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Comment by williamcotton | Hacker News Reader

I'm always told that HFT makes the bid/ask spread go from 0.25 to 0.01. I'm always told this is a good thing... But why is that?

Let's say we didn't have HFT and we had a larger spread... That means that one of the parties is overpaying, right?

But, aside from the burdens of the individual overpayer, doesn't it make more sense for the overall ecosystem to at least keep that money in the pockets of people who are interested in the long term value of the equity?

What are the overall economic marginal returns on squeezing the spread so thin? Is it possible that it might make more macroeconomic sense to NOT have some other entity profiting off of having created a minutely more liquid marketplace?

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The spread is a fee charged by liquidity providers (market makers) to traders. Whether you trade every day or only once a year, the spread is effectively money taken from the trader and put in the pockets of market-makers.

If you want to disincentivize active trading (more than the market already does, by awarding outsized returns to funds that don't rely on active trading), a tax on trades performs this function more effectively than high spreads do.

Worth noting: during the times when spreads were as high as 0.25, that was in large part the result of collusion between the market makers, who were eventually taken to court over it.

The thing I consistently don't see addressed whenever HFTs are advanced as market makers is the fact that HFTs seem not to actually fulfill one important responsibility -- market makers typically operate under an obligation to provide liquidity, but HFTs seem to have a history of bailing out at times when liquidity is actually needed.

I'm not sure I understand what this means. If the HFTs "took their balls and went home", there would be that much less liquidity available as a certainty. The fact that some electronic orders get cancelled doesn't subtract from the orders that don't get cancelled. In other words: the average spread is the average spread regardless of how many "probing" orders are cancelled, and lower spreads are better.

From what I can tell, these issues come into play primarily in two scenarios:

(a) market orders with traders demanding immediate liquidity at the expense of optimal pricing, and

(b) complicated hedged trades in which traders are depending on the synchronization of two different sets of correlated limit orders.

Well, as I understand it sort of the whole point of a market maker is that you don't "take your ball and go home". Traditional market makers are obligated not to do that.

If HFTs want to be hailed as more efficient market makers, they should operate under the same obligation.

Market markets (human, mechanical, hydraulic, electronic) are obligated to trade, but they are not obligated to trade at any particular price. They survive by constantly repricing their best bid/ask. They do that by... wait for it... canceling resting limit orders, and replacing them with orders at different prices.

The story of the flash crash recovery has players of both varieties. When the dive happened, on trading firm, let's call it 'B' backed out of the market. Another trading firm, let's call it 'G' stayed in. 'G' had to stay in because they were contractually obligated to stay in the market by their market maker agreement with NYSE. So for some HFT, yes, they can and do bail, but others don't.

Another interesting anecdote -- most HFT groups shut off during the flash crash because they were running strategies that were fit on normal market conditions and really had no idea how their algorithm would perform in flash crash conditions. But not all HFTs turned off, and I know of at last two groups that kept running throughout the whole thing (trading equities, futures, currencies) and they made a phenomenal amount of money. Many traders I've talked to severely regretted turning off their strategies, and I've heard the argument that if such an event happens again, we're likely to see a lot more groups continue to run everything instead of completely turning off.

they made a phenomenal amount of money That is exactly what I heard as well.

All of these responses only mention market makers and traders. What about the issuers and retail investors? Like, you know, the reason we have this stuff to begin with and the reason we all let our money in to these markets in the first place? Why should I put my money in to such a horribly complex system instead of looking for more direct methods of investing my money? The overhead doesn't seem worth it, but what am I missing?

Buy-and-hold investors are a subset of traders, for the purposes of my comment. Mentally substitute the two terms in my comment and you'll see that it remains true.

I'm not sure how that answers my questions related to why I should trust a marketplace that allows HFT over one that disallows them.

I don't think you've actually asked that question. If you'd like, try restating it, and I'll try to answer it more directly in terms of HFT.

Sorry, I'm on a few threads here trying to figure this stuff out.

Basically, what I want to know is, how does this reduce the spread between some dude trying to sell shares in his venture and some dude wishing to invest his money? I get the role of a market maker in this situation. But what does HFT do to somehow make the two parties willing to either sell for less or buy for more?

You're using the word "spread" idiosyncratically.

"The" spread is the difference between the best bid and the best ask. A market order "crosses" the spread, requiring the buyer to pay the best ask price or the seller to take the best bid price.

The function of a market maker is to bridge the prices of buy-side investors.†

Without market makers, spreads are much wider, because they depend on which particular long-term investors might be willing to trade today and what their limit prices are.

Market makers are willing to buy or sell in the middle of the spread --- presumably not all the way down at the best investor bid, and presumably not all the way up at the best investor ask. By briefly jumping into the middle of the spread, in effect finding compromise prices, market makers collect what's effectively a small fee in exchange for improving the "resolution" of the market's current price --- from, say, "XYZ costs 10.00 plus/minus a dollar" to "XYZ costs 10.00 plus/minus 2 cents".

In the 1990s, market makers were humans, and they were only required to quote prices to the nearest 1/8th of dollar. The price delta between the true market price for an instrument and the nearest 1/8th was a rent captured by the market makers. In practice, the situation wasn't even that good: market makers colluded to avoid quoting "odd eights", in effect offering only "to the nearest quarter dollar" resolution.

Electronic market makers (a/k/a HFTs), though not operating out of the good of their hearts (nobody in the market does) impose serious, fierce competition on market makers for different instruments. Instead of charging 0.12-0.25 cents for the service of discovering the clearing price of an instrument, they charge pennies. The 10-20 cents the HFTs shave off the spread is money into the pocket of anyone who trades, which very much includes "some dude wishing to invest his money".

In fact: if you read the responses to Lewis' book, the one consistent thing you'll see is the notion that if HFT harms anyone, it is not the retail investor. Even the people making the case that HFT is evil are making that case indirectly, by suggesting that HFTs impose costs on large sophisticated investors that act on behalf of ordinary people. (But then, Vanguard disagrees with that, too).

† The "buy" and "sell" in "buy-side" and "sell-side" refers to the intent to transact in liquidity , not the actual shares; the buy-side isn't "people who want to buy shares", but rather "people who want to trade now", or perhaps more accurately, "people who want to maintain long-term positions". The buy-side is "customers of the public markets" and the sell-side is "people who make the public markets work".

Instead of charging 0.12-0.25 cents for the service of discovering the clearing price of an instrument, they charge pennies.

I believe it is more on the order of $0.00005 per share traded.

Because a market that disallows HFT is one that makes somewhat arbitrary decisions about who gets to make markets and who doesn't. Such limits make it easier for the smaller group of "authorized" market makers to collude--which is apparently exactly what happened when the spread was held artificially to 1/4 dollar instead of 1/8.

There have always been middlemen, as, especially with less liquid instruments, there won't necessarily be equal supply and demand from "natural" buyers and sellers. As markets have gone from floor trading, to point+click on computer screens, to automation of different levels of sophistication, efficiency has improved - people complain about HFT stealing pennies, but in the past, someone was stealing quarters. The difference is that the skills required have changed tremendously - a few years ago, it was all about being well connected or going to the right school - now it's all about how good your code is.

It's not particularly surprising that the loudest anti-HFT voices are guys whose profit margins have been killed by it.

Disclosure: my profit margins have been killed by HFT...

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