Most of the complaints I've seen are to do with the fact that HFT is t "fair" to Mr. Joe Trader, in terms of them having an advantage. My argument is that Mr. Joe Trader is at a disadvantage compared to professional traders, regardless of trading mechanism...
No, but when the new "rigging" actually improves the situation for retail investors at the expense of increased costs for hedge funds, it becomes hard to make simplistic comparisons.
The public markets are a series of zero-sum games. When you fully understand this, it becomes apparent that almost any profit-making strategy for engaging with them can be described as a form of "rigging". Every dollar Virtu makes has to come out of someone else's pockets.
The important thing to know is "whose pocket".
People on HN love to play six-degrees-of-Mom's-retirement about this issue. That game doesn't actually work. Consider two scenarios:
(a) By increasing the cost for billion-dollar broker/dealers to shop blocks, electronic trading systems are making it more expensive for mutual funds to trade and thus extracting rents from the hides of pension funds; the pockets picked are ultimately those of ordinary Americans.
(b) By preying on naive market-making strategies, electronic trading systems are disrupting an entrenched cartel of billion-dollar market players, and in the process driving trading spreads to historic lows without measurably impacting volatility in the market; the pockets picked are those of other, more brazen pickpockets.
The difference between (a) and (b) is crucially important. If the status quo ante is bad, and the new situation is better, then organizing against that change is a positive action taken in favor of unfairness.
Since I noticed previously you were also reading Dark Pools (commented in another thread), I found that book to pile up evidence for (b) as well. Do you have similar takeaway from Dark Pools? In particular, in the early days of electronic trading, that book clearly makes the case that the hackers (or maybe mainly Josh Levine) were completely focused on disrupting a corrupt and "good old boy" network driven trading system.
But (and I say this after having read both the Lewis book and Dark Pools), I'm not entirely sure what to think about HFT (or more broadly, electronic trading in general) and market volatility.
It kind of seems like there is going to be some popularly accepted government regulation of electronic trading that my gut tells me will be more acceptable for the "other, more brazen pickpockets" than the new, despite the fact that we think choice (b) is better for investors.
The best thing about Dark Pools is the narrative about the creation of Island and Archipelago and the regs changes that led to the NASDAQ ECNs. There's definitely a clearer "good guy" and "bad guy" in the ECN story: the human market makers are the bad guys in that story, as you can see by their refusal to quote in odd eighths.
HFT is complicated in large part because it's not one thing. The best response to criticisms of HFT is to be wary of anyone who would try to lump a bunch of different entities with different motivations and different business models together based solely on the technology they're using.
Unfortunately, that is in a nutshell what Lewis' book tries to do.
But then you have to make an actual argument stating why HFT would make it more rigged than the alternative would be. The collapse of spreads is a lot more important than speed, for small investors.
Can you explain how the smaller spread is better for the entire system? I'm not convinced that anyone really gains much from these very marginal gains in liquidity other than the HFT entities.
Personally, I'm fine paying 2% more for something if it means that the person I'm buying it from is keeping the money as opposed to some middle-man taking a cut.
There seems to be a lot of unquestioned dogma in the financial world about the efficiency of the marketplace on a macroeconomic scale.
But again, please correct me! I'm honestly trying to learn more about this.
But the person you would buy from is just as much a middle-man as the HFT! Market makers have always existed, and the only difference is that the new middlemen are taking a lot smaller share than they did before. You are no longer paying for fatcat brokers, and HFT bots are a lot less likely to give inside information to friends.
But what about the spread between the actual issuer of the security and the actual investor looking for a long term value store? How does that change? Isn't this minute spread just a result of speculators trading amongst themselves? Pardon me for not making it clear, but I assume that at least one simple market maker is required for the transaction. I'm talking about it passing through more hands than theirs. How does it magically reduce what the fundraiser is willing to sell at and what I'm willing to buy at?
Huh? The fundraiser would get money at the price at the lower end of the spread, and the investor would buy at the upper end, so your question is nonsensical.
The difference is what the market maker takes for providing liquidity (in exchange for providing money now and for taking a risk that the price may change out of the spread range). Spread == price of liquidity.
What I'm asking is, how does HFT lower the spread?
The spread is just the difference between what one person is willing to sell and another willing to buy.
If it's Monday and I'm trying to raise money for a venture by selling shares at a certain price, and some other dude has extra money laying around but wants to buy it for less, that's the spread, right? I either sell for less directly to the retail investor or a market maker happens to come in to the picture and I happily get to sell to him at the price I wanted to. He thinks my price will go up by Friday and that these other dudes will definitely be willing to pay more for the shares that he did by then. At which point he will profit, right? But that never changed what I was willing to sell and some dude was unwilling to buy at on a Monday. How does HFT affect all of this?
HFT lower the spread by being a lot better and more competetive at what they do compared to what stock brokers and day traders used to be, in the bad old days.
Not really. The spread is the difference between the lowest market sell price, and the highest buy price. What the market maker (be it a HFT or a human) provides is the ability to sell and get money immediately. If you have the patience to wait (and can afford to take the risk that the market moves in a direction that is not good for you), then you can put a sell order at a specified price. At that point, you are a market maker.
However, most people don't trade like that. Instead, they put a buy (or sell) order at market price, at which point the exchange will match the current orders in a way that is as favourable as possible to the guy that placed the order. The affect of the market maker is that the seller and buyer don't have to be active at the same time, or even in the same exchange. The spread is simply the price the market maker takes for arranging this. Less spread is the same as less cut for middlemen.
First, resting a limit order on the book makes you a liquidity provider, but not a market maker. Market makers are consistently willing to buy or sell, regardless of where prices are; they are long-term neutral with respect to the instruments they trade. They're able to trade constantly without losing their shirts because (a) they deliberately avoid holding a long-term position in what they're trading and (b) they are constantly adjusting their prices to stay in the middle of the "true" bid-ask prices.
It's easy to see that entering a single limit order doesn't make you a market maker; you're willing to trade only if prices match your preferred valuation, which means you have a long-term long or short position for that instrument.
Second, "most" retail investors do enter market orders (orders fulfilled immediately that cross the spread, buying at the best ask price or selling at the best bid price). But sophisticated investors do not do that. Market orders charge a premium for the liquidity they demand, and so sophisticated traders use different order types.
Can you explain why market makers are necessary? Why doesn't the system just pair "true" buyers and sellers"? If there's a spread and neither is willing to bridge that spread, then the transaction doesn't happen. Big deal. Why is liquidity taken as a goal in and of itself?
Because at any given point in time, the "true" (buy-side) investors are likely to be relatively far apart on prices. This is especially true in thinly-traded markets.
The best way to explain this is by analogy to other kinds of markets. For example: consider housing, which is the canonical example of an illiquid market.
I know the value of my house (it's around $300k). Say I want to sell it. The more liquidity I need, the worse price I'm going to get. Anyone with any intuition for the housing market knows that if I have to sell my house tomorrow, I am going to get a god-awful price for it; the "tomorrow" price for my house is many tens of thousands of dollars off its true value.
This creates huge problems for homeowners. The obvious standard advice for sellers is to wait patiently for the best price, counting on many weeks or months before a reasonable offer arrives. But I have to pay money every month I hold on to the house. If I need to move immediately, for instance for a job, or because my financial circumstances have changed, I might need the house to sell quickly, and because houses are illiquid I have to accept a crappy price. Or consider trends in the market: by forcing me to hold the house for months rather than days, I'm maximally exposed to swings in the market. So if Chicago housing prices crater while I'm trying to sell, the extra time it takes to unload the house takes that price swing out of my hide.
(You can easily see how the same thing happens in reverse in "hot" markets like Palo Alto, with the buyer now assuming the role of the hapless Chicago seller).
The exact same thing happens in the public markets; it's just not as intuitively obvious because we're working in smaller deltas of time and price.
But the public markets have a huge advantage that the real estate market doesn't: market makers.
Imagine if houses traded (were bought and sold) so frequently that a smart company could make good educated guesses about the current value of any given house. Imagine if that company would on any given day snap up a house offered for sale. That company wouldn't pay my asking price for my Chicago house, but it would pay something much closer to it than the "true" market would. After buying my house, the company would immediately offer my house for sale at any price greater than what it bought the house for. I wouldn't care, though: either I'd be thrilled for the opportunity to sell my house quickly and painlessly, or I just wouldn't accept their offer and instead do what I do now, which is to wait for the best offer.
Assuming the housing market makers were smart, the money they'd get by forcing me to accept a lower bid would be "free money" they get simply by being smart about valuing houses and having capital available to deploy. We'd all be a little irritated at them for scalping distressed buyers and sellers. But something else will inevitably happen: other smart firms will smell the free money, and they will compete for it. To capture a share of the premiums, all they have to do is offer a slightly more favorable price, so that's what they'll do. Over time, the money the housing market makers will get less and less "free", and the price penalty for immediate liquidity will get lower and lower.
In my fantasy real estate market, I now have the opportunity to avail myself of a reasonable "market" order, or to buy or sell on a "limit" price. I could do that if there were housing market makers, but in their absence I can't, because the price hit for selling tomorrow is too great; it might be a 25% discount on my asking price, or even something close to 50%. That's the cost of illiquidity, or, stated more directly, the value of liquidity.
It's probably also worth saying that liquidity is a presumption of the public electronic markets. Because it's taken for granted, there are whole trading strategies (hedging, for instance) that depend on its presence. These trading strategies face execution risk: if they can't bail out of a position within a specific window of time, they incur losses for the trader.
Well, what's the difference to me if the spread is 0.1% or 2%? Am I really not going to buy?
If I want to buy a security, don't I have to buy it at whatever price is being offered? Sure, some dude can cover the spread on both sides, but if the guys selling it to me just passed it through 50 hands going from the firm that issued the security to get to me, what's the point of all that? Like, I get the point of the liquidity offered by market makers, but I'm just questioning the marginal utility.
How much less likely am I to buy or sell a security based on the marginal decreases in the spread? It doesn't seem like it would be linear. And what effects are caused by having so much complexity between the issuer and the investor?
The difference is whether you pay middlemen 0.1% of the value of your trade of 2% of your trade.
If you can't get worked up over a 100+bp difference in cost of trading, you shouldn't be worked up over HFT, which is operating at much smaller price deltas.
Is a marketplace designed for retail investors that disallows HFT something that would be better or worse for retail investors?
Let's pretend that the marketplace only sells securities with dividends. The people buying them are not interested in their liquidity, only in their ability to store value as well as ofter a steady return.
Why would I want to buy shares in companies in any other type of marketplace?
Can you explain how this hypothetical market would function differently than how our current markets function?
Worse. You don't have to guess: there are two compelling pieces of evidence you can use to evaluate. First, you can look at spreads since electronic traders wiped out the 1/8ths market makers in the 1990s. Second, you can look at the Canadian experiment that increased cost of trades and drove spreads up.
"Type of company" and "marketplace" are orthogonal concerns.
Let's say I'm not interested in spreads or liquidity beyond being able to within a day or two purchase or sell a share that pays dividends on company earnings.
What would make me want to go with a market that offered lower spreads and more liquidity? How would it affect a long term holder?
Isn't there a cost to all of these transactions occurring?
Like, why do I need the spread to be as small as possible? How much is actually saved? How much are the infrastructure costs for maintaing a marketplace that supports these high frequency trades? Isn't there room for a much simpler, low frequency marketplace that had fractions of the operational costs? Couldn't savings be passed on to retail investors with a cheaper marketplace?
Why would you go with a market that offered lower spreads? What a strange question. You'd pick the market that offered the lowest cost of trades, which absent some other fact you haven't named, is the one with the lowest spreads.
There is the opposite of a cost to normal investors of "all these trades" occurring. The volume of trades makes the pricing of stocks more competitive and increases the odds that when you want to trade, someone who agrees with you about the price of that stock will be available to take the other side of the trade.
This discussion keeps waving the term "spread" around like a totem, but in reality the term just captures that paragraph.
The infrastructure required to offer incredibly low latency trades and super high volumes seems like it would cost a heck of a lot of resources.
I'm not convinced that all of these marginal gains makes up for these costs.
I don't get the jump from describing an illiquid real estate market to this hypermarket with millions of trades a second. Are you telling me that it is a linear function? We will always need more trades, and more volume? What about the underlying economic activity? How does this follow any sort of market fundamentals?
Are you really saying there is no upper limit? How could that make any sense at all?
No, there's surely a point at which the marginal utility of additional liquidity stops justifying the expense of providing it. We may even be far past it.
But even if you stipulate that we are, it doesn't follow that interventions to suppress trading will do more good than harm, because we also know that prior to the advent of electronic trading, we had "not enough" liquidity.
Surely the current system is imperfect in many ways, and I'm sure Nash has something to say about the competition among market makers of varying degrees of competence.
"Mr. Joe Trader" might need some definition. For instance, I felt that HFT didn't change the game for "Mr. Joe Trader" as much as the rules limiting daytrading ($25k minimum for margin, restriction on round-trip trades per quarter) did. Now you need to be fairly well off or trade pretty much full-time to be able just to enter the game. Fees may be down but fewer players can play.
