[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?