.

If you believe that this situation is impossible, then the law is irrelevant

Quite the opposite. The law is highly relevant because it's what makes the "cheating" possible. For example, if Apple got the government to bad the Google Store. Or if the EU bans Microsoft tightly bundling IE in Windows, for a real example.


> My point is that your only means to do that is to use government force, i.e., laws.

You are mistaken.


How so?


Antitrust law came about because near-monopolies had formed in the late 19th century.

Microsoft was almost a monopoly and tried to use that monopoly to shut out competitors in adjacent markets.

This is just speculation, but I suspect Microsoft's life-saving investment in Apple could only have happened after they had been targeted by antitrust law. Otherwise Bill would've told Steve to get lost.

Would Apple still exist if not for antitrust law?


I addressed some of this in detail in a more philosophical manner in response to a "sibling" comment of your comment, so I'll just be more specific here.

I believe that if it were not for various antitrust action (in both the EU and the US), MS would have continued bundling IE with Windows in a way that made the two inseparable. This would have led to the collapse of the Windows, because IE was too bug-ridden and security-vulnerable at the time, just barely acceptable. There had to be a separation of the two for Windows to remain viable. The EU had a particularly harsh ruling on this, IIRC.

Were it not for the EU, Linux, Solaris, BeOS, Amiga, or something else would have suddenly become much more important and would have taken up the slack. In other words, antitrust action may have "accidentally" saved Microsoft from their own mistakes.

I actually think this theory is plausible. (I know I actually was driven away from Windows because it was too virus-prone, and yes, this is for technical reasons, not just being the most used.)

Maybe MS and Windows would have survived just fine anyway. But the true moral of the story is, MS fundamentally cannot achieve a true monopoly in the operating system market, unless they get the government to ban all other operating systems. Unless other operatings systems become illegal, somebody else can always make a new one.


I believe that if it were not for various antitrust action (in both the EU and the US), MS would have continued bundling IE with Windows in a way that made the two inseparable.

"Would have continued"? MS still bundles IE with Windows and uses its backend rendering tech in the system. The decision made by the court was that they had to provide access to "secret" APIs, not that they had to stop bundling IE.

This would have led to the collapse of the Windows, because IE was too bug-ridden and security-vulnerable at the time, just barely acceptable. There had to be a separation of the two for Windows to remain viable. The EU had a particularly harsh ruling on this, IIRC.

But there was never any separation! All copies of Windows with the sole exception of Windows 7 in the EU come with IE as the default and only browser. The HTML rendering technologies are still the same (Trident). And IE is still the most used browser.


The decision made by the court was that they had to provide access to "secret" APIs

What did those APIs do? If they were APIs that one would need access to to make a competitive alternative to IE for Windows, then my story would be surprisingly accurate given the little that I remember. To be clear, the case I'm remembering greatly predated Windows 7.

Anyway, maybe I just got the story from some shitty pop news article many years ago and it's all wrong. But it stands as a hypothetical rhetorical device in the discussion about monopolies.


US steel was a near monopoly (70% of the market) not though government regulation but simply by buying up the competition. It was also lost market share to more innovative rivals.

ALCOA was the opposite they become a monopoly by out competing everyone else.


In case it wasn't clear, the way I define monopoly is synonomous with coercive monopolies. So I would not consider 70% marketshare to be a monopoly, and in most cases I would not even consider 100% marketshare to be a monopoly. Likewise, in the vast majority of the types of cases you're raising, I don't consider it to be a problem.

With US Steel and ALCOA, if these companies were in any way not serving the needs of the market, it would be perfectly feasible for competition to successfully enter the market. (Maybe that's what you're saying too.) Assuming they were not using government regulatory capture to prohibit the operations of their competitors (which, actually, is practically universal these days, and is precisely what I do consider to be a monopoly).


Your redefining the term. In law, a monopoly is business entity that has significant market power, that is, the power, to charge high prices. http://en.wikipedia.org/wiki/Monopoly

While, I get where your coming from. If you want to redefine a term use a new word, I would suggest Monopower if you don't want to say coercive monopolies.

PS: The reason you don't need 100% market share to count as a Monopoly is once your competition can't meet the full needs of the market so you can increase prices which in theory causes a loss of market share, significant barriers to entry can dramatically slow this process down. If the barriers to entry are high enough you can fluctuate between high prices -> slightly below market prices -> high price to prevent the competition from affording to expand quickly or even drive them out of the market as they must conserve cash to survive your dumping product on the market.


I'm not redifining the term, economists are. Here is an etymology from dictionary.com

monopoly : "exclusive control of a commodity or trade," 1530s, from L. monopolium, from Gk. monopolion "right of exclusive sale"...

The people who have started using "monopoly" to mean "significant market power" and the like were doing a bait-and-switch to try to further an anti-business academic or political agenda. And most of the arguments you hear using the word "monopoly" imply the older definition that I'm using, but apply it to much looser definitions. For example, MS was never even remotely close to having a monopoly on operating systems. In fact, such a thing is not even really fathomable.

PS: The reason you don't need 100% market share to count as a Monopoly is once your competition can't meet the full needs of the market so you can increase prices which in theory causes a loss of market share, significant barriers to entry can dramatically slow this process down.

I didn't quote your entire paragraph, but I'm referring to all of it.

This kind of reasoning (which is reasonable and extremely common) is totally rationalistic (which is properly defined, by the way, as being an argument that seems deductively valid but is divorced from the way reality really is). I could talk about this at length, but I'd rather just give a short example for now. Imagine I'm a big business. If I'm consuming a particular kind of product as an input to my production, and one particular supplier charges a very high price, it wlll be greatly to my interest to either invest capital to produce it on my own, or (much more likely) seek out new producers to enter the market. If the existing supplier then tries to manipulate prices to drive the new competition out, only planning to raise them right after, I'll just see through it and continue purchasing from the new producer. A group of companies in my industry could even come to a mutual agreement of this sort to ensure that new competition enters.

The point is, in a capitalist (that is, politically and economically laissez-faire system), people don't just keel over when there are problems in the market, if those problems are actually big enough to be worth solving.


By the 1530 definitive it's the ability to control not the act of control. Historically, governments have granted monopoly's for various activity's, that did not mean someone needed increase prices just that they had the ability to do so should they chose. Obviously after being granted the power most chose to exercise it and become weathly, but not all.

More recently manufacturing has enabled company's to create capabilities though investments that are not easy to duplicate.

Intel is the only company on the planet capable of manufacturing 22nm chips at scale. Other companies can do 28nm and given time other companies will catch up. But, their Monopoly on 22nm chips has nothing to do with patents and is dependent on the incredible multi billion dollar investments required to manufacture at such scales. 14nm Fab's are expected cost more than 5 billion dollars per facility, and vary few institutions can afford such investments. http://www.kitguru.net/components/cpu/carl/intel-plan-fab-42...

PS: In 5 years 22nm manufacturing will be yet another commodity process, but by then Intel will have moved on. Intel has no interest in becoming a true monopoly, in large part due to the legal limitations that monopoly's face. However, that does not mean if the law was revised they could not rapidly do what Standard Oil or Alcoa did.


"Anti-competitive" is a well-defined term in the law that reflects behaviors that undermine the "perfect competition" assumption of certain economic theories regarding efficient markets.

It's definitely possible for private agreements to be anti-competitive in the sense of undermining efficient markets. Collusion to fix prices is the pedagogical one.


I understand that, and I maintain both that the term is invalid in the way it is commonly used, and that that kind of regulatory behavior shouldn't be part of the law.

I've discussed this quite extensively in other comments descending from the one you're replying to, which you can find if you want, and I don't really want to start another separate branch of commentary.


The rebuttal at ritholtz.com is largely propaganda as well. It was penned by the brokerage firm Themis Trading who has been on a crusade against private exchanges, HFT, reg NMS, and pretty much any change in market structure that could negatively impact their business model. Not only that but the post simply lists properties of the equities markets and implies they are bad. For example:

"-the IOI’s that dark pools send to each other"

If IOI's are bad, why exactly are they bad? The post fails to explain the "why" for any counter argument it presents.

One additional rational not previously mentioned for multiple exchanges is redundancy. Reg NMS allows trading venues to match orders of listed securities from other markets. Because these markets compete as liquidity centers it behooves large market participants to have direct connections to all of them. If the NYSE has technical problems (this happens more often than you may realize, to all the exchanges) trading in NYSE listed securities continues unabated on the other platforms.


That's not a "nice rebuttal", that's some bullet points spat back. Whereas the original linked article in this discussion provides some context and explanation, the bullet points in your second link are meaningless to the layperson (e.g, me).


...the original linked article in this discussion...

Do you mean the Chris Stucchio piece? Because, despite it being an apology, it doesn't justify how HFT is socially beneficial. This piece makes hand-wavy claims about liquidity, and says that it will better justify HFT in a coming blog post.

As for the Bloomberg piece defending HFT, it fails to address a few issues that the SEC and critics have with HFT. These issues are enumerated in the Ritholtz blog post. Pointing out certain facts that an argument ignores is a valid rebuttal.


Jiminy! Chris Stucchio is 'yummyfajitas, one of the oldest contributors on HN. He was a dev for an actual HFT firm for a bunch of years before doing a totally unrelated startup.

Could he just maybe write a post and spark a discussion about how his field actually works so we can learn something about it?

I DO NOT UNDERSTAND this HN mentality that equates "learning more about X" with "joining the death cult of X". And it comes up all the time: no, we can't discuss how SEO works, because that would make us morally black hat SEOs; no, we can't discuss how HFT works, because that would make us morally Goldman Sachs executives; no, we can't discuss how a law is written, but that would mean we want to give the Internet to the MPAA.

The particular mode of argument in your comment and many like it on this thread is directly counter to the whole idea behind this site and every other worthwhile message board on the Internet. Yes, we get it, you don't know who G.H. Hardy is or didn't pick up on the joke in the title --- but it's obvious from the rest of the post that it's trying to explain how things work, not make a case for why it works that way.


I see you're at the end of your rope too. The "must not know" and "more important to be right than correct" mentalities are really starting to kill it.


My rope is long and sturdy but it's giving my hands some serious burns.


This piece makes hand-wavy claims about liquidity...

The word "liquidity" doesn't appear in my blog post.

All I made were very concrete claims about how a matching engine works (all of which you can verify from the sources I listed) and some explanation of how why being faster helps HFT's to make money.


I'm sorry, I didn't intend to put words in your mouth. I read your piece thinking it was going to present some justification for HFT. In your first paragraph you state that the point of this post is "merely an intellectual justification of a field which is often misunderstood." But then you don't directly justify HFT in the post, instead explaining the mechanics of HFT and market making. This is great; you explain it well.

However, I was still looking for the justification promised in the opening sentences. So I look for the subtext in your technical explanation that would justify this oft misunderstood field. I clearly misunderstood your justification for HFT. What is your justification for HFT?


From paragraph 2: "In future blog posts, I’ll attempt to justify the social value of HFT (under some circumstances), and describe other circumstances under which it is not very useful."

From paragraph -1: "In future posts, I’ll discuss it’s societal utility and costs."


These issues are enumerated in the Ritholtz blog post. Pointing out certain facts that an argument ignores is a valid rebuttal.

Perhaps to those that already understand the significance of those facts. But to people who want to learn, it's not useful.


Can anyone explain why multiple exchanges exist...allowed to operate as monopolies in a market or country.

Which are you complaining about? The fact that we have multiple privately operated exchanges, or the fact that we don't have a single government-run monopoly on exchanges?


I don't think he was complaining. I think he asked a really interesting question. What's the benefit of multiple exchanges?

It isn't obvious to me that multiple exchanges are either good or bad. If it is obvious to you, I'd love to hear a technical explanation.


I'm personally confused that we could even ask this question.

How could you not have multiple exchanges? They don't sprout out of magic beans; they're markets. Inherently, they're groups of people deciding to do business with each other. Almost the only thing that makes them substantively different from a farmer's market is standardized contracts.

In the stock market of the 1950s, if you were a naive corporate buyer or seller, something like 10 different kinds of market participants could (and would) fleece you on every transaction. You probably couldn't even get a quote without getting hit by some kind of scam.

How much better would the markets be today if we had taken the 1950s system and granted it a monopoly?


Actually, it IS just one big distributed exchange since Reg NMS requires each ATS to route an order to a rival with a better price.

This is good, because new ATS's dont need to worry about network effects and can compete on features.

On the other hand, this required functionality could limit the set of possible new features. For example, it may be difficult to implement some way to discretize or slow down markets to remove any unnecessary advantages conferred on HFT traders, because of this mechanism.


NASDAQ got caught in a price-fixing scandal in the mid 1990's. Part of the fall-out from that was Reg ATS, an SEC regulation that permitted "alternative trading systems" who eventually became ARCA (bought by NYSE Euronext), INET (bought by NASDAQ OMX), BATS, and Direct Edge. These four venues have spawned an enormous amount of innovation in the market space that NYSE and NASDAQ simply wouldn't have done without competition. Electronic order matching, market-maker rebate schedules, and equal opportunity for displaying liquidity all came from the ATS's.

Without the market fragmentation, we'd still have "specialists" controlling stock prices physically from the floor of the stock exchange.


Thanks - alternative trading systems can surely only come into existence if they offer a clear advantage, and of course this drives the evolution of the markets. That's great.

My question: how much do network effects matter. Internet guys always assume network effects are a primary force in marketplaces. I'm an Internet guy, so I can't help but have this bias.

It's fascinating to me that there are so many ATSs. What's the endpoint? Will we eventually see hundreds of ATS's, each with some benefit valued by some arcane subset of traders? Or can an individual ATSs incorporate the range of improvements, and through network effects crowd out the others?


The four ATS's I mentioned all became full exchanges. ARCA and INET got bought by existing exchange operators, while BATS and Direct Edge were cleared by the SEC to be exchange operators. These four all exist after a massive wave of consolidation among the ATS's from the past decade.

There are also dark pools, whose innovation is that they don't display quotes. Every large brokerage has a dark pool. I wonder if there will be consolidation there; it's anyone's guess at this point.

As for network effects, Reg NMS requires an exchange to route an order to a rival if the rival has published a better price. So network effects are less important than you might think outside the dark pools. The features that really attract market makers are things like fees and likelihood of getting a fill (ie, priority rules).


Thanks! I didn't realize that exchanges need to route orders to any other exchange with a better published price. That's a great rule. I assume that most ATS's are located within a short distance of each other.

Really helpful post. Thanks for the information.


> "I assume that most ATS's are located within a short distance of each other."

... if only. Reg NMS is a massive headache. This sort of price convergence would be better left to the arbitrageurs. Let the market deal with the light speed issues instead of trying to regulate physics.


Fascinating. Even more interesting. Thanks for the information.


> What's the benefit of multiple exchanges?

Free open markets, anyone? Multiple exchanges ensure that the markets are not controlled by any one exchange, which can use its monopolistic advantage to increase costs by levying high fees etc.

Furthermore, if one exchange does something shady like front-running, or preferential information sharing with its "partners", then people can just move to another exchange. Basically, multiple exchanges make the markets more honest.


One benefit of multiple exchanges is that company owners can choose to offer trading of shares of the company they own on whichever exchange they think would do their company best.

Some people in this thread have expressed that they think a discrete-time market (where trades are executed at certain time ticks, instead of continually) would be beneficial. If these people were to IPO their company, they could choose exchanges that use this approach.


I believe multiple exchanges do foster competition and innovation. I believe NASDAQ was one of the first computerized exchanges in an era when human traded in the pits.

Multiple exchanges allow customers to choose from better trading fees, execution times, colocation offering, etc.


Multiple exchanges allow customers to choose from better trading fees, execution times, colocation offering, etc.

I'm not sure how big of a plus this is. Most people wan to expend effort on picking the right stocks to buy or sell, and while they want low transaction costs the price of too many alternatives is increased complexity.


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