If you assume that the number of 'real' trader (not middlemen) who want to buy or sell is constant (not necessarily true, but assume it for a moment), then it stands to reason that the tighter the spread, the less the market makers are profiting. At a small enough spread, they make no profit, since the profit from the flow on both sides is cancelled out by the losses from adverse selection (trading when they couldn't cancel in time - being victim to a predator). But if they can increase their speed, and minimize their adverse selection losses, then they can quote tighter and still make a profit. And do it with machines, and cut overheads of hiring humans, and you can quote even tighter since you need less trading profit to make a net profit. So this is the value generated, automation + speed = the smallest amount of frictional costs being extracted from the market.
Ok, this makes sense. But it still leaves the question, how much are the frictional costs decreased by HFT, and is that benefit enough to offset the social costs?
Such as? All I heard was smart boys and girls go and do a quantitative finance degree instead of Solve The World's Problems degree.
And that's bullshit. The social cost of _not_ providing other, better alternatives to our youth (downsizing NASA, underfunding research and scientific endeavors), lack of patent reform, lack of bandwidth and unified cross-country 3G/4G has much worse costs.
No, they go and do a Solve The World's Problems degree and then end up in quantitative finance because they can't get rich solving the world's problems.
> The social cost of _not_ providing other, better alternatives to our youth (downsizing NASA, underfunding research and scientific endeavors), lack of patent reform, lack of bandwidth and unified cross-country 3G/4G has much worse costs
I think we're in violent agreement. This is exactly the social cost I was talking about. Our society is run by people who can't be bothered to compensate someone properly for curing cancer, but who will throw millions of dollars a year at someone for shaving a few microseconds off an HFT algorithm. That makes no sense to me.
Why are things this way? Lots of reasons, of course, but one of them is that, whenever anyone suggests that maybe it would be better if smart people were directed into more productive endeavors, the financial people have kittens and say it's going to wreck the world's economy if we don't shave those few microseconds off the HFT algorithm, because there won't be enough liquidity or something like that.
And that is bullshit. Sure, if we were at a point where all the big problems were solved, then yes, making tiny incremental improvements in the price of liquidity might be near the top of the priority list. But as things are, it should be somewhere around 56,732nd place. The problem to be solved is that there is huge, huge value to be captured by things like curing cancer, much, much more value than there is to be captured by shaving microseconds off HFT algorithms, but nobody knows how to capture it. How is making stock trading a fraction of a percent more efficient going to fix that?
Is that enough of an advantage to outweigh the cost of the small number of intelligent people in HFT? I don't know, but it certainly seems easier to justify than the phenomenal amount of capital spent on internet ads. I'm a bit of a free market capitalist, so my biased response is how else should we allocate people's output?
I don't actually have a sense of how big or small the number is as a percentage of intelligent people. Particularly when you observe that, as you say, HFT is just a tiny part of the finance industry. There are many other parts of that industry that are also sucking up smart people to do things that, to me, have very little value compared to the other things those people could be doing.
> how else should we allocate people's output
Sorry to redirect again, but see my response to pas upthread. :-)
So it's hard to have the "it's terrible so many smart people are doing X" argument when our society has made it pretty obvious we value selling internet ads as high as any other possible commercial enterprise.
Me, I'll take the other position, which is that yes, the markets are bad at allocating capital, but they are better than our alternatives, and the silly little pocket change inefficiencies that go into speculative market making are a small price to pay for all the advantages of a modern liquid, price efficient market.
How are you getting that from what I said? You could s/HFT/internet ads/ in my post in response to pas and it would be pretty much the post I would have written about internet ads if that had been the subject under discussion. (Well, not really, because you'd have to change other things as well, but hopefully you see what I mean.)
> markets are bad at allocating capital, but they are better than our alternatives
This I agree with. But markets are as bad (or good) at allocating capital as the people who participate in them. In other words, markets reflect the values of the people who trade. I wasn't ranting about markets not being able to properly compensate curing cancer because markets are bad; I was ranting about people's values being so screwed up that the price signals they are sending into markets are making people rich for HFT and internet ads but not for curing cancer.
It's implied by what you didn't say. You don't require technologists involved in internet ads to justify their existence whenever a post about google comes up. Nor when news breaks of a new internet startup being acquired. I'm picking on you a little bit as a proxy for the entire HN community, as there seems to be a bias against HFT and towards internet ads that is a little unseemly.
Further, I'm not convinced you understand the scope of money involved in HFT vs cancer treatment for instance. When Roche bought genentech (a cancer research company) they paid 46 billion dollars for the privilege. Knight Capital Group, one of the biggest players in HFT is worth around 1.4 billion dollars. The market seems to be allocating resources correctly. The PR companies on the other hand...
Wow, you've gone through my entire HN corpus to verify that?
> I'm picking on you a little bit as a proxy for the entire HN community
I would prefer that you didn't do that, since I am not a good proxy for any community that thinks figuring out ways to get people to click on ads is a good use of smart people's time and energy. (Btw, I'm not sure that the entire HN community is such a community; a part of it may be.)
> The market seems to be allocating resources correctly
The numbers you give are interesting, but I'm not so much interested in money as in human resources. Genentech may have cost $46 billion, but are they paying smart people enough to get them to do cancer research instead of becoming quants?
Some of this may be a perception problem, as you imply by your comment on PR companies. What data I've seen on where smart people can get paid the most indicates that it's not cancer research. But I'm sure the data I've seen is incomplete; I would love to see more comprehensive data if there is any.