Comment by patio11 | Hacker News Reader

Comment by patio11 | Hacker News Reader

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I would have agreed with you prior to hearing this argument: if someone's pension fund wants to trade 10,000 shares of a stock with a 2 cent spread, then in the next few seconds market makers are going to make $200, guaranteed. The only thing HFT changes is who the marketmaker that pockets the $200 is going to be: some day trader in the bathrobe, market maker at the exchange, automated proptrading strategy, or a sickeningly optimized HFT bot which measures execution times in nanoseconds. Either way, the pension fund is going to transfer $200 to marketmakers.

What you should be worried about is your pension fund actively trading, which it is doing because it is being managed by someone who takes ~2% off the top every year and who has to justify this by showing they can beat all these damnfangled machines at stock selection. They'll almost certainly underperform the index over time and overcharge index funds by about, oh, 180 basis points or so, precisely because they insist on conveying your wealth to marketmakers every time they trade.

Umm, yes and no.

Example, I'm Fidelity Bob Fund Manager; after extensive research, I decide to make a decision to buy 200,000 shares of AAPL. So I enter my buy order into my OMS screen, which slices and dices these 200,000 shares into blocks of 100 shares (as for traders not to front-run me, because a naked buy order of 200,000 shares will drive the price up and I'll overpay long after my transaction is completed).

HFT program meanwhile is actively scanning the quote book on all market centers for patterns of such a huge "whale order". Bob Fund may leave discriminating traces of evidence, such as executing the same blocks of buy order under my unique MPID multiple times. Or the HFT program is hooked up to a dark pool where it's constantly sending out small sell orders for 1 share to try to sniff out and match Bob Fund's huge buy order. Or it just might be that the HFT program has reverse-engineered the Bob Fund's VWAP algorithm for slicing/dicing orders and can detect how the orders are being sliced/diced under any given market conditions.

Once the HFT algorithm is certain of a "whale order." It'll actively go out to every single market center, buy up all of the remaining AAPL liquidity on those markets and then present it to Bob Fund (voila! I'm providing you with liquidity at artificially inflated price!). Mr.Bob has no choice but to buy AAPL at a maybe a penny or two higher than what he could have paid for without HFT.

The flip-side of the argument for HFT traders are that perhaps, they are better dealers than traditional dealers. For all we know, there might not be any interested retail investors who are willing to trade with Bob Fund; so Mr.Bob ends up trading with traditional dealers which have traditionally higher spread on the price of their stock, as they take on more risk as a dealer because they don't have the same execution speed and high-turnover rate as a HFT dealer. Also, HFT increases nominally execution speed and brings all market center's prices in line, as if there is a NBBO on ARCA and Bob Fund's order is on BATS, HFT will essentially act as the middle-man to match the true best bid and offer together, in the quickest time.

However, the other counter argument against HFT is that it actually doesn't really provide liquidity to the market, as evident by the June flash-crash. During a situation such as this, broker-dealers are suppose to step during irrational exuberance and depression and trade with irrational investors and put a stop to the crash/rise. But HFT dealers stopped trading that day, triggering a lot of people's stop-market orders and hence we saw ridiculous sell orders of Accenture at $0.01.

So I'd say, HFT is a mix-bag.

There are two sides to every trade.

The sophisticated Bob fund is trying to fool the markets into thinking that demand for AAPL has not increased. I.e., Bob is trying to keep inside information hidden and trade in such a way that he captures all the profits from this information himself. A predatory trader (algorithm or human) will bid up the prices, thereby capturing part of the gains of trade for themselves and part of it for the other market participants.

So basically, while Bob pays more, the retail investor Bob is buying from receives more (and of course, the predator takes a cut).

Ah, but your point is more philosophical than technical.

Who should SEC and public interests side with? Bob, the retail investors Bob trades with, or the HFT/professional broker-dealers that Bob trade with?

Bob would argue that public interests should ultimately place the highest priority with him, as he represents the "pension fund and 401(k) accounts of the hard working American public." (Never mind the fund fees, soft dollars & insider trading)

The retail investors argue that public interests should ultimately rest with them. What how do you define retail investors? The long-term investors that trade blue chips and the day-traders with IB accounts? How are the day-traders with IB accounts different from professional broker-dealer except that they are typically less sophisticated but both out for blood? Should you really let the inmates run the asylums.

The broker-dealers argue that public interests should side with them. Because they are the psychiatrists of the asylum that could orderly organize the inmates, make that the mental hospital is well-run and efficient place. But can you trust people when they have so much more leverage and power at a place? And but if you do away with them, wouldn't mental asylum collapse?

> However, the other counter argument against HFT is that it actually doesn't really provide liquidity to the market, as evident by the June flash-crash.

As far as I can tell, this is the only argument presented against HFT.

> But HFT dealers stopped trading that day, triggering a lot of people's stop-market orders

Are there other factors involved in this outcome, or is this a canonical HFT failure?

> As far as I can tell, this is the only argument presented against HFT.

The argument is that HFT provides liquidity precisely when traders don't need it. You need broker/dealer to step in and take the other side of the trade when someone wants to trade and there isn't anyone else willing to trade. The issue with HFT is that, as the predatory example provided above, that HFT is actually buying up your liquidity in the market and selling it back to you at a higher price. Specifically, most HFT prop shops deals in ETB (easy to borrow) stocks such as GOOG, AAPL, & BAC where tens of millions of shares are traded daily. These securities don't need liquidity broker/dealers, as there are already tons of true buyers and sellers out there. Are there any HFT dealers in penny stocks or small caps where some liquidity would be much needed? Nope.

> Are there other factors involved in this outcome, or is this a canonical HFT failure?

Nope. The reason a lot of dealers stopped trading that day were tactical. A lot of stat-arb prop shops got burned during when Bear collapsed, one black box decided to sell everything which cascaded another black box to sell everything, which cascaded to everyone wanting to dump everything. So from that experience, HFT shops decided to not hold any positions beyond seconds and shut down everything when market crashes seriously. So they provide liquidity when the market is doing well, but when the shit hits the fan, self-interests also hits in and the "liquidity-providers" head for the hills.

Are there any HFT dealers in penny stocks or small caps where some liquidity would be much needed?

False. There are long tail funds, I believe tradebot works on the long tail (among many others).

The thinly traded stocks have better spreads and less competition, which means there is money to be made.

Incidentally, most HFT firms stopped trading on may 6 due to a fear of broken orders. If you buy at 5, sell at 10, and the market goes up to 15, you could wind up losing $5 on a short position if your buy order is broken. Unfortunately, broken orders are impossible to predict algorithmically, since humans came up with the criteria for order breaks hours later.

On the topic of the Flash Crash:

Arguing that HFT is bad because people sometimes stop doing it abruptly kind of suggests that HFT is good when people are doing it.

But HFT dealers stopped trading that day is not entirely true. Some HFT traders (not dealers) stopped at the flash crash, but others stayed in, partly because they were obligated to due to their liquidity agreements with the exchanges, and partly in retrospect to make bags and bags of money. If the latter were not in the market, you would not have seen the flash-uncrash that was the recovery, and it would have been 1987 all over again.

Yes. You are both right and wrong. Dealers are obligated by their contractual agreements to make offers to trade; but what exchanges didn't specify are what prices their dealers could offer for their trades.

If the dealers don't want to trade, they just make their buy and sell limit orders to be way out of the normal price band. Hence, I want to buy Accenture at $0.01 and sell Accenture at $1000. Yea, I'm meeting my exchange contractual obligation, but who's going to trade with me now?

What happened during the flash-crash is that people's market stop-orders were getting triggered after the initial crash, when the market went down 20%; when all other human traders stepped out of the market, but there were still tons of market stop-orders to sell; guess whose limit buy orders were matched? Accenture buy order at $0.01.

To be fair though, a lot of those ridiculous trades were later busted by the exchanges. But the irony of the whole crash is that the HFT traders actually fanned the fire on the crash and then later rode the wave all the way back up (for the trades that weren't busted anyways).

But the irony of the whole crash is that the HFT traders actually fanned the fire on the crash and then later rode the wave all the way back up (for the trades that weren't busted anyways).

You are conflating two separate groups:

A) Conservative HFT funds who left the markets due to a fear of broken trades.

B) Risk taking HFT funds who stayed in the markets, hoping to make money off volume/higher spreads.

Group A "fanned the fire" by pulling liquidity out of the market. Group B "rode the wave", and in the process mitigated the flash crash [1].

It's a fallacy to lump all HFT firms together.

[1] The market crashed and corrected itself in 10-15 minutes. Without HFT firms, it's likely that it would have corrected itself much later (if at all).

Exchanges like HFT because they make the markets work: http://www.reuters.com/article/idUSTRE65T5IF20100630 From that article: Shortly after the flash crash, U.S. exchange executives told the SEC these firms help keep markets functioning.

Playing games with prices is not providing liquidity.

If you look at http://batstrading.com/ and click through to the fee schedule, you see that Bats pays liquidity providers $0.0024 rebate per share traded.

Yep. That's true, but not because the exchanges are altruistic - but because the exchanges are trying to compete against each other for the greatest volume.

BATS is the latest new-comer to the game and it attracts volume to its exchange by attracting HFT firms who have the highest trade volume with rebates. In fact a lot of these firms don't even try to make money anymore, as long as you have a strategy that breaks even and you collect rebates and trade enough volume. You make a profit.

The definition of liquidity becomes pretty fuzzy here when you have HFT take away liquidity from one market center to offer it to the next depending on how various rebate structure will make them the most money; and exchanges themselves in collusion to pump up their trade volume.

  The only thing HFT changes is who the marketmaker 
  that pockets the $200 is going to be [..]

And the amount of times they step in and take that $200 out of the market. In earlier times, when there weren't many market makers yet, the 2 cent spread would often sort itself out, without someone stepping in and pocketing those $200. Market makers don't just pocket the 2 cents: they pocket them every single chance they got, even when the market would have sorted itself out. I'm sure they improve the liquidity of the market (or how do they call it?), but it's likely we are long past the optimum, where they just step in when it's necessary to improve the liquidity. Why else would hedge fund profits have skyrocketed, without any measurable improvement in the market?

In earlier times, the spread was considerably higher. So instead of an HFT firm earning a $0.02 bid/ask, a human on the trading floor might be earning a $0.05 bid/ask.

If you don't want to pay the spread, you can place ALO orders and you will NEVER pay the spread. Your order might never be filled, however.

The $0.02 spread you pay is the cost of getting filled right now. Pay it or not, it's your choice, but remember that immediacy isn't free.

  The $0.02 spread you pay is the cost of getting filled right now.

The cost of it getting filled right now against the maximum spread they can find, even if that means executing a dozen obscure orders that cancel each other out in such a way that the spread can be reaped.

If HFT's are actually creating value (or preventing value from being lost), they are immediately cashing all of it. I'm not sure that counts as something good. Inevitable perhaps.

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