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Comment by hcknwscommenter | Hacker News Reader

The entity selling the order flow is not front-running, but the entity buying the order flow (market maker, HF trading firm) is basically front-running. It's just that the front running is done in a way to actually lower prices or increase liquidity for the underlying trades in the order flow being sold.

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No it isn't. I've worked at an HFT, this is not why they buy the order flow.

Retail order flow is worth buying because it's what's called "non-toxic". That means the retail traders generally don't know which way the market is going, ie they are either wrong or too small to make the market move against the market maker.

Contrast that to trading against a hedge fund which might have a better clue and is potentially large enough to push the market in some stock.

I'm confused how this is valuable. If the retail traders are wrong, then why do you want that information?

You don't want the information. You want the order, so that you can be the other side of the trade. As long as the order arrival isn't too correlated with price movements, the market maker can buy a little above the bid price and sell a little below the ask price and make some fraction of a cent on each share, on average.

It's called adverse selection. You don't want to be on the other side of an order from an informed trader, because the market is moving against you in the short run. In the longer run, if the big fund is more often correct than not, then you are also more likely to have made a losing trade. HFTs care mostly about the effect on the market today, so they probably don't care whether the information is correct or not, they just want to get out of the way of big moves.

That's super interesting

Liquidity is a product like a hamburger is a product. Some firms expose themselves to the ability to sell liquidity for the same reason that other firms expose themselves to the ability to sell hamburgers. They think they can make money doing that.

Liquidity is unlike hamburgers in that there is a risk profile associated with it if you sell it to anyone who wants it. Adverse selection happens as detailed elsewhere; you lose money on their custom, potentially a lot of money relative to the margin on your product.

Certain buyers of liquidity are, like essentially all buyers of hamburgers, functionally riskless. You can profitably sell your product to them at a positive margin all day long, at virtually any quantity they could demand.

Payment for order flow is setting up a liquidity stand in a place where you structurally only get the non-risky customers. That liquidity stand is, like a hamburger shop, a cash machine, and justifies CapEx and OpEx to run. Part of the OpEx is paying your landlord for prominent placement of your liquidity stand in front of willing customers who are buying that sweet, sweet liquidity you're selling.

The price of liquidity changes moment-to-moment based on market conditions but is effectively standardized by law nationwide (NBBO). You are not overcharging your customers for liquidity; they pay the same price literally anyone in the country buying it in that instant does and you can, at your option, discount it further to reward them for buying it from you.

You are making superior margins on their custom because you don't inevitably lose lots of money by being in the liquidity business. The liquidity stand down the street is doing the same thing; your vicious competition against each other has caused the prices for your product to crater, to the enduring joy of the people who line up daily to buy your liquidity.

You might also think about it as the difference between opening up a cafe with unlimited free refills in San Francisco versus doing the same thing in exurban Utah.

I agree that HFT don't buy order flow in order to make trades execute better for retail investors. They buy order flow in order to make money. The retail order flow is, as you say, non-toxic. That is, HFT can reasonably expect to make money with the data and not get rolled over. The question then becomes, who is paying HFTs and why. The highly simplified answer is that HFTs are allowed by the regulatory agencies/exchanges to pay themselves a slice of the bid offer spread in return for the liquidity benefit their market making activity provides. How do they do it? By using the retail order flow information, which allows them to "front-run" the order (step in between offers and asks) and provide liquidity. The offeror gets a better fill and the askor gets a better take and the HFT gets a profit and the exchange has vastly higher liquidity and everyone is happy with this type of front-running.

No, if the flow is non toxic it's easy to make money from. You pocket the spread and eventually you do the same on the other side to get flat. No shenanigans required.

Nothing you state above contradicts anything I stated. I explicitly stated that non-toxic flow is easy to make money from. I explicitly said that you make money by capturing some of the spread. You say "pocket the spread" which is simply wrong. No market maker gets the entire spread. My point is that there are many versions of "front-running" that are not "shenanigans." You seem confused as to how all this works.

No need to get personal. I guess you could use a less loaded term than front-running. Or at least qualify what you mean when you put it in "here".

It's not basically front running. Front running is specifically when a broker gets your order and sits on it until either they or another client can trade in front of it before the market moves. Market makers want to interact with retail orders since they typically don't have size and in aggregate are either non-directional or predictably directional. This reduces the market makers risk of adverse selection.

If you want to define front-running that way, then I agree HFTs don't front-run. But they do step in between buyers and sellers. If you want to call that something else, shrug.

Stepping in between buyers and sellers is called market making. They smooth supply and demand across time.

Also I don't define front running that way, FINRA does.

https://www.finra.org/rules-guidance/rulebooks/finra-rules/5...

Your link contradicts your definition.

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