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I'm not sure that they actually reduce the cost of anything. I just finished reading "Flash Boys" by Michael Lewis and; as I understand it, this is how HFT work

I'm not sure that they actually reduce the cost of anything. I just finished reading "Flash Boys" by Michael Lewis and; as I understand it, this is how HFT works: 1. You the buyer, tell N exchanges that want to buy at a maximum price $X. 2. HFT "watches" the exchange that my bid reaches first (by milliseconds) 3. HFT traders then place themselves between you and the N-1 exchanges and offer to sell you the stock at the maximum bid price. They do this by finding the stock on those other exchanges at less than your max bid price and owning it for a fraction of a second before they sell it to you at a higher price.

kasey_junk 12y ago
This is the single biggest problem with the Michael Lewis book is that it implies that this is happening without ever walking through it. What is actually happening is that: 1. HFT is quoting both buy and sell prices on every exchange. 2. A big buyer sends orders to all of the exchanges trying to buy (or sell) all of the available inventory at a given price. 3. On 1 exchange the big buyers order gets there earlier than on other exchanges, triggering a transaction with the HFT. 4. The HFT uses that transaction as a price signal to change their prices on all the other exchanges and if they are faster than the big buyer, the big buyer cannot take advantage of the lower price. There is no middleman buying from 1 place and selling to another and driving up the price. What this sort of price signaling does is allow the HFT to quote smaller spreads in the more common case, when 1 participant is not trying to wipe out all of the liquidity in the market at a given price point.
- nkurz 12y ago
  I'm ignorant and only working from first principles, while you seem knowledgeable about actual practice. In your explanation, the fastest HFT knows before anyone else that the someone is buying large quantities of a stock at Exchange A at a price higher than the ask at Exchange B. From this, they know to raise their asking price at B, since they (and no one else) know that there is a buyer willing to pay a higher price. This makes sense, and they would make some money doing this. But why wouldn't they also buy up all the stock at B that is priced less than transaction price they observed at A? If they do, they (hopefully) get to quickly resell it for a slightly higher price. If they don't, much of the order from the big buyer they are counting on will be filled with lower priced stock from their slower competitors, and they will make less money. There is no middleman buying from 1 place and selling to another and driving up the price. If they have the knowledge and they ability, why wouldn't they? I'd think it would be in their financial interest to do so. Or is your point that they are indeed doing what would normally be called "frontrunning", but that the knowledge comes from one exchange while the transactions all take place at another?
  - kasey_junk 12y ago
    Let me first clarify, there very well may be certain HFT that try to do this, but it isn't a large class, because the sophistication and speed required would mean that you could market make more profitably in most instances. The short answer to your question, is that other HFT prevent them from doing this. It is very rare for a single HFT entity to represent the entire order level at a price. Therefore just because they can react to their own transactions (the only ones that aren't on a public feed) faster doesn't mean they can react to everyone else. Further, just because demand on one exchange implies demand on others, it doesn't require it. So in the case where you read the demand wrong, and you are just changing your price you lose priority at the old price point and therefore there is an opportunity cost, but if you are actually making a transaction you lose both priority and the bid/ask spread which is a real cash cost. Finally, we need to be very careful about the term frontrunning. It is a specific thing. Acting on the same information available to a counterparty faster than them is never frontrunning. The only time it is frontrunning is if you have a fiduciary duty to be acting on a parties behalf and you don't live up to that duty by trading ahead of orders they placed with you.
    - nkurz 12y ago
      Thanks for details. In chollida's top comment: bigger players like Citadel pay the retail brokers for their retail flow so they can trade against the "dumb" money before anyone else. I've heard that most Canadian banks sell their flow to a big US fund that has a chance to trade against it before it reaches the market. This sounds a lot like frontrunning, but with the behaviour split between two parties. The bank sells the information but doesn't make the trade. The HFT makes the trade, but has no fiduciary duty. It would seem that if the HFT is benefitting, and if this any any way causes the banks client to pay more, it the bank is in breach of fiduciary duty. I'd want to be a little broader about 'frontrunning' so that it includes any case where you gain knowledge about an upcoming trade before it happens, and manage to change the market in your favor so that you profit and the original buyer pays more than they otherwise would. If this isn't frontrunning, is there a different term for that more general case?
      - 12y ago

kasey_junk 12y ago

This is the single biggest problem with the Michael Lewis book is that it implies that this is happening without ever walking through it. What is actually happening is that: 1. HFT is quoting both buy and sell prices on every exchange. 2. A big buyer sends orders to all of the exchanges trying to buy (or sell) all of the available inventory at a given price. 3. On 1 exchange the big buyers order gets there earlier than on other exchanges, triggering a transaction with the HFT. 4. The HFT uses that transaction as a price signal to change their prices on all the other exchanges and if they are faster than the big buyer, the big buyer cannot take advantage of the lower price. There is no middleman buying from 1 place and selling to another and driving up the price. What this sort of price signaling does is allow the HFT to quote smaller spreads in the more common case, when 1 participant is not trying to wipe out all of the liquidity in the market at a given price point.

nkurz 12y ago
I'm ignorant and only working from first principles, while you seem knowledgeable about actual practice. In your explanation, the fastest HFT knows before anyone else that the someone is buying large quantities of a stock at Exchange A at a price higher than the ask at Exchange B. From this, they know to raise their asking price at B, since they (and no one else) know that there is a buyer willing to pay a higher price. This makes sense, and they would make some money doing this. But why wouldn't they also buy up all the stock at B that is priced less than transaction price they observed at A? If they do, they (hopefully) get to quickly resell it for a slightly higher price. If they don't, much of the order from the big buyer they are counting on will be filled with lower priced stock from their slower competitors, and they will make less money. There is no middleman buying from 1 place and selling to another and driving up the price. If they have the knowledge and they ability, why wouldn't they? I'd think it would be in their financial interest to do so. Or is your point that they are indeed doing what would normally be called "frontrunning", but that the knowledge comes from one exchange while the transactions all take place at another?
- kasey_junk 12y ago
  Let me first clarify, there very well may be certain HFT that try to do this, but it isn't a large class, because the sophistication and speed required would mean that you could market make more profitably in most instances. The short answer to your question, is that other HFT prevent them from doing this. It is very rare for a single HFT entity to represent the entire order level at a price. Therefore just because they can react to their own transactions (the only ones that aren't on a public feed) faster doesn't mean they can react to everyone else. Further, just because demand on one exchange implies demand on others, it doesn't require it. So in the case where you read the demand wrong, and you are just changing your price you lose priority at the old price point and therefore there is an opportunity cost, but if you are actually making a transaction you lose both priority and the bid/ask spread which is a real cash cost. Finally, we need to be very careful about the term frontrunning. It is a specific thing. Acting on the same information available to a counterparty faster than them is never frontrunning. The only time it is frontrunning is if you have a fiduciary duty to be acting on a parties behalf and you don't live up to that duty by trading ahead of orders they placed with you.
  - nkurz 12y ago
    Thanks for details. In chollida's top comment: bigger players like Citadel pay the retail brokers for their retail flow so they can trade against the "dumb" money before anyone else. I've heard that most Canadian banks sell their flow to a big US fund that has a chance to trade against it before it reaches the market. This sounds a lot like frontrunning, but with the behaviour split between two parties. The bank sells the information but doesn't make the trade. The HFT makes the trade, but has no fiduciary duty. It would seem that if the HFT is benefitting, and if this any any way causes the banks client to pay more, it the bank is in breach of fiduciary duty. I'd want to be a little broader about 'frontrunning' so that it includes any case where you gain knowledge about an upcoming trade before it happens, and manage to change the market in your favor so that you profit and the original buyer pays more than they otherwise would. If this isn't frontrunning, is there a different term for that more general case?
    - 12y ago