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None of the examples given showed liquidity being added, because the people involved would have traded with each other directly without an HFT being there....In every example OP gives...

You clearly ignored one of my examples.

Consider the example of Fry and Zoidberg. Fry places his sell order at 12:01. Leela and Bender are absent, so Fry's order goes into the book. Zoidberg places his buy order at $9.50 at 12:05. The bid/ask spread is now $0.50 and Fry has not traded.

In this case Fry is better off with Leela in the market.

At any point that an HFT is willing to buy stock, it's because there's a high likelihood that someone will show up to pay more after a few seconds or minutes.

If you want to take that risk, place an ALO order at the bid or ask price. You won't cross the spread, though your order might go unfilled.

The fact that most people don't place ALO orders suggests they don't want to take the risk.

Will your proposal be along the lines of "only allow trades every x (milli) seconds, and randomize among the bids/asks submitted in the most recent time interval"? This seems like the most natural, simple solution one might suggest. How does it sound to you?

(Edit: sorry, this doesn't really relate particularly to this sub-topic.)

No, my proposal is much simpler.

I don't think that SomeCallMeTim understands that 0.10/share is a lot of money ($100,000) when a mutual fund is trading 1 million shares over 10 days.

Now mulitply that by 60 holdings which are turned over 100% per year and you can see why pensions would want those mutual funds to save $6,000,000/year in liquidity costs.

(Obviously mutual funds don't just do program trades, they also negotiate directly with each other etc. but the example still stands).

Exactly. Even more direct benefit to retail investors - low liquidity costs mean that we can invest in mutual funds and especially ETFs that have extremely low fees. Those funds have to shuffle around their holdings as investors come and go, and they'd have to charge a lot more if they were paying $0.10 to cross the spread.

The ETF concept could be interesting to look at. I was reading Tryenor's book and I thought he mentioned how entering an ETF position still nets out below an index return because of the cost of liquidity.

I wonder if ETFs would have ever grown as large as they had if HFT never existed (the time periods of the rise of ETF parallels to the rise of HFT.) Anybody have any insight here?

The success of ETFs is probably significantly underwritten by the increased liquidity. As a rule of thumb liquidity makes markets less volatile and thus able to sustain more complex structures.

ETFs control tracking error, how closely the ETF follows the index to which it is benchmarked, by letting authorised participants (APs) arbitrage the ETF against the underlying. For example, if you are a SPY AP, you can turn in a certain quantity, called the creation unit, of S&P 500 constituent stocks and "create" the correct number of ETF units. Alternatively, you could surrender a creation unit of SPYs and the ETF trust would "destroy" those ETF units and issue you the S&P 500 constituent stocks [1].

The risk for APs increases non-linearly vis-a-vis the liquidity of the underlying. This has been empirically witnessed as a "U-shaped relationship between fund premium and market liquidity, which suggests that more active trading does lead to lower mispricing but only after a certain level of liquidity is reached" [2].

[1] http://www.londonstockexchange.com/traders-and-brokers/secur...

[2] http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0416.2008....

Please explain why small improvements in the spread are relevant compared to intraday movements. If I were trading a million shares over 10 days, then I would be much more worried about trading them at the right time of day, rather than worrying about bid/ask spreads.
Edit: I am assuming here that we are talking about trades that actually change my long-term position. That is, I am selling or buying those million shares for good because I am re-weighting my portfolio or something like that.

They are both relevant. In general a portfolio manager + investment analysts are worried about stock price movements but the trader for the fund is worried about liquidity spreads and about buying the shares for the lowest price while selling shares for the greatest price.
While $6M in not large by percentage, there is no reason to want to give that up.

While $6M in not large by percentage, there is no reason to want to give that up.
On the other hand, imagine a world of only portfolio managers and no HFT. That is, trades happen only between portfolio managers with no middle man.
Then yes, on one day you as a portfolio manager would have to give up $6M. But where do those $6M go? Logically, they must go to another portfolio manager. By symmetry of portfolio managers, it follows that on other days, you will be the one who gains $6M. That should net out to zero on average, at least assuming that all portfolio managers are equally sophisticated.
On the other hand, the HFTs earn money, otherwise they wouldn't be in the business. Where does that money come from, if not from the portfolio managers?
So it seems that as long as you're looking at a narrow micro perspective, the story makes sense. But once you add up everything to a macro perspective, the argument vanishes.
This does not necessarily apply against algorithmic trading in general. Algorithmic trading may well serve to always have some orders in the order book even on low volume markets, since humans just cannot trade on as many markets simultaneously as a computer can. But the arms race to ever lower latencies just seems useless from the point of view of society.

The macro case is as follows:
HFTs will not net positive out over the long term so they are not taking away from other investors. (this is based on what I said in another comment above).
Mutual funds trade huge volume and need liquidity to take advantage of market research. Without liquidity their size would require them to stay smaller and require more investment professionals for any dollar amount they have under management. Without liquidity you would see smaller and smaller mutual funds as their capacity got capped which would lead to higher expense structures for investors.
--- As far as the arms race, I agree with you.
But the arms race to ever lower latencies just seems useless from the point of view of society.
5 years ago it made sense and helped investors, now or at some point in the future the market will reach the point of dimishing returns from incremental small gains in hardware. At the same time HFTs will be investing more in hardware than they will be netting out of the system. Soon, if not already the HFT business will be mature and they will net negative and become consolidated. At that point (if it hasn't happened already) HFTs will have benefited the market with additional liquidity but any profitability long term will be negative.

I get that $0.10/share is significant, or I wouldn't have bothered posting. Why be annoyed at a process that isn't costing anyone anything significant?
I also know that HFTs are taking money out of the equation, not adding money into the equation. If they weren't, they wouldn't be doing it -- and if the only value they're adding is reducing the time that a trade takes place by minutes or seconds, then I still submit that the value added to the stock market isn't worth the ACTUAL dollar cost.
The OP pointed at the example with Fry and Zoidberg. In that case, Leela either makes $0.05/share on the transaction (which otherwise would have gone to Fry and/or Zoidberg), or takes a hit of $0.50/share. In the latter case Fry (say that's you're mutual fund) makes $0.50/share more than they would have otherwise, but that money doesn't come out of thin air -- it's lost by Leela.
But in order for HFTs to do well, they have to make more money than they lose, so for every case like the above where Fry does better than he would have otherwise there is more money lost by people who would have done better without the interference of HFTs.
So for every $100,000 saved by a mutual fund, much more is being siphoned off by HFTs, for no real added value.

I also know that HFTs are taking money out of the equation, not adding money into the equation. If they weren't, they wouldn't be doing it
This assumption is questionable. There are a vast number of market participants who do loose money.
The best start up example is the bias toward reporting companies who just got funding and not reporting all the companies that hit the dead pool.
We don't really have a good idea on the net of HFT strategies and it is just as safe to assume they net zero.
Lets just say HFT firms did net to zero, would you still have the same argument?

That seems massively unrealistic to me. It's safe to assume that HFT makes its participants a lot of money, for example because we know that they tend to spend a lot of money on hardware.

Do VCs all make money?
Mutual funds beat the bench?
Hegde funds?
Airlines? They spend a ton of money on fixed costs.
Some make money some do not.

They all have revenues. Whether they make profits is another question, but that's not relevant to the point. If HFTs didn't at least have positive revenues from their trades, then no, they wouldn't be buying expensive servers and hiring expensive talent. Money extracted from the market is the issue here, not whether the amount extracted is sufficient to cover costs.

I understand where you are coming from, but investments are not made the way you are assuming.
An HFT investment likely involves someone deciding they want to create an HFT fund, going out to institutional investors and selling them on the idea that THEIR fund will be profitable.
That happens over and over and investors in these HFTs (as well as hedge funds, PE etc. all think they are picking winners who can make it work. Whether they can or not will depend on execution.
Investment in a sector, industry, or asset class does not mean there is net winning from that sector.
At the end of the day, HFT is still competitive since they are bidding against each other (hence the arms race for faster equipment). Even if the market is growing for HFT now, it does not mean it will be forever. At some point it will become mature and all that will be left is net negative HFT profitability with all the benefit going to investors in the form of liquidity.
I am not backing up HFT because I trade in HFT, I do not. I am backing it up because I find it agitating that smart people on HN look at HFT and assume because they are smart, and because they don’t understand it that it must be bad. If something in the market is happening you don’t fully understand it really pays to sit back for a second and think about it.
(I’m guilty of not doing that with a variety of topics too and I do not fully understand HFT, but I understand enough to say that I cannot say with any certainty that it is bad and lean more to saying it is net good.)

>Lets just say HFT firms did net to zero
Sorry, crazy premise. If a particular HFT netted less than $100k/year, I'd be surprised if they kept doing it, and I've certainly heard of HFTs who made in excess of $400k/year.
>There are a vast number of market participants who do loose money.
Irrelevant. It's not about whether people ever lose money, but about whether HFTs add any real value to the market. If no one can give me real evidence that they do, then I say that the rules should be changed to make such trading unprofitable; if it went away, then the people who are actually buying stocks as a medium to long-term investment would make MORE money (on average), or at least lose less.

When speculators (HFTs) trade they either move prices in the right direction or they make a mistake and move prices in the wrong direction. When they move prices in the right direction, they provide a valuable price setting service to the market, and when that happens they also make a profit, in effect the market pays them for this service. When they move prices in the wrong direction they lose money, and they pay the fees of those other speculators who move prices in the right direction or they reduce costs for end producers and consumers. So in both cases the market benefits from the activity of speculators.

>they provide a valuable price setting service to the market
[Citation Needed]
My thesis above is that there IS no value added. You're saying that they are being paid for value provided, but other than possibly causing the price to be updated more quickly (on the 100 millisecond scale mostly, but possibly as much as a few minutes sooner), I don't see how that provides any real value. And honestly I don't see how even helping the prices move a few minutes sooner adds any value.
In ALL the examples in the OA, if there were no HFTs and you simply WAITED a few minutes, then the people actually making trades would end up with better deals. Sure the market wouldn't be as volatile and instantaneous, but in what tangible way is that a bad thing?
So, again, how does moving prices a few seconds sooner provide value? The examples given all assume the market would be completely static without HFTs, which is obviously bogus. HFTs are only interested in stocks with minimum levels of volume, meaning there would likely already be a lot of liquidity, and they won't touch stocks with too little volume, where they'd actually be useful (OP or another HFT, correct me if I'm wrong).
I think extraordinary claims require extraordinary proof. It certainly seems to me and a lot of other people like they're stealing money from valid transactions by taking advantage of a corner case in the system; claiming that "price setting" adds value when in the very examples given they don't seem to add any net value (except when the HFTs are doing it wrong and losing money!) seems like an extraordinary claim. So where's the proof that the market wouldn't actually be better off without them?

In ALL the examples in the OA...
Except for the example you choose to ignore, even after it was pointed out to you.

No, I didn't ignore it. I've addressed it twice already.
For a third time: If the only example that causes someone to benefit is the one where the HFT is losing money, then HFTs are motivated NOT to help people.
So no, I don't count an example where an HFT screws up as a positive. If the best you can say is that "some of my revenues are redistributed to people who otherwise wouldn't have been able to make a sale because there were no other buyers for a particular stock", well, sorry, but that pretty much proves my point.
You're claiming to be a Robin Hood, but without the whole moral justification -- you're robbing from random people and occasionally giving some of your proceeds to other random people. The latter doesn't justify the former.

In that case, you shouldn't count insurance companies are positive. They only help their customers when they screw up and pay out benefits.
Incidentally, if you feel HFTs add no value, why do people choose to pay them? In my example (and in the real markets), there is nothing stopping Fry from posting a sell order at $10.04 and not trading with Leela. So why does he?

Your insurance company example is totally unrelated.
A well-run insurance company spreads risk among all of its customers. There are NON-PROFIT insurance companies that do an excellent job of spreading that risk around (Kaiser Permanente spends 95% of its insurance dues actually paying for medical care, for example). When you buy insurance you're not EXPECTING to have a problem, but you want to be protected if you do. When someone DOES have a problem, the insurance company hasn't "screwed up" -- the entire point of insurance is to cover unexpected problems.
The only time that the insurance company could be said to have screwed up is if they're losing money overall. And in that case they'll eventually go bankrupt.
>why do people choose to pay them?
Ignorance? Given how many times I've seen advice to never (or at least only rarely) place a market order, I have no idea why anyone does.
Or possibly it's just the "greater fool" theory: They will sell to the HFT if and when they think they know better than you do.
You're claiming that the HFTs are providing insurance to the people who are buying or selling? I find that to be a stretch, since the entire point is that you look for sure bets and attempt to only sell this "insurance" to people who (in your opinion) don't need it.
And frankly most people trading in the stock markets don't know they're even "buying" this insurance. If they did, then yes, I could buy your argument. But they don't. And the ability to choose makes all the difference in this case.
I'd like to hear from someone trading stocks for a mutual fund, and whether they would "choose" to pay an HFT.
The reason that we don't have market makers standing around in pits any more -- that computers can do the trades directly -- also implies to me that we don't need those intermediaries at all. There's a lot of economic leeching that goes on in Wall Street, and I suspect that much of it is obsolete. HFTs are merely another symptom of the same problem.

An HFT spreads risk among it's customers as well. When you cross the spread you aren't necessarily EXPECTING the stock to go down, you just don't want to take the chance.
The only time the HFT could be said to have screwed up is if they're losing money overall.
I find that to be a stretch, since the entire point is that you look for sure bets and attempt to only sell this "insurance" to people who (in your opinion) don't need it.
No, you look for bets with a 90% chance of collecting a $0.10 spread and a 10% chance of a $0.50 price drop (for a net profit of $0.04/trade across many trades). Actually, the odds are usually much worse than that, if your expected profit/share is greater than a penny, you are doing fantastically well. Any HFT who hunts for a sure thing isn't making any money - there are far more 51% gain, 49% loss opportunities than there are sure things.

>Any HFT who hunts for a sure thing isn't making any money - there are far more 51% gain, 49% loss opportunities than there are sure things.
There may be far more 51/49 opportunities. However, saying that HFTs hunting for sure things isn't making money is far from true.
I worked for a UHFT firm that had a winning percentage of more than 95% of the time. The 5% losers had VERY small losses too. All arbitrage trading. Not market making like everyone seems to be focused on in here.

>I also know that HFTs are taking money out of the equation, not adding money into the equation. If they weren't, they wouldn't be doing it
Either this logic, that profit is evidence of value destruction, is flawed or capitalism doesn't work.
You assume that the capital markets are a zero sum game. But by promoting liquidity HFTs make the markets (a) more attractive to play in, and, (b) cheaper for companies to finance themselves from.

>Either this logic, that profit is evidence of value destruction, is flawed or capitalism doesn't work.
Strawman. That's not at all what I said.
In this particular case the only time the market really benefits is when the HFT isn't making money. And I didn't say that "because he's making money it's evidence of value destruction." Just that the only example OP was able to point out that was an advantage to the consumer was when the HFT was losing money.

That example, however, it not solely germane to ultra-HFT. More traditional market makers have provided that level of liquidity for a long time.
Do you have an example of where sub-100 ms execution truly adds significant liquidity?
I'm open to listening, but have never heard a convincing case for why HFT below such a time threshold adds net value (i.e., enough to make up for the volatility it can cause).
Edit: Changed to "solely germane"

That example, however, it not solely germane to ultra-HFT. More traditional market makers have provided that level of liquidity for a long time.
The studies I link to provide compelling evidence that traditional market makers provided much lower levels of liquidity.
Do you have an example of where sub-100 ms execution truly adds significant liquidity?
Please reread my post starting from the words "The Latency Arms Race".

Actually, out of the three links the first one does not talk about HFT at all, but about algorithmic trading. I don't think anybody seriously thinks algorithmic trading is bad per se.
The third link talks about reducing the bid/ask spread. Fair enough. However, what people seem to forget in these discussions is that if you are genuinely trading in the long run, then the bid/ask spread is mostly irrelevant anyway, because it is totally dominated by intraday fluctuations. Whether I buy at the offered price at 12am vs 1pm makes a much bigger difference than whether a HFT reduced the spread by some small amount. I have yet to see an argument that the sum of intraday fluctuations + bid/ask spread is helped at all by HFT.
So one study remains (this one: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1624329). This one might genuinely apply - I haven't had the time to go through it - but the abstract isn't exactly enthusiastic, and probably disregards the social costs that come from people being sucked into the field. So I am still skeptical. Confirmation bias applies as well, I guess ;)

That's a familiar pattern: disingenuously link to studies that don't validate an assertion.

I thought he answered your question well in the section Automated market makers - like humans, but faster and smarter.

Ummm...so the only example where an HFT has helped someone out is the one where the HFT screwed up and lost money?
In other words, the better an HFT gets, the less benefit they're providing. This isn't doing much to convince me.
Yes, in that case, it would suck to be Fry. But the problem at that point is that the price dropped before Fry got his order in, and that's a price of doing business in the stock market. Considering that an HFT would do all in their power NOT to be helping Fry in that case, it doesn't really support your position. You're not in this to try to help people like Fry; you're in this to AVOID helping people like Fry as much as possible.
>If you want to take that risk, place an ALO order at the bid or ask price.
ALO? How does that differ from a limit order? I only ever use limit orders when buying or selling stock -- and pretty much every bit of investment advice I've read recommends that you only ever use limit orders, though advice on where to place your limit varies. If "most people" use market orders, well, most people also lose money in the stock market.

Ummm...so the only example where an HFT has helped someone out is the one where the HFT screwed up and lost money?
Yes. This isn't all that uncommon - see insurance companies, for example.
Without Leela, the problem is not that the market moved before Fry got his order in. The problem is the market moved before his order was filled.
ALO? How does that differ from a limit order?
It's a limit order which Adds Liquidity Only. But it's not even necessary in this case - if Fry is willing to accept execution risk, he can place a sell order at $10.05 instead of $10.00:
Sell(Fry, $10.05, 100) Sell(Leela, $10.05, 100) ---------------- Buy(Leela, $10.00, 100) Buy(Bender, $10.00, 100)
If Zoidberg and Amy each buy 100 shares, Fry's order gets filled. If not, Fry loses money.
Fry could also have placed his sell order at $10.04 and jumped the queue:
Sell(Leela, $10.05, 100) Sell(Fry, $10.04, 100) ---------------- Buy(Leela, $10.00, 100) Buy(Bender, $10.00, 100)
In this case Fry gets filled before Leela, so he doesn't need Amy to show up.

Insurance companies don't have to screw up for people to benefit from having insurance.
>the market moved before his order was filled.
In what tangible way is this different from "the market moved before Fry got his order in"?
The market for a particular stock depends on there being people who are willing to buy it. Saying "the market moved" blurs the fact that there simply weren't any buyers at that price any more by the time he got his order in.
If we're talking about a stock with a lot of volume, and Fry "jumps the queue" by setting a limit order in the current spread (something I almost always do myself, FWIW, based on that same investing advice I mentioned), then he'll sell his stock with or without HFTs. What value does the HFT add in this case?
The argument is that HFTs add liquidity. Don't HFTs only work with stocks that have high volume? How is adding liquidity when there's already high volume a value?

Insurance companies don't have to screw up for people to benefit from having insurance.
How does insurance benefit someone who's car doesn't crash? It's a couple of hundred bucks a month for nothing.
What value does the HFT add in this case?
None. If Fry doesn't want to cross the spread and pay for liquidity, he doesn't have to.
Similarly, Arthur's Steakhouse doesn't benefit me because I'm a vegetarian and don't want to buy what they are selling.
Don't HFTs only work with stocks that have high volume? How is adding liquidity when there's already high volume a value?
First of all, many HFTs do work with the long tail of US securities. Second, adding liquidity via price improvement (i.e., narrowing the spread) is useful even if volume is high.

> Ummm...so the only example where an HFT has helped someone out is the one where the HFT screwed up and lost money?
They haven't lost money until they sell at a lower price. The price could still go back up and the HFT would make money overall. But Fry is still better off in this case because he got to sell right away at a better price than he could have gotten if Leela wasn't around.
In this case, everyone benefited: Fry got to sell when he wanted at a better price than the non-HFT's were offering and Leela made money. Leela made money by taking on risk. Leela makes money overall only if she is smart enough to win more often than she loses.

> How does an HFT, in practice, add liquidity to a market?
Bid/ask spreads used to be 10 cents or more. Now they're generally a penny. That is evidence of a more liquid market.
In practice, this is because computers are now market makers instead of humans so they can do this job at a lower cost.

Even fractions of a penny in some cases.

Is there evidence that the bid ask spreads have that substantially declined across the board, or is the decline limited to the most actively churned stocks?

> Anyone who is worried about waiting a few minutes for a trade to complete is Doing It Wrong.
Why do you get to decide that? I could think of several examples where I would be concerned about a trade happening quickly (hedging bets made elsewhere, breaking news affecting the underlying value of a product, etc.)

This exact logic suggests that all market makers are "parasites", and that any market that has them is Doing It Wrong. Why is it being taken seriously?

The way I am reading these comments it would seem that HNers are more curious than idolizing. Personally I do not believe that the length of time in which an entity chooses to own a stock makes that entity inherently bad or good. It is not unreasonable to think a fast execution could make a position unprofitable if delayed by minutes, and I fail to see how that is doing anything wrong.