Where does this money come from? The industry doesn't actually create any wealth. There must be a greater fool who lost this $5 billion to the HFT industry. But who is that? Who became $5 billion poorer to make the HFT guys that $5 billion richer? Is the article just counting the total profit of HFT winners and ignoring the HFT losers?
This is not rhetorical, I really want to understand this.
You'll find people trotting out the same old chestnuts (brain drain, unfairness of server colocation, etc.) but those are distractions from the interesting issues.
As an aside, I once had the distinct pleasure of watching a conversation on one of the CNBC programs running in our kitchen in which a NYSE floor trader actually used the phrase "we're the institutional investor looking out for the little guy" while managing to keep a straight face. This dude probably would have curb stomped his own grandmother to pick up a $100 bill. Even the usually sympathetic hosts just laughed outright.
I'm surprised that the outrage against HFT is so strong given how comparatively little is at stake there. After the HFT's much, much, much larger financial cousins, the "big bank" market participants nearly destroyed the entire planet's financial system, it's quite a coup for them that they've shifted the outrage to the guys competing over less money than some banks pay out in bonuses.
I have no love for anyone in the financial industry (I'm a self-loather, if you haven't noticed), but the HFT guys are way, way further down on my list of people to be pissed off at.
TLDR: ... their stated value add of liquidity does not compensate the US and World Economy nearly enough for the risk of collapse they introduce into the system.
Banning HFT or otherwise regulating them out of business will have about as much of an effect at "bring[ing] our markets back to their original goals of creating capital for business" as banning Super Extra Gulp sodas would have in curbing the obesity epidemic. (Incidentally, that quote about the true purpose of a market is a claim I've never seen proven, and even were that true, it would be only true in the case of equity markets, which are not the only kind.)
If one accepts that the financial industry is a perversion of its original goals (whatever they may be), I can think of a lot more effective places to start than the HFT guys: the bond ratings framework that nearly helped lead us to economic disaster; the outsize influence that big banks (i.e. not HFT shops) have in our political climate; the irrational insistence that unregulated financial markets are "best"; etc.
Blaming the HFT guys seems to be an easy out rather than tackling the more difficult issues. Judging by the regulatory and legislative response to the crisis (or more accurately, the lack of an effective response), that's true. It's a lot easier to blame a technology that isn't well understood by outsiders than to reform the political election funding system, or to recognize that it is an absolutely mind-numbingly stupid idea to have bond issuers pay to have their own bonds rated and allow them to choose what company rates them.
Yes, the flash crash and subsequent events have caused some concern, but these events corrected themselves relatively quickly. It's an issue, but the far bigger issue is that we haven't effectively dealt with the thing that very, very nearly put us in a second great depression.
Same way as a rail company or Amazon creates wealth not by 'building things', but by moving things from point A to point B cheaper, more easily and for less risk.
From the other responses, it sounds like the real answer is salami slices from lots of other market participants. A large mutual fund buyer pays a slightly worse price because the HFT jumped in ahead of them to arbitrage between the selling market maker and this buyer. So the HFT's profit comes out of the mutual fund's capital. The loss would show up as tracking error for an index fund, for example.
The HFT's profits do come from a large mutual fund, but then that large mutual fund can lower it's risk because it can quickly move from one position to another because it can expect a HFT to buy whatever it is selling. Risk has a price (ask an insurance company) and reducing it adds value to the economy.
Perhaps HFT was very lucrative for a while, but competition has naturally squeezed the margins out, but the markets has all the benefits of having HFT around.
The caveats are (i) there are diminishing returns to what trades add in terms of wealth because reducing time and cost of offloading stock a further 15 milliseconds and 0.001% clearly isn't going to radically alter the risks of investing in productive enterprises as reducing the time and cost of selling stock by an hour and 5% was (ii) certain trading behaviours can actually scare real investors away.
The benefit of this is that the chances are small that you and I will be trading at exactly the same time. So, I say "I want to sell this stock," and a market maker buys it. Later, you say "I want to buy that stock", and you buy it from the market maker. The market maker makes money on the profit of the sale. So, I may get a little less, and you may pay a little more. But, it means that when I wanted to sell, someone was there. And when you wanted to buy, someone was there. That's what people mean by liquidity.
So, back to HFT: the losers are the conventional market makers. The guys in the pit who used to shout-out buys and sells.
Different trading strategies will make money in different ways. Trading ahead and ticker-tape trading will redirect some of the profits that that an index fund would have made to the HFT trader. On the other hand, market making is in effect providing a service to everyone who wants to trade in the market, and they pay for it (partly through the spread between buy and ask prices -- this is like a fee for being able to buy/sell now rather than later, and partly through explicit ECN fees charged by the exchange).
As to not creating wealth, it is possible that HFT adds value by seeing where the market is going (slowly) and putting the price there right now. Also, it may be able to extract more information from the truly informed traders, so that the market as able to have more information given less informed traders.
That said, I doubt HFT adds much positive value, but as the rules of the game evolve, ultimately the will favor people who add value.
Let's say I'm a fledgeling lemonade stand and I want $10 of investment. You give me that $10 and with it I make $15. You wanted a 10% return on your investment so you get back $11.
With this model, you have "created" $1 in investments. That $1 originally came from the $15 I made with my lemonade. And all those $15 were exchanges for convenience or sheer happiness gained from having lemonade.
So no one really "lost" in this scenario. But I think the finance people call this "creating wealth". Vs other scenarios, where if you invest in someone who is bad at selling lemonade, you only get $8 back, now you have lost $2 from your initial $10. The idea is to continually "create" wealth by making good choices, investing in good lemonade stands vs bad ones.
So when someone says x-machination (high frequency trading) has "made" $5B, there isn't necessarily a loss anywhere. That's just how much that came out on top.
I mean, people 'lose' money all the time for things they get pleasure for. And Even when the thing they gained is very abstract.
Like vegas. People lose money almost by definition.
Or basketball games. Normal people get a -100% return on basketball games. And no one writes articles how the Grizzlies are somehow not providing value to society.
It's the same with capital markets. A lot of people get a huge kick out of speculating on the future. Even if they lose. The capital markets, no matter whether you are an HFT firm in Shoreditch, PIMCO, or some retail investor, are more a game than anything. Everybody wins.
No, it's a tragedy when we start saying that people need to rely on the capital markets. Then, sure, there is loss that's not like basketball games or lemonade. It's a horrible, tragic loss. But then you are talking about policy, not speculation. The real question is why on earth do people rely on the capital markets in the first place? Why is this 'loss' different?
Arbitrage: balancing the prices between exchanges. This helps settle all exchanges on the market price, so you don't pay $5 more just because of the exchange you're on.
Market making: By placing both bid and ask orders, algorithms can tighten the bid-ask spread around the price. When the spread is too large, people are disincentivized to trade because neither buyers nor sellers can agree on a common price.
I would guess that day traders lose out, since they miss the opportunity to act on many of these same opportunities. Also I've heard index funds lose several basis points to HFTs when rebalancing.
In theory those posting liquidity will reduce the bid/ask spread, those that are taking liquidity will see a reduction in frictional costs of buying and selling costs. It is the reduction in frictional costs that generates $$$. That and being able to have an edge in whatever orderbook/microstructure you are playing on.
=> in theory, does not "investing" sorta "create" wealth? This might be the answer, otherwise I, too, am stumped.
Are you certain about that?