4 ms·

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

by yxhuvud 13y ago

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.

williamcotton 13y ago
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?
- yxhuvud 13y ago
  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.
  - williamcotton 13y ago
    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?
    - yxhuvud 13y ago
      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.
      - tptacek 13y ago
        Two things. 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.
glesica 13y ago
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?
- tptacek 13y ago
  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.

by yxhuvud 13y ago

williamcotton 13y ago

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?

yxhuvud 13y ago
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.
- williamcotton 13y ago
  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?
  - yxhuvud 13y ago
    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.
    - tptacek 13y ago
      Two things. 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.

glesica 13y ago

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?

tptacek 13y ago
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.