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I have nothing against HFT but I don't buy your liquidity argument. Liquidity is needed most when markets are falling outside the norm. Any algorithm with a fai

by tricky 16y ago

I have nothing against HFT but I don't buy your liquidity argument. Liquidity is needed most when markets are falling outside the norm. Any algorithm with a fail-safe or kill switch will immediately shut off when times get bad thereby ending their contribution to liquidity at a time when it is needed most. Please help me understand this better if I'm incorrect. (edited for clarity)

secretasiandan 16y ago
"Liquidity is needed most when markets are falling outside the norm" True but humans have fail-safes and kill switches too, thus this is not a valid argument against HFT in favor of human market makers. At any time, humans could step in and provide liquidity during the flash crash and during other crashes.
- tricky 16y ago
  "At any time, humans could step in and provide liquidity during the flash crash and during other crashes." Humans can, and do. But algorithms can't and won't.
vecter 16y ago
Short answer: there is a large demand for liquidity throughout most of the trading day. I'll give you the long answer when I get back from work.
vecter 16y ago
The main point that you're missing is that there is a huge demand for liquidity during a majority of market hours. On average, 7 billion shares of US equities are traded every day. That is a monumentally large number if you think about it. According to the TABB consulting group, roughly 50-70% of American stock trades are done by HFT [1]. Let's assume that 10-20% of trading is non-profit motivated (utilitarian, you could say). That means that roughly 1 billion shares are exchanged every day by utilitarian traders. That in itself should be clear evidence that there is a large demand for liquidity. HFT market makers play an important role in those transactions. Specifically, they make it cheaper to buy and sell stocks by (1) tightening the bid-ask spread and (2) providing more quantity at each price, so that the average cost of executing an order is less. Not only that, when markets become tighter, they actually enable transactions to occur that would not have happened before. In other words, previously where buyers and sellers would NOT have traded because the transaction costs of crossing the bid-ask spread were too high, those two parties can now trade. Specifically, without HFT, there would be far fewer than 1 billion shares traded by utilitarian traders on a daily basis. To address the other point of providing liquidity "when the markets need it most", let's take a step back. When you say that "market makers should step in to provide liquidity [for society's benefit]", you're implying that there's some externality to lack of liquidity in financial markets (if so, this is yet another reason that we need HFT on a daily basis). Suppose that this is the case: there is some negative externality to society when markets are illiquid, as is oft to happen when things go crazy in the world. During those times, volatility is insanely high because the risk of being in any position is also insanely high. Remember, market makers get compensated (on average) for holding risk that you don't want. If risk is higher, naturally, the compensation should be also. This is manifested in higher costs of execution: spreads widen and the available quantity at each level decreases. If you want to force HFT market makers, which are private corporations, to step in to provide more liquidity, then you are forcing these companies to pay for that externality. In effect, they would take on huge risk for far diminished expected returns. That doesn't make any particular sense to me. However, if society as a whole has this view that some private corporations need to pay for public externalities, then that should be a matter of regulation. But if that's the case, why pick on HFT in particular? Why not force McDonalds and Whole Foods to give food to hungry people during famines? Surely, there is an externality to the food industry NOT stepping in during periods of extended hunger, "just when people need it the most." [1] http://georgewashington2.blogspot.com/2010/10/yes-70-of-us-equity-trades-are-high.html http://georgewashington2.blogspot.com/2010/10/yes-70-of-us-e...
- tricky 16y ago
  I'm still in the "learning the syntax" stage of finance so this is great information. thank you. do you think that one reason why people say bad things about HFT is because they see them being unfairly compensated for taking on what they perceive is a small amount of risk? as in - "come on, how hard can it be to grab a block of stock on an upward trend and quickly sell it." Of course, the more I dig into this, the more I realize how hard it is to find those trends and how easy it is to lose your ass. But, people don't dig in themselves.
  - vecter 16y ago
    do you think that one reason why people say bad things about HFT is because they see them being unfairly compensated for taking on what they perceive is a small amount of risk? I think that's definitely part of it. The issue is that people don't know how much high frequency traders actually make per contract. The amount is pretty small (on average). Typically, each trade takes on "bite-sized" risk and expects "bite-sized" returns. Do that thousands of times a day, and your bite-sized returns grow to something reasonable, but not ridiculous. Certainly, it's not on the order of how much other forms of proprietary trading make. I think the other issue is that people don't understand that all traders, HFT or not, take on risk when they enter a trade. A lot of people use terms like "skimming off the top" or "making money for nothing". This indicates to me that they don't realize why market makers should even make money (on average). It's simply risk transfer, and that has a price (on average). You're right though, identifying bona fide trends are pretty difficult. If it were easy, everyone would be doing it and arbing those trends away.

by tricky 16y ago

secretasiandan 16y ago

"Liquidity is needed most when markets are falling outside the norm" True but humans have fail-safes and kill switches too, thus this is not a valid argument against HFT in favor of human market makers. At any time, humans could step in and provide liquidity during the flash crash and during other crashes.

tricky 16y ago
"At any time, humans could step in and provide liquidity during the flash crash and during other crashes." Humans can, and do. But algorithms can't and won't.

vecter 16y ago

Short answer: there is a large demand for liquidity throughout most of the trading day. I'll give you the long answer when I get back from work.

vecter 16y ago

The main point that you're missing is that there is a huge demand for liquidity during a majority of market hours. On average, 7 billion shares of US equities are traded every day. That is a monumentally large number if you think about it. According to the TABB consulting group, roughly 50-70% of American stock trades are done by HFT [1]. Let's assume that 10-20% of trading is non-profit motivated (utilitarian, you could say). That means that roughly 1 billion shares are exchanged every day by utilitarian traders. That in itself should be clear evidence that there is a large demand for liquidity. HFT market makers play an important role in those transactions. Specifically, they make it cheaper to buy and sell stocks by (1) tightening the bid-ask spread and (2) providing more quantity at each price, so that the average cost of executing an order is less. Not only that, when markets become tighter, they actually enable transactions to occur that would not have happened before. In other words, previously where buyers and sellers would NOT have traded because the transaction costs of crossing the bid-ask spread were too high, those two parties can now trade. Specifically, without HFT, there would be far fewer than 1 billion shares traded by utilitarian traders on a daily basis. To address the other point of providing liquidity "when the markets need it most", let's take a step back. When you say that "market makers should step in to provide liquidity [for society's benefit]", you're implying that there's some externality to lack of liquidity in financial markets (if so, this is yet another reason that we need HFT on a daily basis). Suppose that this is the case: there is some negative externality to society when markets are illiquid, as is oft to happen when things go crazy in the world. During those times, volatility is insanely high because the risk of being in any position is also insanely high. Remember, market makers get compensated (on average) for holding risk that you don't want. If risk is higher, naturally, the compensation should be also. This is manifested in higher costs of execution: spreads widen and the available quantity at each level decreases. If you want to force HFT market makers, which are private corporations, to step in to provide more liquidity, then you are forcing these companies to pay for that externality. In effect, they would take on huge risk for far diminished expected returns. That doesn't make any particular sense to me. However, if society as a whole has this view that some private corporations need to pay for public externalities, then that should be a matter of regulation. But if that's the case, why pick on HFT in particular? Why not force McDonalds and Whole Foods to give food to hungry people during famines? Surely, there is an externality to the food industry NOT stepping in during periods of extended hunger, "just when people need it the most." [1] http://georgewashington2.blogspot.com/2010/10/yes-70-of-us-equity-trades-are-high.html http://georgewashington2.blogspot.com/2010/10/yes-70-of-us-e...

tricky 16y ago
I'm still in the "learning the syntax" stage of finance so this is great information. thank you. do you think that one reason why people say bad things about HFT is because they see them being unfairly compensated for taking on what they perceive is a small amount of risk? as in - "come on, how hard can it be to grab a block of stock on an upward trend and quickly sell it." Of course, the more I dig into this, the more I realize how hard it is to find those trends and how easy it is to lose your ass. But, people don't dig in themselves.
- vecter 16y ago
  do you think that one reason why people say bad things about HFT is because they see them being unfairly compensated for taking on what they perceive is a small amount of risk? I think that's definitely part of it. The issue is that people don't know how much high frequency traders actually make per contract. The amount is pretty small (on average). Typically, each trade takes on "bite-sized" risk and expects "bite-sized" returns. Do that thousands of times a day, and your bite-sized returns grow to something reasonable, but not ridiculous. Certainly, it's not on the order of how much other forms of proprietary trading make. I think the other issue is that people don't understand that all traders, HFT or not, take on risk when they enter a trade. A lot of people use terms like "skimming off the top" or "making money for nothing". This indicates to me that they don't realize why market makers should even make money (on average). It's simply risk transfer, and that has a price (on average). You're right though, identifying bona fide trends are pretty difficult. If it were easy, everyone would be doing it and arbing those trends away.