[gd1]

The speed for a market maker (largely passive and posting limit orders) isn't about how fast you can place a limit order, it is about how fast you can cancel it. It is a defensive mechanism against predators who are even quicker (arbitrageurs, aggressive HFTs).

Imagine that there is a "true price" of some security at price x, and your bid and your offer are positioned around that true price at x - d (your bid) and x + d (your offer). So your spread is 2d. Then some external (public) event happens, which moves the true price by an amount greater than d. Let's say it is a big event, and the true price falls by 4d. Now there is a race. If you don't manage to cancel your bid in time, a predator will 'pick you off', take out your bid, and they'll sell to you at (x - d) when the true price is now (x - 4d). The predator has made an immediate (paper) profit of 3d, and you've made a loss of the same amount. If you're fast enough, you can successfully cancel your bid and repost it further down the book at x - 5d.

Now, as a market maker, a liquidity provider, you could increase your safety margin by quoting a wider spread, setting your bid and offer at +- 2d instead of +- 1d. Now it takes a larger move before you're in danger of being "picked off", but you'll also attract less customers and make less profits. Speed (latency) is directly correlated to how tight a spread a market maker can quote.

[pdonis]

What benefit do tighter spreads and faster response times provide to ordinary investors, like me with my retirement fund? I understand how they benefit the market makers; you've explained that. But all that really determines is who takes losses when an exogenous event that affects the underlying fundamentals of a stock gets reflected in its price. That's a zero-sum exchange: the market maker's loss is the predator's gain. How does all this create value on net?

[gd1]

So you've accepted that greater speeds allow market makers to quote tighter, so the answer is pretty simple. The tighter a market maker is quoting the less money he is making per transaction (smaller spread), so less money is leaving the system and going to middlemen. The speed allows them to undercut other market-makers and steal their 'flow' (customers) while still being able to avoid predators, and so they offer the service cheaper. The service being the provision of liquidity to bridge time gaps in a continuous time market.

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.

[pdonis]

> 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?

[pas]

> 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.

[pdonis]

> smart boys and girls go and do a quantitative finance degree instead of Solve The World's Problems degree

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?

[kasey_junk]

If you need to buy/sell right now, having tighter spreads means that the price is cheaper for you. Your retirement fund, they need to buy/sell right now all the time, to re-balance their portfolio, whether for risk or for benchmark tracking, cash allocations, etc.

[pdonis]

See my response to tptacek upthread.

[kasey_junk]

Saw your response and I'd offer the following: A) the advantages that automation bring to the markets impact every single trade there is. Even if we take a very tiny sample of people who need to rebalance their EFTs today. Each day it is a tremendous savings. B) HFT is a tiny part of the finance industry, yet it has had a huge impact on the cost of trading, to the end result of trading being phenomenally cheaper than it has ever been.

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?

[pdonis]

> the small number of intelligent people in HFT

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. :-)

[kasey_junk]

Again, looking at your other posts, I can only assume either A) you socially value internet ads much higher than most people who claim to value social equity over profit or B) you underestimate how many resource we as a society are throwing at internet ads or C) you over value how many resources we as a society are throwing at automated market making. In any case, Google by itself, whose entire revenue model seems to be based on internet ads, makes more profits in a year than the entire HFT industry does.

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.