Capitalism and Its Discontents

Now, what news on the Rialto?
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Heracleum Persicum
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Re: Capitalism and Its Discontents

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I'm posting this here because I don't where else

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Zack Morris
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Re: Capitalism and Its Discontents

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Mr. Perfect wrote: And please address the bolded. How is making trading almost free (rock bottom spreads and $10 or less commissioned trades) "punching holes in the economy or real value".

How is making trading more expensive for the retail investor by increasing profit margins for trading houses good for the economy.
I'll come back to the topic of HFT/electronic trading later, but Parodite specifically mentioned that you are free loading, and you tried to change the subject to HFT. There is a world of difference between a market making operation and a day trader. Market making obviously adds value, personal-scale day trading is just a series of negligible zero-sum transactions and are non-essential to value creating enterprises like market making and fund management. Day trading is no more essential to wealth creation than penny stock scammers or casino operators.
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Doc
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Re: Capitalism and Its Discontents

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Heracleum Persicum wrote:.

I'm posting this here because I don't where else

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That is really interesting Az. Thanks
"I fancied myself as some kind of god....It is a sort of disease when you consider yourself some kind of god, the creator of everything, but I feel comfortable about it now since I began to live it out.” -- George Soros
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Re: Capitalism and Its Discontents

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Parodite wrote:Mr. P. Your assignment for today:
Mr. P is correct on this topic and I think you two would find a lot to agree on if you both discussed it methodically. The HFT debate has been framed very poorly by the media. It's a fairly technical subject but actually not too complicated to understand if explained correctly. Let me see if I can help, since I happen to know a thing or two about this field.
1. Explain how HFT adds liquidity to the markets
Simply put, the more parties competing for your trade, the more liquid the market is. The faster your orders are hit, the less time they are posted for others to see and factor into their own decisions, the less risk there is that the market will move against you and the more likely your order is to be filled at the price you desire.

A fundamental concept here is that of a market maker. A market maker is someone who is willing to both buy and sell securities. They are facilitating a market for you by not only selling you securities but buying them back from you. The foreign exchange counter at your bank is a perfect example. Look carefully and you'll notice that the bid price (the maximum price the market maker will buy from you for) is lower than the ask price (the minimum he will sell to you for). This spread is how the market maker profits.

The reason market makers charge a spread is because by both buying and selling (as opposed to trading in one direction, as an individual buying or selling stock typically does), he bears inventory risk. Ideally, a market maker wants to buy low, sell high, and hold no inventory at the end of the day. But 1) that is almost never possible and 2) market prices can change rapidly, leaving the market maker holding a position that is suddenly deeply in the red. As compensation, the market maker charges a premium, which is the spread, hoping to make profit.

Firms can enter into agreements with any of the financial exchanges to serve as market makers. HFT firms operate this way. These agreements obligate market makers to be in the market providing valid quotes (bid/ask prices) throughout virtually the entire day. Failure to do so results in financial penalties and can ultimately result in a loss of market making privileges. One way a market maker can effectively pull out of the market and stop trading without actually withdrawing their quotes is by widening their quotes. Imagine dropping your bid price to some obviously low-ball value and then raising the ask (sell) price to some absurdly high value. Nobody would trade with you. Exchanges, therefore, have put in place rules to prevent this. There is a maximum spread beyond which market makers are considered to be violating their obligations.

As you can imagine, in a situation where a stock is plunging in value, the market maker is in a terrible situation: you want to sell your shares of Twitter because the world has woken up to the fact that it will never turn a profit and the market makers, many of whom are HFT firms, have to stand by and purchase it from you, no matter how low the price goes. That is the service they are providing you: liquidity. Exchanges charge some small fee per order executed but this fee can be negative for market makers providing liquidity (a liquidity rebate).

The more market makers there are, the narrower the spread becomes. It's obvious why: if you make your price just a teeny-tiny bit better, the order will go to you and you earn some money. Repeat this N times and eventually the spread becomes very small. Small spreads make trading cheaper but if the volume is high, you can still be very profitable, and so even more players are drawn to the game.

Now, why would you want to be a market maker? Investors talk about edge a lot -- some advantage they believe they have over other investors that will earn them a relatively low-risk profit. The primary edge for market makers is the spread in an idealized world. Market makers are uninformed traders, as are the vast majority of investors, meaning they do not know where prices will go. In reality, this is mostly true, but some market makers might think they have a different kind of edge. That's how HFT became popular: brainiacs began to realize that given the way exchanges work, with multiple exchanges spread around the east coast, Chicago, and the rest of the world, they could gain an edge by trading really fast using computers co-located next to the exchanges. They could capture more edge by investing in high-speed fiber and microwave links between exchanges to relay information to their computers even faster than the exchanges and customers themselves, thereby anticipating small price movements.

This dubious behavior is what most people term front running and is what has drawn the most condemnation. However, there are two points to consider: 1) as more players try to do this, they end up undercutting each other further and further. More importantly, 2) this can be viewed as compensation that the HFT firms extract for providing liquidity, functionally equivalent to an exchange charging you a fee to trade or a market maker charging a spread directly. It's a roundabout way of doing the same thing and the good news is that it's also a self-limiting problem as more HFT firms pile in. In fact, HFT today is far less lucrative than in its prime back in 2009 or so. While it's true that this is exploitation of an inefficiency in how exchanges operate and could be eliminated -- and maybe it should for purely technical reasons -- it will still be beneficial to trade quickly and with high volume, and you will benefit from low spreads.

The motivation may be anything but pure but then again, nobody trades unless they think they have some sort of edge they can extract over their competitors, right?
2. Explain how without HFT there would be less liquidity
Without HFT, you would either have humans doing the trading and extracting higher premiums, front-running clients, colluding with other traders, etc. Throttling trading to fixed-length increments would definitely wipe out some HFT firms but would probably have no long-term impact on liquidity or algorithmic trading. Exchanges are free to implement this if they'd like and compete for investors. I suspect many of the same HFT strategies would work similarly well on such throttled systems. There would still be an incentive to reduce latency to make sure the next trading cycle is not missed. On derivatives exchanges, electronic trading operations are often much, much slower than equity HFT firms due to the added complexities of derivatives pricing and risk management, so they would not be affected at all.
3. Explain how HFT is beneficial to others next to its backers
Hopefully this is clear from my other answers.
What makes you think that HFT is anything but a race against time where computers compete for getting information nano-seconds earlier? Knowing things before others do... means making money. Has nothing to do with trading stocks not even with trading business risk. Doesn't add any liquidity, just drains the systems of some nice money into the pockets of the small free loader. Doesn't do big harm to the system nor is it costly to the bigger players. Stealing a few cents from a enough many others still means a considerable amount of bounty for each free loading leech.
Think about this: why not reduce the time of information propagation down to exactly 0? What would happen then? Market makers and high-frequency-oriented investors would need to find some new way to collect edge. There are many algorithmic trading operations that do not rely on being the fastest. Machine learning is an active area of interest for many esoteric quantitative funds. Now, this does raise a good question, and is I think what you were trying to get at: is this kind of investing necessary at all? There is clearly a benefit to you personally from HFT in the form of liquidity and reduced fees. But it doesn't quite feel right that this much money and brainpower is being spent on what is ultimately a mundane problem. Investors are investing not because of fundamentals but because of the market itself. And many of these algorithms are simply following each other, creating a very large feedback loop. Is this wealth creation? I don't know. Probably not. But it's debatable.

Defining legitimate and illegitimate investing is a difficult exercise, one better suited for skilled economists. Most people would agree that something feels wrong about the way investing works in the secondary market (i.e., stock markets). It is the primary market, after all, where money is actually injected into commercial ventures. HFT shops aren't responsible for the problem but they certainly aren't helping. Then again, neither were the stock brokers of yesteryear. In fact, most of the investment industry is indeed a sham. Just look at sites like Minyanville, Marketwatch, and even CNBC's TV programming. It's a lot of bogus bullshit. It has been known for decades that the market is semi-strong form efficient, meaning all publicly known information is almost immediately incorporated into stock prices (translation: you can't predict them, they are effectively random walks). Technical analysis is a scam that was discredited decades ago and yet still pervades investment news articles, blogs, and books. Brokerages love to promote it because it encourages trading, which is how they earn money.

You want to know a couple of interesting facts?

1. Big, successful, profitable Wall Street electronic trading operations don't even try to predict stock prices in the ordinary sense. They consider it impossible. They rely on incredibly complex math, of course, but their trading strategies are far different than what retail investors (like you) would envision. They do not trade on insider information, either. It's all kosher.

2. They actually pay money to trade against you. When Mr. Perfect day trades at home on the options market, he may or may not be aware that the big market makers pay big money to retail brokerages for the privilege of receiving his orders directly. What happens next is interesting: they don't front run him. That wouldn't even be legal, as far as I understand. Instead, they tag his order with a special code and then send it to the exchange (firms like eTrade, Fidelity, etc. don't necessarily connect to exchanges themselves). When the exchange posts his order, they will submit an order with a better price than anyone else to ensure that the exchange matches them together. The market maker will quote one price in the open market but will submit a better price when a customer is detected. This benefits the customer because it improves their price, which is why Fidelity, etc. enter into these agreements. But what does the market maker get out of paying a lower price than they think is safe? Well, it turns out that retail order flows are extremely uninformed and it is nearly always profitable to trade against them! That's how bad day traders are. Market makers -- uninformed traders themselves who have no long-term views and perform no price prediction beyond a few seconds or minutes -- will fork over money just to get a chance to trade against them.

It's an odd industry, to say the least :)
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Parodite
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Re: Capitalism and Its Discontents

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Thanks Zack Morris! :) Now we talking..

I'll study your reply and will continue to play the devil's advocate with some follow up questions and remarks. My general assumption as the devils advocate is that people who make their money in the financial industry will always use a genuine method or product but also as a cover for an added layer of process or complexity specifically meant to fool or rig and pickpocket the client while he is looking the other way. The financial industry seems to me the perfect environment for advanced pickpocketing.
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Parodite
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Re: Capitalism and Its Discontents

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Zack Morris wrote:
Parodite wrote:Mr. P. Your assignment for today:
Mr. P is correct on this topic and I think you two would find a lot to agree on if you both discussed it methodically. The HFT debate has been framed very poorly by the media. It's a fairly technical subject but actually not too complicated to understand if explained correctly. Let me see if I can help, since I happen to know a thing or two about this field.
1. Explain how HFT adds liquidity to the markets
Simply put, the more parties competing for your trade, the more liquid the market is. The faster your orders are hit, the less time they are posted for others to see and factor into their own decisions, the less risk there is that the market will move against you and the more likely your order is to be filled at the price you desire.
But nowadays, buyers and sellers don't need any middleman to do the trade for them. All they want is the information about the +/- value of what it is they want to sell or buy. This information is readily available, right?
A fundamental concept here is that of a market maker. A market maker is someone who is willing to both buy and sell securities. They are facilitating a market for you by not only selling you securities but buying them back from you. The foreign exchange counter at your bank is a perfect example. Look carefully and you'll notice that the bid price (the maximum price the market maker will buy from you for) is lower than the ask price (the minimum he will sell to you for). This spread is how the market maker profits.
I'm skeptical of this claim. As a buyer or seller all I need to know is the +/-market value of what I want to buy or sell. When that information is made publicly available I don't see the need for market makers / agents / middle men. To me, they want to appear indispensable making unsubstantiated claims of how they are of added value to the market. "Lubricating the market" sounds much too sexy to me. ;) But maybe I'm wrong... Is there a simple analogy that explains why such claims are valid?

Note that the trend is that the role of many middle men is detoriating. People buy their products from Amazon etc.. Real estate agents make less money because people recognize that the added value today of a real estate agent is smaller; people put their houses for sale on real estate websites, show potential buyers around in their own house.. the financial and legal documents are standardized and can be bought directly from the notary who does the legal transfer from one owner to the new one. Real estate agents could claim that they are needed "to lubricate the market"... but it would simply be a lie. Why is it not a lie in the case of HFT?
The reason market makers charge a spread is because by both buying and selling (as opposed to trading in one direction, as an individual buying or selling stock typically does), he bears inventory risk. Ideally, a market maker wants to buy low, sell high, and hold no inventory at the end of the day. But 1) that is almost never possible and 2) market prices can change rapidly, leaving the market maker holding a position that is suddenly deeply in the red. As compensation, the market maker charges a premium, which is the spread, hoping to make profit.
I understand that. Given that the market makers do what they do.. they must make some money on it and create arguments of why what they do is necessary. What remains however is they question of what they do is necessary, i.e. of added value to buyers and sellers. I don't think they have added value, which can only mean that they found a way to extract money from the market and in the end making securities more expensive then they need be from the perspective of the buyers and sellers themselves. They drive up the price.. i.e. they artificially tax the system in fact.
Firms can enter into agreements with any of the financial exchanges to serve as market makers. HFT firms operate this way. These agreements obligate market makers to be in the market providing valid quotes (bid/ask prices) throughout virtually the entire day. Failure to do so results in financial penalties and can ultimately result in a loss of market making privileges. One way a market maker can effectively pull out of the market and stop trading without actually withdrawing their quotes is by widening their quotes. Imagine dropping your bid price to some obviously low-ball value and then raising the ask (sell) price to some absurdly high value. Nobody would trade with you. Exchanges, therefore, have put in place rules to prevent this. There is a maximum spread beyond which market makers are considered to be violating their obligations.
This typically illustrates my point, where I said that layers of complexity are added to the system from which nobody benefits, except the market makers who use it to pickpocket you with their other hand. Analogously I make you ill without you noticing it.. but then present you with the cure and ask a price for it. Where does this analogy break down with this particular reality of HFT?
As you can imagine, in a situation where a stock is plunging in value, the market maker is in a terrible situation: you want to sell your shares of Twitter because the world has woken up to the fact that it will never turn a profit and the market makers, many of whom are HFT firms, have to stand by and purchase it from you, no matter how low the price goes. That is the service they are providing you: liquidity. Exchanges charge some small fee per order executed but this fee can be negative for market makers providing liquidity (a liquidity rebate).
But buyers and sellers would buy and sell anyways for the market value... All the market maker did was go sit in between them, claim that everybody needs them.. buy and sell back and forth in some near-zero-sum game.. and when push comes to shove the middle men take their wins and losses.. when securities are sold for their real market value. In the mean time though.. people have made some money on this extra layer of complexity where also the market maker operates. I can only describe them as leeches or pickpockets that burden the system with dog poo.
The more market makers there are, the narrower the spread becomes. It's obvious why: if you make your price just a teeny-tiny bit better, the order will go to you and you earn some money. Repeat this N times and eventually the spread becomes very small. Small spreads make trading cheaper but if the volume is high, you can still be very profitable, and so even more players are drawn to the game.
I want to sell my car. Based on the model, age, mileage, condition etc.. is has a market value. The information is available and the result of previous market results. Lets say the best available statistics say my car now has a value of 5525,- dollars. Both I and potential buyers know this. We can come to a deal very fast. How would we benefit from any market maker that operates in between us? For starters.. because he, "the market maker"{ , also needs to make a buck one way or other.. so the price of the car has to be higher than necessary.

The rest I'll respond to later.

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Zack Morris
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Re: Capitalism and Its Discontents

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Parodite wrote: But nowadays, buyers and sellers don't need any middleman to do the trade for them. All they want is the information about the +/- value of what it is they want to sell or buy. This information is readily available, right?
Is it? Let's think about it. But first, some clarification about what we mean by "middleman" is necessary. Middlemen are presumably intermediaries that you have virtually no option but to transact with, which allows them to charge a risk-free premium. A foreign exchange counter is kind of like that. Of course, you could go to another bank, but ultimately, there are few players in town (or at the airport!) and you are kind of shielded from the broader market. I don't know the FX market but I think (someone correct me if I'm wrong) that exchanges don't exist. So in that market, the market maker-as-middleman model is a real thing.

Technically, I think that FX markets are broker markets, where a broker is defined as someone who arranges transactions by finding counter-parties and then charging a commission for the service. A classical middleman. Think real estate brokers. Here in New York, I know a real estate agent who will definitely not be appearing on Million Dollar Listing anytime soon. He makes a rather poor income and most of the 6% commission made on his (often > $1M) real estate transactions are split between the agencies, after which only a small cut goes to the individual agent, resulting in a less-than-6-figure income. I asked him why he doesn't just strike it out on his own and take his relationships with him. Well, licensing requirements for such a business in New York City are expensive, making it too risky. This is the classic example of an artificially restricted market that protects middlemen of dubious value.

But what about market makers and stock brokers in the securities markets? To be honest, the precise definition of a stock broker today is a mystery to me. It's a common model in fixed income (bonds) but I don't know of any common examples in equities. I guess technically, the large investment banks operate brokerage businesses where traders will trade over-the-counter, acting both as middlemen and market makers for the purpose of helping clients execute very large orders conspicuously without having the market move against them. To do this, traders have to take the risk of engaging in potentially toxic (meaning the counterparty knows more than they do about the future value of the asset) trades in the hopes of liquidating their positions later on for a better price. I'll elaborate more on this aspect later.

When I talked about market makers in my previous post, I wasn't referring to typical middlemen. Let's forget about brokered trading altogether and focus on automated exchanges, which is where the bulk of trading occurs. The real middleman here is the exchange and, also, whoever gives you access to infrastructure that connects to the exchange (example: Interactive Brokers, and really any other electronic platform). The market makers I discussed -- the HFT firms, big banks, etc. -- are exchange participants. They are special participants in that they have certain quoting obligations, can get priority allocation, and are sometimes better positioned near the physical infrastructure of the exchange, but nevertheless, they are simply participants. When you place an order on an exchange, the exchange's matching engine attempts to match it with the best possible price. Furthermore, Regulation NMS requires exchanges to trade on the venue with the best price, meaning they have to be aware of what the best price (called the BBO, best bid/offer) is on other exchanges and route your order there. Orders (bid or ask prices) and quotes (bid and ask pairs from market makers) are sorted into an order book continuously and matched.

So you can see that in this model, the market maker is not an ordinary intermediary that you go to trade with. As I mentioned in my previous post, Mr. Perfect's orders may well be going directly to a market maker but that market maker still has to submit the order to the exchange. In reality, he will end up hitting only a fraction of Mr. P's order flow because other participants out there might be faster and get it first, even though the market maker is expecting it to appear.

Side point: Reg. NMS is often blamed for facilitating the rise of HFT. Obviously, it takes time for a single computer (which is what an exchange boils down to) to sort and match orders. How can they know in real time what is happening on other exchanges given the propagation delay between them? They can't but try to do so on a best effort basis. There is a concept of NBBO -- national best bid and offer, which is the best bid price and best ask price for the entire market nationwide. There are consolidated feeds that disseminate this information as well as indicating which exchanges are contributing to the NBBO (for example, the NBBO at any given moment may consist of a bid price found on NYSE and an ask price that is best on ISE). There is obviously some uncertainty to this quantity because the NBBO at any given moment received via a consolidated feed is already stale due to the latencies involved in aggregating all the requisite information. This is what HFT exploits for edge. They know that exchanges are sometimes going to route orders to competitors to comply with Reg. NMS.
I'm skeptical of this claim. As a buyer or seller all I need to know is the +/-market value of what I want to buy or sell. When that information is made publicly available I don't see the need for market makers / agents / middle men. To me, they want to appear indispensable making unsubstantiated claims of how they are of added value to the market. "Lubricating the market" sounds much too sexy to me. ;) But maybe I'm wrong... Is there a simple analogy that explains why such claims are valid?
As explained above, market makers in securities markets are probably not the kind of middlemen you were thinking of. They are basically just buyers and sellers who compete for your orders alongside other retail and institutional investors. If another retail client is offering a better price, the exchange will match your order to his. The top of the order book is what determines the market price. The market price is defined as the midpoint between the best bid and the best ask.

Surely you can see some real value in having such participants standing by ready to take your orders?
Note that the trend is that the role of many middle men is detoriating. People buy their products from Amazon etc.. Real estate agents make less money because people recognize that the added value today of a real estate agent is smaller; people put their houses for sale on real estate websites, show potential buyers around in their own house.. the financial and legal documents are standardized and can be bought directly from the notary who does the legal transfer from one owner to the new one. Real estate agents could claim that they are needed "to lubricate the market"... but it would simply be a lie. Why is it not a lie in the case of HFT?
Correct but Amazon is itself a middleman, is it not? It provides the technology platform that allows you to discover counterparties and then takes a cut of their profits. Real estate by all accounts seems to be an inefficient market and the middleman situation there is certainly to blame.

In the electronic trading space, middlemen serve other, less obvious purposes. Think about stock and derivatives traders. Big funds call up traders at banks and ask them to quote prices on large orders they want to place (buy or sell). The trader then consults with his buddies, calls up other traders at other banks and funds, and then gets back with a price he thinks he can take the order for. The fund calls a few traders and picks the best offer. Why would anyone do this instead of routing directly to an exchange where it can be matched according to well-defined rules? Well, the market is so highly active that participants have to worry about transaction costs, which are costs incurred due to the very act of trading. Not fees, which are already known, but adverse price movements. As you are well aware, when someone knows you want to buy something, they will raise their price as high as they can get away with. Lots of buyers drive prices up. When you want to sell, they will try to lower the price. Lots of sellers drive prices down. Supply and demand. Participating on open exchanges by naively routing orders in big chunks exposes you to transaction costs. You will see your order only partially filled at the target price. Then the market (all participants, including market makers of course) will quickly react. Traders are paid to execute orders efficiently. They want to get you the best possible price so that they can charge a little more and earn a commission for their service. They bear risk by committing to a price. If they execute poorly, they may end up losing money on the transaction, but you get your desired price and forget about it.

Large banks and other trading operations offer so-called smart electronic trading services, which attempt to do the same thing through a largely automated process. You submit a big order and they will attempt to route it over time to various trading venues in such a way as to deliver the best price possible. I don't think they quote a price ahead of time (not 100% sure on the business model from the client's perspective) but I assume you just end up paying whatever the execution prices plus their service premium is. If you're not happy, you move your business to another group. These electronic trading services (offered by Credit Suisse, Morgan Stanley, Goldman Sachs, Royal Bank of Canada, and just about everyone else) were largely a response to HFT and algorithmic traders, but this was inevitable in an open exchange system.

If there were no market makers or smart executors, you would be quite vulnerable on an open exchange as an uninformed trader. Informed traders, or traders with superior infrastructure and capital, would move aggressively against you. There would be a huge incentive (just as there is now) for such players to enter the market one way or another.
I understand that. Given that the market makers do what they do.. they must make some money on it and create arguments of why what they do is necessary. What remains however is they question of what they do is necessary, i.e. of added value to buyers and sellers. I don't think they have added value, which can only mean that they found a way to extract money from the market and in the end making securities more expensive then they need be from the perspective of the buyers and sellers themselves. They drive up the price.. i.e. they artificially tax the system in fact.
It's not the HFT firms or operations I described above that are necessarily to blame for any deficiencies in the larger securities markets, which there are arguably many. Obviously, the markets remain highly irrational. Maybe that's inevitable but maybe not. There is also definitely a big industry out there trying to drum up trading activity for no real reason other than to make you think you can ride the wave and cash in. This is all economically dubious.
Firms can enter into agreements with any of the financial exchanges to serve as market makers. HFT firms operate this way. These agreements obligate market makers to be in the market providing valid quotes (bid/ask prices) throughout virtually the entire day. Failure to do so results in financial penalties and can ultimately result in a loss of market making privileges. One way a market maker can effectively pull out of the market and stop trading without actually withdrawing their quotes is by widening their quotes. Imagine dropping your bid price to some obviously low-ball value and then raising the ask (sell) price to some absurdly high value. Nobody would trade with you. Exchanges, therefore, have put in place rules to prevent this. There is a maximum spread beyond which market makers are considered to be violating their obligations.
This typically illustrates my point, where I said that layers of complexity are added to the system from which nobody benefits, except the market makers who use it to pickpocket you with their other hand. Analogously I make you ill without you noticing it.. but then present you with the cure and ask a price for it. Where does this analogy break down with this particular reality of HFT?
As I pointed out, in an open system where you can find out the price and place an order -- which is how electronic exchanges function -- you are still vulnerable to predators who are better informed or equipped than you. All participants, be they savvy funds or boring bank-run market makers or even your dentist day trading at home, are predators. But the more of these there are and the faster their trades can be executed, the more competitive pressure there is to reduce overhead costs you pay. This is good if you think you are making a transaction for a fundamentally sound reason. This is all in the nature of any market. HFT market makers specifically provide a benefit in that they guarantee someone will fill your orders. Exchanges want liquidity providers to keep markets operating even in times when conditions are unfavorable. The idea is that there is always a market there ready for you to unload your securities onto. You can fire and forget but someone else has to bear the risk.
But buyers and sellers would buy and sell anyways for the market value... All the market maker did was go sit in between them, claim that everybody needs them.. buy and sell back and forth in some near-zero-sum game.. and when push comes to shove the middle men take their wins and losses.. when securities are sold for their real market value. In the mean time though.. people have made some money on this extra layer of complexity where also the market maker operates. I can only describe them as leeches or pickpockets that burden the system with dog poo.
The real market value is determined by market activity, though. And the easier it is to buy or sell a security, the quicker the value converges to what everyone believes is "fair." I'll elaborate below with your car example.

I want to sell my car. Based on the model, age, mileage, condition etc.. is has a market value. The information is available and the result of previous market results. Lets say the best available statistics say my car now has a value of 5525,- dollars. Both I and potential buyers know this. We can come to a deal very fast. How would we benefit from any market maker that operates in between us? For starters.. because he, "the market maker"{ , also needs to make a buck one way or other.. so the price of the car has to be higher than necessary.
A market maker in this case would enhance liquidity by offering you a price more quickly. Might it be higher? Yes. But the alternative is having to hunt for a buyer for an indefinite period of time because cars are not sold anywhere near as frequently as smaller, cheaper, and easier to maintain items. During that time, you bear the risk of someone else coming onto the market and offering the same car for even less. If only a market maker had been willing to purchase your vehicle at day 1 for what was thought to be the market price then!

Back in 2006, I bought a 2005 Honda Accord, sight unseen, off of eBay for $15K. (Best car-related decision of my life, by the way!) Fast forward to 2013 and I was now living in Seattle but had accepted a job in New York. I moved back to my parents' place for a month and decided to sell my car, since I wouldn't need it here. I discovered on Craigslist that prices for 2005 Accords were lower in the nearest large metro areas but noticeably higher in my smallish (~250K people) hometown. This was of course the same reason that I bought off of eBay in the first place. The blue book value of my car was something on the order of $8K-$9K but I wanted $11K, and that's what I advertised on Craigslist for. Someone offered me the blue book price, claiming that he had done his research and this was the fair market price. I felt bad for the guy and his wife -- they were a low-income blue collar couple and didn't realize that my car was actually worth a premium. It was in excellent condition and would have spared them the maintenance costs of an $8K lemon. I held firm. Another buyer, this one more informed, came calling. He and his father took my Accord for the most intensive and meticulous test drive I've ever experienced and spent a lot of time examining the engine, unscrewing fluid caps, examining the suspension, etc., etc. They frowned and offered me the blue book value as well, asking why I was charging a steep $11K. I said, "yes, it's more expensive than the national market value, but if you want a 2005 Accord in comparable condition for less, the nearest one is hundreds of miles away. Given its condition and the lack of local availability, I think the premium is worth it."

We talked it down to $10.5K, and they bought it. What does this say about market making? Well, not a whole lot, but it illustrates another point: illiquidity itself can distort prices. In the case of cars, local markets develop. Transactions are entered into only after a considerable amount of searching and thought. Market makers competing for your sale would drive the price down quickly to some national best price and no lower.
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Parodite
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Re: Capitalism and Its Discontents

Post by Parodite »

In reply to the rest of your first post:
Now, why would you want to be a market maker? Investors talk about edge a lot -- some advantage they believe they have over other investors that will earn them a relatively low-risk profit. The primary edge for market makers is the spread in an idealized world. Market makers are uninformed traders, as are the vast majority of investors, meaning they do not know where prices will go. In reality, this is mostly true, but some market makers might think they have a different kind of edge. That's how HFT became popular: brainiacs began to realize that given the way exchanges work, with multiple exchanges spread around the east coast, Chicago, and the rest of the world, they could gain an edge by trading really fast using computers co-located next to the exchanges. They could capture more edge by investing in high-speed fiber and microwave links between exchanges to relay information to their computers even faster than the exchanges and customers themselves, thereby anticipating small price movements.

This dubious behavior is what most people term front running and is what has drawn the most condemnation. However, there are two points to consider: 1) as more players try to do this, they end up undercutting each other further and further. More importantly, 2) this can be viewed as compensation that the HFT firms extract for providing liquidity, functionally equivalent to an exchange charging you a fee to trade or a market maker charging a spread directly. It's a roundabout way of doing the same thing and the good news is that it's also a self-limiting problem as more HFT firms pile in. In fact, HFT today is far less lucrative than in its prime back in 2009 or so. While it's true that this is exploitation of an inefficiency in how exchanges operate and could be eliminated -- and maybe it should for purely technical reasons -- it will still be beneficial to trade quickly and with high volume, and you will benefit from low spreads.

The motivation may be anything but pure but then again, nobody trades unless they think they have some sort of edge they can extract over their competitors, right?
Itself it is normal that in any ecology, included the financial ecology, competing participants try to have an edge over others. As I said to Mr.P., I don't blame anyone, each species has its own survival strategy. And it can result in wonderful species! Like the deep sea lantern fish that wants you to think it is showing you the light... and then eats you when you believe the message ;)

2. Explain how without HFT there would be less liquidity

Without HFT, you would either have humans doing the trading and extracting higher premiums, front-running clients, colluding with other traders, etc. Throttling trading to fixed-length increments would definitely wipe out some HFT firms but would probably have no long-term impact on liquidity or algorithmic trading. Exchanges are free to implement this if they'd like and compete for investors. I suspect many of the same HFT strategies would work similarly well on such throttled systems. There would still be an incentive to reduce latency to make sure the next trading cycle is not missed. On derivatives exchanges, electronic trading operations are often much, much slower than equity HFT firms due to the added complexities of derivatives pricing and risk management, so they would not be affected at all.
I would think one first needs to establish how much liquidity is actually needed for what type of product or service. A crop that is harvested and sold once a year.. may need a much lower paced liquidity than the more virtual/hypothetical products like certain derivatives that are sold like scary moments in a bad dream with a certain bad ending, quickly sold to the next potential victim.. where the last one is the sucker as in a Ponzi scheme. The latter of course, it seems to me, is exactly where the markets can suffer most from panic and paranoia. The risk though, is that such paranoia also drags down other more stable an calm markets like crops with it... because the financial Dalton brothers long ago understood that after you destroy Glass & Steagall and can mix and remix all value into sexy new financial products alias "port folios" with a bit of bad real estate, a bit of commodities, a bit of risk insurance, a bit more of disguised dog poo default swaps and waste you needed to get rid of, some future this or that in exchange for a secured gvt bond..in other words... a bad stew where all is connected and made dependent on each other.. no structural compartmentalization, just more extra layers of complexity that allow you to create edge nevertheless in a bad dream.. for as long as it lasts...and all new risk is paid for by others who produce and consume in the real economy when everybody defaults and wakes up again.

3. Explain how HFT is beneficial to others next to its backers


Hopefully this is clear from my other answers.


What makes you think that HFT is anything but a race against time where computers compete for getting information nano-seconds earlier? Knowing things before others do... means making money. Has nothing to do with trading stocks not even with trading business risk. Doesn't add any liquidity, just drains the systems of some nice money into the pockets of the small free loader. Doesn't do big harm to the system nor is it costly to the bigger players. Stealing a few cents from a enough many others still means a considerable amount of bounty for each free loading leech.
Think about this: why not reduce the time of information propagation down to exactly 0? What would happen then? Market makers and high-frequency-oriented investors would need to find some new way to collect edge. There are many algorithmic trading operations that do not rely on being the fastest. Machine learning is an active area of interest for many esoteric quantitative funds. Now, this does raise a good question, and is I think what you were trying to get at: is this kind of investing necessary at all? There is clearly a benefit to you personally from HFT in the form of liquidity and reduced fees. But it doesn't quite feel right that this much money and brainpower is being spent on what is ultimately a mundane problem.
Indeed. My feeling is that modern technology is removing at fast speed many intermediate points in trade. Take eBay. Buyers and sellers decide themselves how and when to buy, sell, auction... EBay could of course also be a co-op and owned by a community of buyers and sellers. Most matching can be done automatically. Enough liquidity guaranteed. All you want is keeping out leeches and pickpockets that in fact only tax the system without adding liquidity. I would also like to know if the concept of "too much liquidity" has even been considered. "Snake oil liquefiers" comes to mind ;)

Investors are investing not because of fundamentals but because of the market itself. And many of these algorithms are simply following each other, creating a very large feedback loop. Is this wealth creation? I don't know. Probably not. But it's debatable.

Defining legitimate and illegitimate investing is a difficult exercise, one better suited for skilled economists. Most people would agree that something feels wrong about the way investing works in the secondary market (i.e., stock markets). It is the primary market, after all, where money is actually injected into commercial ventures. HFT shops aren't responsible for the problem but they certainly aren't helping. Then again, neither were the stock brokers of yesteryear. In fact, most of the investment industry is indeed a sham. Just look at sites like Minyanville, Marketwatch, and even CNBC's TV programming. It's a lot of bogus bullshit. It has been known for decades that the market is semi-strong form efficient, meaning all publicly known information is almost immediately incorporated into stock prices (translation: you can't predict them, they are effectively random walks). Technical analysis is a scam that was discredited decades ago and yet still pervades investment news articles, blogs, and books. Brokerages love to promote it because it encourages trading, which is how they earn money.
I have no doubt the financial industry is infested with all types of small and big scams and gimmicks that are only there because the rules allow them to be there, or to develop. Key therefore are the regulatory bodies that set the rules of the game. But guess what, vested interests and bribing are as old as the world.


You want to know a couple of interesting facts?

1. Big, successful, profitable Wall Street electronic trading operations don't even try to predict stock prices in the ordinary sense. They consider it impossible. They rely on incredibly complex math, of course, but their trading strategies are far different than what retail investors (like you) would envision. They do not trade on insider information, either. It's all kosher.

2. They actually pay money to trade against you. When Mr. Perfect day trades at home on the options market, he may or may not be aware that the big market makers pay big money to retail brokerages for the privilege of receiving his orders directly. What happens next is interesting: they don't front run him. That wouldn't even be legal, as far as I understand. Instead, they tag his order with a special code and then send it to the exchange (firms like eTrade, Fidelity, etc. don't necessarily connect to exchanges themselves). When the exchange posts his order, they will submit an order with a better price than anyone else to ensure that the exchange matches them together. The market maker will quote one price in the open market but will submit a better price when a customer is detected. This benefits the customer because it improves their price, which is why Fidelity, etc. enter into these agreements. But what does the market maker get out of paying a lower price than they think is safe? Well, it turns out that retail order flows are extremely uninformed and it is nearly always profitable to trade against them! That's how bad day traders are. Market makers -- uninformed traders themselves who have no long-term views and perform no price prediction beyond a few seconds or minutes -- will fork over money just to get a chance to trade against them.

It's an odd industry, to say the least :)
These systems are obviously not working with the best interest of both buyers and sellers of items of real economic value in mind. They are precisely made complex, as complex as possible.. because it allows them to play games that only they understand and control. The Mob.
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Re: Capitalism and Its Discontents

Post by Mr. Perfect »

Zack Morris wrote: I'll come back to the topic of HFT/electronic trading later, but Parodite specifically mentioned that you are free loading, and you tried to change the subject to HFT. There is a world of difference between a market making operation and a day trader. Market making obviously adds value, personal-scale day trading is just a series of negligible zero-sum transactions and are non-essential to value creating enterprises like market making and fund management. Day trading is no more essential to wealth creation than penny stock scammers or casino operators.
Actually no reading miscomprehension strikes again. CS brought up hft, P glommed on and mentioned something nonspecific about me freeloading and then went into hft. So the bulk of the "argument" is about hft. Which I am 100% right about.
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Re: Capitalism and Its Discontents

Post by Mr. Perfect »

Zack Morris wrote: Simply put, the more parties competing for your trade, the more liquid the market is. The faster your orders are hit, the less time they are posted for others to see and factor into their own decisions, the less risk there is that the market will move against you and the more likely your order is to be filled at the price you desire.

A fundamental concept here is that of a market maker. A market maker is someone who is willing to both buy and sell securities. They are facilitating a market for you by not only selling you securities but buying them back from you. The foreign exchange counter at your bank is a perfect example. Look carefully and you'll notice that the bid price (the maximum price the market maker will buy from you for) is lower than the ask price (the minimum he will sell to you for). This spread is how the market maker profits.

The reason market makers charge a spread is because by both buying and selling (as opposed to trading in one direction, as an individual buying or selling stock typically does), he bears inventory risk. Ideally, a market maker wants to buy low, sell high, and hold no inventory at the end of the day. But 1) that is almost never possible and 2) market prices can change rapidly, leaving the market maker holding a position that is suddenly deeply in the red. As compensation, the market maker charges a premium, which is the spread, hoping to make profit.
You were doing ok till this part, market makers generally hold no inventory risk because almost every trade they make is hedged with a synthetic position of some sort.

http://www.optiontradingpedia.com/market_makers.htm

Market Makers protect themselves from directional risks through "Hedging" and flexible use of synthetic positions. A Market Maker hedges his inventory through buying or selling additional stocks or stock options in order to achieve a position whereby stocks and options falls as much as the other rises in order to maintain the overall value of the account. This is what we call a "Delta-Neutral" position. A Market Maker's positioning strategy, especially in making markets for stock options, is extremely complex and requires to the second calculation and execution. It is because of this complexity in balancing all kinds of risks that some new Market Makers actually lose money to the market despite all the privileges of being a Market Maker.


Market maker risk generally is not being competitive enough during changes in volume. P should love hft because it puts floor traders under the gun.


Firms can enter into agreements with any of the financial exchanges to serve as market makers. HFT firms operate this way. These agreements obligate market makers to be in the market providing valid quotes (bid/ask prices) throughout virtually the entire day. Failure to do so results in financial penalties and can ultimately result in a loss of market making privileges. One way a market maker can effectively pull out of the market and stop trading without actually withdrawing their quotes is by widening their quotes. Imagine dropping your bid price to some obviously low-ball value and then raising the ask (sell) price to some absurdly high value. Nobody would trade with you. Exchanges, therefore, have put in place rules to prevent this. There is a maximum spread beyond which market makers are considered to be violating their obligations.

As you can imagine, in a situation where a stock is plunging in value, the market maker is in a terrible situation: you want to sell your shares of Twitter because the world has woken up to the fact that it will never turn a profit and the market makers, many of whom are HFT firms, have to stand by and purchase it from you, no matter how low the price goes. That is the service they are providing you: liquidity. Exchanges charge some small fee per order executed but this fee can be negative for market makers providing liquidity (a liquidity rebate).

The more market makers there are, the narrower the spread becomes. It's obvious why: if you make your price just a teeny-tiny bit better, the order will go to you and you earn some money. Repeat this N times and eventually the spread becomes very small. Small spreads make trading cheaper but if the volume is high, you can still be very profitable, and so even more players are drawn to the game.

Now, why would you want to be a market maker? Investors talk about edge a lot -- some advantage they believe they have over other investors that will earn them a relatively low-risk profit. The primary edge for market makers is the spread in an idealized world. Market makers are uninformed traders, as are the vast majority of investors, meaning they do not know where prices will go. In reality, this is mostly true, but some market makers might think they have a different kind of edge. That's how HFT became popular: brainiacs began to realize that given the way exchanges work, with multiple exchanges spread around the east coast, Chicago, and the rest of the world, they could gain an edge by trading really fast using computers co-located next to the exchanges. They could capture more edge by investing in high-speed fiber and microwave links between exchanges to relay information to their computers even faster than the exchanges and customers themselves, thereby anticipating small price movements.

This dubious behavior is what most people term front running and is what has drawn the most condemnation. However, there are two points to consider: 1) as more players try to do this, they end up undercutting each other further and further. More importantly, 2) this can be viewed as compensation that the HFT firms extract for providing liquidity, functionally equivalent to an exchange charging you a fee to trade or a market maker charging a spread directly. It's a roundabout way of doing the same thing and the good news is that it's also a self-limiting problem as more HFT firms pile in. In fact, HFT today is far less lucrative than in its prime back in 2009 or so. While it's true that this is exploitation of an inefficiency in how exchanges operate and could be eliminated -- and maybe it should for purely technical reasons -- it will still be beneficial to trade quickly and with high volume, and you will benefit from low spreads.

The motivation may be anything but pure but then again, nobody trades unless they think they have some sort of edge they can extract over their competitors, right?
2. Explain how without HFT there would be less liquidity
Without HFT, you would either have humans doing the trading and extracting higher premiums, front-running clients, colluding with other traders, etc. Throttling trading to fixed-length increments would definitely wipe out some HFT firms but would probably have no long-term impact on liquidity or algorithmic trading. Exchanges are free to implement this if they'd like and compete for investors. I suspect many of the same HFT strategies would work similarly well on such throttled systems. There would still be an incentive to reduce latency to make sure the next trading cycle is not missed. On derivatives exchanges, electronic trading operations are often much, much slower than equity HFT firms due to the added complexities of derivatives pricing and risk management, so they would not be affected at all.
3. Explain how HFT is beneficial to others next to its backers
Hopefully this is clear from my other answers.
What makes you think that HFT is anything but a race against time where computers compete for getting information nano-seconds earlier? Knowing things before others do... means making money. Has nothing to do with trading stocks not even with trading business risk. Doesn't add any liquidity, just drains the systems of some nice money into the pockets of the small free loader. Doesn't do big harm to the system nor is it costly to the bigger players. Stealing a few cents from a enough many others still means a considerable amount of bounty for each free loading leech.
Think about this: why not reduce the time of information propagation down to exactly 0? What would happen then? Market makers and high-frequency-oriented investors would need to find some new way to collect edge. There are many algorithmic trading operations that do not rely on being the fastest. Machine learning is an active area of interest for many esoteric quantitative funds. Now, this does raise a good question, and is I think what you were trying to get at: is this kind of investing necessary at all? There is clearly a benefit to you personally from HFT in the form of liquidity and reduced fees. But it doesn't quite feel right that this much money and brainpower is being spent on what is ultimately a mundane problem. Investors are investing not because of fundamentals but because of the market itself. And many of these algorithms are simply following each other, creating a very large feedback loop. Is this wealth creation? I don't know. Probably not. But it's debatable.

Defining legitimate and illegitimate investing is a difficult exercise, one better suited for skilled economists. Most people would agree that something feels wrong about the way investing works in the secondary market (i.e., stock markets). It is the primary market, after all, where money is actually injected into commercial ventures. HFT shops aren't responsible for the problem but they certainly aren't helping. Then again, neither were the stock brokers of yesteryear. In fact, most of the investment industry is indeed a sham. Just look at sites like Minyanville, Marketwatch, and even CNBC's TV programming. It's a lot of bogus bullshit. It has been known for decades that the market is semi-strong form efficient, meaning all publicly known information is almost immediately incorporated into stock prices (translation: you can't predict them, they are effectively random walks). Technical analysis is a scam that was discredited decades ago and yet still pervades investment news articles, blogs, and books. Brokerages love to promote it because it encourages trading, which is how they earn money.

You want to know a couple of interesting facts?

1. Big, successful, profitable Wall Street electronic trading operations don't even try to predict stock prices in the ordinary sense. They consider it impossible. They rely on incredibly complex math, of course, but their trading strategies are far different than what retail investors (like you) would envision. They do not trade on insider information, either. It's all kosher.

2. They actually pay money to trade against you. When Mr. Perfect day trades at home on the options market, he may or may not be aware that the big market makers pay big money to retail brokerages for the privilege of receiving his orders directly. What happens next is interesting: they don't front run him. That wouldn't even be legal, as far as I understand. Instead, they tag his order with a special code and then send it to the exchange (firms like eTrade, Fidelity, etc. don't necessarily connect to exchanges themselves). When the exchange posts his order, they will submit an order with a better price than anyone else to ensure that the exchange matches them together. The market maker will quote one price in the open market but will submit a better price when a customer is detected. This benefits the customer because it improves their price, which is why Fidelity, etc. enter into these agreements. But what does the market maker get out of paying a lower price than they think is safe? Well, it turns out that retail order flows are extremely uninformed and it is nearly always profitable to trade against them! That's how bad day traders are. Market makers -- uninformed traders themselves who have no long-term views and perform no price prediction beyond a few seconds or minutes -- will fork over money just to get a chance to trade against them.

It's an odd industry, to say the least :)
Well I appreciate the typing. I get tired of doing it. It is mostly correct, with a lot of errors, but I don't have the time to fix them all. But there is enough for someone to start googling the key words.

If anyone can understand anything he said (I will give Zack Morris a B+, which is really a ridiculously high grade considering his historic reading problems) you can simplify it this way, hft is a form of arbitrage among floor trading, and is likely in the end due to (here it comes) government interference in the market. One could argue that you shouldn't need a securities license to make markets and that hft bursts the bubble of artificially constrained markets.

In the end hft has made trading ridiculously cheap and fast. Which is the definition of creating value. Why anyone wants to go back to more expensive and slower can only be explained by perhaps damage to the organ carried in the skull.

I actually remember the beginning of hft, sometime in 98 or 99 I think, I was getting into the cutting edge stuff of the time and the exchanges were a bit behind the curve. You could find a lazy market maker who failed to update his chain prices just by pointing and clicking, buy an undervalued option from him at one price, wait for him to update his quote and then sell it back to him for as much as a point profit, across 10 contract, $1,000 profit. Just for sport. Then these terminal traders started getting off the scalping and starting arbing, then writing programs and here we are today. It was interesting to watch but was not my forte. Required being able to write programs, which I didn't want to do. I just benefitted in lower spreads and commisions and lightning fast execution.

God Bless America. :) :) :) :)
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Re: Capitalism and Its Discontents

Post by Parodite »

Mr. Perfect wrote:In the end hft has made trading ridiculously cheap and fast. Which is the definition of creating value. Why anyone wants to go back to more expensive and slower can only be explained by perhaps damage to the organ carried in the skull.
That seems too much credit to HFT. The digital age made trading fast and cheap. Now buyers and sellers that want to trade real economic value can do it faster, easier and cheaper on any electronic market platform. But as with any market place, it attracts pickpockets and other leechy folks. They in fact created a huge empire, Pickpocket your Wallet Street. No need to remind that those pickpockets indeed love Harvard Democrats who hand them over the bubble cash on a silver platter. ;) In fact it is a brilliant tactic when two thiefs who belong to the same gang always blame each other in order to just distract the public from their crimes. The blame game is the perfect cover.
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Re: Capitalism and Its Discontents

Post by Parodite »

Zack Morris wrote:
Parodite wrote: But nowadays, buyers and sellers don't need any middleman to do the trade for them. All they want is the information about the +/- value of what it is they want to sell or buy. This information is readily available, right?
Is it? Let's think about it. But first, some clarification about what we mean by "middleman" is necessary. Middlemen are presumably intermediaries that you have virtually no option but to transact with, which allows them to charge a risk-free premium. A foreign exchange counter is kind of like that. Of course, you could go to another bank, but ultimately, there are few players in town (or at the airport!) and you are kind of shielded from the broader market. I don't know the FX market but I think (someone correct me if I'm wrong) that exchanges don't exist. So in that market, the market maker-as-middleman model is a real thing.
Ok, got that. Nothing wrong with that. But is there fair competition possible? If so.. no big deal. People will choose for a service for the best price. Regulators however may have interests in certain middlemen being the only one.
Technically, I think that FX markets are broker markets, where a broker is defined as someone who arranges transactions by finding counter-parties and then charging a commission for the service. A classical middleman. Think real estate brokers. Here in New York, I know a real estate agent who will definitely not be appearing on Million Dollar Listing anytime soon. He makes a rather poor income and most of the 6% commission made on his (often > $1M) real estate transactions are split between the agencies, after which only a small cut goes to the individual agent, resulting in a less-than-6-figure income. I asked him why he doesn't just strike it out on his own and take his relationships with him. Well, licensing requirements for such a business in New York City are expensive, making it too risky. This is the classic example of an artificially restricted market that protects middlemen of dubious value.
Yup. The regulatory bodies that distort the free market by protecting certain vested interests. The Mob in action. A "license" that in fact forces me to buy food in your shop only.
But what about market makers and stock brokers in the securities markets? To be honest, the precise definition of a stock broker today is a mystery to me. It's a common model in fixed income (bonds) but I don't know of any common examples in equities. I guess technically, the large investment banks operate brokerage businesses where traders will trade over-the-counter, acting both as middlemen and market makers for the purpose of helping clients execute very large orders conspicuously without having the market move against them. To do this, traders have to take the risk of engaging in potentially toxic (meaning the counterparty knows more than they do about the future value of the asset) trades in the hopes of liquidating their positions later on for a better price. I'll elaborate more on this aspect later.


In my devils advocate opinion, the fact that this stuff is kinda hard to understand since it has a high density of complexity.. should ring a very loud alarm bell. Complexity, chaos, unpredictability.. always is a very good environment to pickpocket because there is loads of distraction. Trade, in my very simplistic view, is a very simple thing. Given that all buyers and sellers of real economic value will naturally seek the shortest route to find each other in the safest possible environment for the best price... the only true suspect of obstructing the free market to work properly are the regulators that can rig the system.

Now somebody has to regulate... so that the free market can operate optimally and as a level playing field, protected from various potential disturbers that try to rig the system or pickpocket others. In my view this still has to be the gvt., but not a gvt / politicians with vested interests in the market. In the USA obviously, such politics does not exist interest given that legislation is by and large bought with money. Legalized bribery.
When I talked about market makers in my previous post, I wasn't referring to typical middlemen. Let's forget about brokered trading altogether and focus on automated exchanges, which is where the bulk of trading occurs. The real middleman here is the exchange and, also, whoever gives you access to infrastructure that connects to the exchange (example: Interactive Brokers, and really any other electronic platform). The market makers I discussed -- the HFT firms, big banks, etc. -- are exchange participants. They are special participants in that they have certain quoting obligations, can get priority allocation, and are sometimes better positioned near the physical infrastructure of the exchange, but nevertheless, they are simply participants. When you place an order on an exchange, the exchange's matching engine attempts to match it with the best possible price. Furthermore, Regulation NMS requires exchanges to trade on the venue with the best price, meaning they have to be aware of what the best price (called the BBO, best bid/offer) is on other exchanges and route your order there. Orders (bid or ask prices) and quotes (bid and ask pairs from market makers) are sorted into an order book continuously and matched.
I would think the for an exchange, any open electronic market, the core question is who owns the infrastructure and who regulates that particular electronic market. A simply analogy I made earlier: eBay. If buyers and sellers of real economic value decide to trade on such a platform, the platform should be theirs; run, managed and regulated. If however eBay is not owned by the buyers and sellers but by a third party with also other interests.. the chance is big that eBay will regulate not in the best interest of the buyers and sellers only. That would not be a disaster per se.. of there are more eBays that compete among each other. But even then, it seems preferable to me that buyers and sellers own the platform and regulate, operate it themselves. Is this possible (or the case already) in the USA and elsewhere? Or have in fact regulators in gvt and in the industry monopolized a few selected platforms in fact?
So you can see that in this model, the market maker is not an ordinary intermediary that you go to trade with. As I mentioned in my previous post, Mr. Perfect's orders may well be going directly to a market maker but that market maker still has to submit the order to the exchange. In reality, he will end up hitting only a fraction of Mr. P's order flow because other participants out there might be faster and get it first, even though the market maker is expecting it to appear.
I understand that this is how it could work.. that things are moved around, go from one hand to another.. and that every hand that is in the short position of holding it.. hopes to make a lil' buck when it is handed over to the next. Now this does not seem to be a form of "liquidity" that the real buyers and sellers are in need of. It is just the liquidity of another artificially created flow of value where others benefit from the source stream indirectly.
Side point: Reg. NMS is often blamed for facilitating the rise of HFT. Obviously, it takes time for a single computer (which is what an exchange boils down to) to sort and match orders. How can they know in real time what is happening on other exchanges given the propagation delay between them? They can't but try to do so on a best effort basis. There is a concept of NBBO -- national best bid and offer, which is the best bid price and best ask price for the entire market nationwide. There are consolidated feeds that disseminate this information as well as indicating which exchanges are contributing to the NBBO (for example, the NBBO at any given moment may consist of a bid price found on NYSE and an ask price that is best on ISE). There is obviously some uncertainty to this quantity because the NBBO at any given moment received via a consolidated feed is already stale due to the latencies involved in aggregating all the requisite information. This is what HFT exploits for edge. They know that exchanges are sometimes going to route orders to competitors to comply with Reg. NMS.
Al least a lot of people can make a living thanks to those extra layers of complexity. I'm sure specialized lawyers can have a field day too. Complex processes and structures require more regulation.. and more lawyers. Viva Reg. NMS!
Note that the trend is that the role of many middle men is detoriating. People buy their products from Amazon etc.. Real estate agents make less money because people recognize that the added value today of a real estate agent is smaller; people put their houses for sale on real estate websites, show potential buyers around in their own house.. the financial and legal documents are standardized and can be bought directly from the notary who does the legal transfer from one owner to the new one. Real estate agents could claim that they are needed "to lubricate the market"... but it would simply be a lie. Why is it not a lie in the case of HFT?
Correct but Amazon is itself a middleman, is it not?
Yes. But a cheaper one than the 500 physical shops that would otherwise sell the product for a higher price. So what I'm looking for is which type of last standing middleman in this digital age creates the real added value for buyers and sellers of real economic value.
It provides the technology platform that allows you to discover counterparties and then takes a cut of their profits. Real estate by all accounts seems to be an inefficient market and the middleman situation there is certainly to blame.
Maybe the real estate analogy applies big time with the financial markets. I really have nothing against anyone trying to make a buck in the system as it is. Pickpockets and leeches should perfect that they are good at. The big guys, the syndicate leaders, the Al Capones of the financial industry are in regulatory positions both in Gvt and the Industry itself. The Chieftains in the Oligarchy.
In the electronic trading space, middlemen serve other, less obvious purposes. Think about stock and derivatives traders. Big funds call up traders at banks and ask them to quote prices on large orders they want to place (buy or sell). The trader then consults with his buddies, calls up other traders at other banks and funds, and then gets back with a price he thinks he can take the order for. The fund calls a few traders and picks the best offer. Why would anyone do this instead of routing directly to an exchange where it can be matched according to well-defined rules? Well, the market is so highly active that participants have to worry about transaction costs, which are costs incurred due to the very act of trading. Not fees, which are already known, but adverse price movements. As you are well aware, when someone knows you want to buy something, they will raise their price as high as they can get away with. Lots of buyers drive prices up. When you want to sell, they will try to lower the price. Lots of sellers drive prices down. Supply and demand. Participating on open exchanges by naively routing orders in big chunks exposes you to transaction costs.
But who or what decides on what the transaction costs are?
You will see your order only partially filled at the target price. Then the market (all participants, including market makers of course) will quickly react. Traders are paid to execute orders efficiently. They want to get you the best possible price so that they can charge a little more and earn a commission for their service. They bear risk by committing to a price. If they execute poorly, they may end up losing money on the transaction, but you get your desired price and forget about it.
Again, I'm skeptical that those intermediaries produce a liquidity that benefits the buyers and sellers of real economic value. They distort real market information and process.
Large banks and other trading operations offer so-called smart electronic trading services, which attempt to do the same thing through a largely automated process. You submit a big order and they will attempt to route it over time to various trading venues in such a way as to deliver the best price possible. I don't think they quote a price ahead of time (not 100% sure on the business model from the client's perspective) but I assume you just end up paying whatever the execution prices plus their service premium is. If you're not happy, you move your business to another group. These electronic trading services (offered by Credit Suisse, Morgan Stanley, Goldman Sachs, Royal Bank of Canada, and just about everyone else) were largely a response to HFT and algorithmic traders, but this was inevitable in an open exchange system.
Good to know that Exchanges can be open and competitive. But again, I'd prefer that buyers and sellers real economic value own their own Exchanges. So they can regulate it optimally and tailored to their own interests.. and not the interest of some shady third party.
If there were no market makers or smart executors, you would be quite vulnerable on an open exchange as an uninformed trader. Informed traders, or traders with superior infrastructure and capital, would move aggressively against you. There would be a huge incentive (just as there is now) for such players to enter the market one way or another.
I don't think there is any risk to trade whatever on any open market, as long as all information is public (prices as information). The fact that big players can play tricks on small players... means that the Exchange is rigged and meant to benefit people who are best at tricking others. Of course then, the more money you have to play tricks.. the better those tricks are. That however is not free market capitalism but analogous to a rigged lottery.
As I pointed out, in an open system where you can find out the price and place an order -- which is how electronic exchanges function -- you are still vulnerable to predators who are better informed or equipped than you. All participants, be they savvy funds or boring bank-run market makers or even your dentist day trading at home, are predators. But the more of these there are and the faster their trades can be executed, the more competitive pressure there is to reduce overhead costs you pay. This is good if you think you are making a transaction for a fundamentally sound reason. This is all in the nature of any market. HFT market makers specifically provide a benefit in that they guarantee someone will fill your orders. Exchanges want liquidity providers to keep markets operating even in times when conditions are unfavorable. The idea is that there is always a market there ready for you to unload your securities onto. You can fire and forget but someone else has to bear the risk.
I'm sorry I'm probably just repeating my stupid uniformed tune. But what you describe above does not sound like a free market to me at all. Or maybe as a free market but where what is actually traded are dubious products where nobody knows how much dog poo is in the box, which price is the real one, until the Exchange closes and everybody opens his box on Christmas eve. "Surprise surprise! Never thought that Santa loved me so much.. look!" "I knew it, he hates me! I'm so stupid always wanting to believe the opposite :( "

Obviously.. all the lucky ones and all the suckers cancel each other out at the end of the day.. but that also is not the reality of course. Someone is making a buck somewhere on it. The Exchange itself for starters... What a little transaction cost can do on another wonderful day.

[..]
I want to sell my car. Based on the model, age, mileage, condition etc.. is has a market value. The information is available and the result of previous market results. Lets say the best available statistics say my car now has a value of 5525,- dollars. Both I and potential buyers know this. We can come to a deal very fast. How would we benefit from any market maker that operates in between us? For starters.. because he, "the market maker"{ , also needs to make a buck one way or other.. so the price of the car has to be higher than necessary.
A market maker in this case would enhance liquidity by offering you a price more quickly. Might it be higher? Yes. But the alternative is having to hunt for a buyer for an indefinite period of time because cars are not sold anywhere near as frequently as smaller, cheaper, and easier to maintain items. During that time, you bear the risk of someone else coming onto the market and offering the same car for even less. If only a market maker had been willing to purchase your vehicle at day 1 for what was thought to be the market price then!
Yes that is the sales argument of how market makers add liquidity, but I'm still as skeptical as ever. As for selling or buying a car.. many people understand driving an older car a bit longer.. is in fact a way to save money, since driving in a new(er) car is more costly in terms of insurance and writing off value goes fast in the beginning. So you can take your time to sell your old car... there is no real hurry. You just assess the +/- value of it now.. and the coming weeks maybe months ahead. Buyers looking for that type of 2nd hand car.. depending how much they need that type of 2nd hand car and in how much of a hurry they are.. will find my car without the help of anybody else and nor does my car need to be moved around from one temporary middleman "owner" to another because it would "add liquidity to the 2nd hand car market". It is a bogus argument.

More likely, if 2nd hand cars would be moved around by short-term middlemen all the time before they end up in the final owner who will actually drive it, you would invite the type of predatory abuse you mention. Big middlemen can buy all 2nd hand cars of a certain type, thusly have a monopoly on that type of car and drive up the price unilaterally and make a very big buck in a relatively short time. As another example of how added complexity wll invite predators and schemes that serve nobody except the predator, alias MeddleMan 8-)
Back in 2006, I bought a 2005 Honda Accord, sight unseen, off of eBay for $15K. (Best car-related decision of my life, by the way!) Fast forward to 2013 and I was now living in Seattle but had accepted a job in New York. I moved back to my parents' place for a month and decided to sell my car, since I wouldn't need it here. I discovered on Craigslist that prices for 2005 Accords were lower in the nearest large metro areas but noticeably higher in my smallish (~250K people) hometown. This was of course the same reason that I bought off of eBay in the first place. The blue book value of my car was something on the order of $8K-$9K but I wanted $11K, and that's what I advertised on Craigslist for. Someone offered me the blue book price, claiming that he had done his research and this was the fair market price. I felt bad for the guy and his wife -- they were a low-income blue collar couple and didn't realize that my car was actually worth a premium. It was in excellent condition and would have spared them the maintenance costs of an $8K lemon. I held firm. Another buyer, this one more informed, came calling. He and his father took my Accord for the most intensive and meticulous test drive I've ever experienced and spent a lot of time examining the engine, unscrewing fluid caps, examining the suspension, etc., etc. They frowned and offered me the blue book value as well, asking why I was charging a steep $11K. I said, "yes, it's more expensive than the national market value, but if you want a 2005 Accord in comparable condition for less, the nearest one is hundreds of miles away. Given its condition and the lack of local availability, I think the premium is worth it."

We talked it down to $10.5K, and they bought it. What does this say about market making? Well, not a whole lot, but it illustrates another point: illiquidity itself can distort prices. In the case of cars, local markets develop. Transactions are entered into only after a considerable amount of searching and thought. Market makers competing for your sale would drive the price down quickly to some national best price and no lower.
I don't see how market makers in your example would have driven down the price to a national best price. The money the market maker makes adds to the price of the car necessarily.. so it is questionable what added value he really had in the end. And as said, I think this example of 2nd hands car actually illustrates something else: not all products/services require fast trading.. In other words, everything requires a sort of optimal liquidity that is unique to it of that moment.

Isn't it wonderful and food for thought... that once upon a time.. products could be put for sale behind windows and in shops... without any stress stay there for even a couple of weeks without anyone being in pain because of it. Of course bread... should be sold the same day.. but a tv set.. could be sold two weeks later easily. No problems. Compare that to the new Credo that more liquidity is good! Best is even when things are sold and bought for different prices, change owner 50 times per second! It really adds to a wonderful, prosperous and stable international market. Not. :shock:
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Re: Capitalism and Its Discontents

Post by Mr. Perfect »

Parodite wrote: That seems too much credit to HFT.

You would have no way of knowing one way or the other.

The digital age made trading fast and cheap.
Through hft. There is nothing else.
Now buyers and sellers that want to trade real economic value can do it faster, easier and cheaper on any electronic market platform.
Thanks to hft. Entirely. Nothing else changed.
But as with any market place, it attracts pickpockets and other leechy folks. They in fact created a huge empire, Pickpocket your Wallet Street. No need to remind that those pickpockets indeed love Harvard Democrats who hand them over the bubble cash on a silver platter. ;) In fact it is a brilliant tactic when two thiefs who belong to the same gang always blame each other in order to just distract the public from their crimes. The blame game is the perfect cover.
Trading costs are 95% less then they were 15 years ago.

Please explain how my pocket is getting picked using real world examples.
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Re: Capitalism and Its Discontents

Post by Zack Morris »

Parodite wrote:In reply to the rest of your first post:
Itself it is normal that in any ecology, included the financial ecology, competing participants try to have an edge over others. As I said to Mr.P., I don't blame anyone, each species has its own survival strategy. And it can result in wonderful species! Like the deep sea lantern fish that wants you to think it is showing you the light... and then eats you when you believe the message ;)
Terms like "parasite" and "leech" have an intentionally negative connotation in the context of human activities. In an ecosystem, there is no morality and there is no objective. The ecosystem is what it is and if "parasites" and "leeches" are a part of it, then they are a necessary part of it, no better or worse than any other participant, because they are by definition the ecosystem.

That's very different than what you are trying to say, which is implying that parasitic activity is redundant and unnecessary beyond what is required to earn a profit (in other words, economic leeches are extracting economic rent). You can't conflate parasites in an ecosystem with parasites in a market.
I would think one first needs to establish how much liquidity is actually needed for what type of product or service. A crop that is harvested and sold once a year.. may need a much lower paced liquidity than the more virtual/hypothetical products like certain derivatives that are sold like scary moments in a bad dream with a certain bad ending, quickly sold to the next potential victim.. where the last one is the sucker as in a Ponzi scheme.
A crop that is harvested once a year is very risky indeed and will require hedging. One party needs to hedge, the other party may want to speculate, and the role of the derivatives market is to match the two in a mutually beneficial arrangement. "Too much liquidity" would mean too many suppliers of a service in this case, wouldn't it? Their profits would dwindle.

Indeed, that is what's happening to HFT. For the past few years, HFT has become a diminishing business. The easy days are over, the big players remain successful but there are fewer of them. If you want to make money today, HFT with its incredibly high operational cost is not the space you want to be in.
The latter of course, it seems to me, is exactly where the markets can suffer most from panic and paranoia. The risk though, is that such paranoia also drags down other more stable an calm markets like crops with it... because the financial Dalton brothers long ago understood that after you destroy Glass & Steagall and can mix and remix all value into sexy new financial products alias "port folios" with a bit of bad real estate, a bit of commodities, a bit of risk insurance, a bit more of disguised dog poo default swaps and waste you needed to get rid of, some future this or that in exchange for a secured gvt bond..in other words... a bad stew where all is connected and made dependent on each other.. no structural compartmentalization, just more extra layers of complexity that allow you to create edge nevertheless in a bad dream.. for as long as it lasts...and all new risk is paid for by others who produce and consume in the real economy when everybody defaults and wakes up again.
I think you're conflating very different things here. Structured products, real estate investment, insurance, etc. have nothing to do with HFT. These are entirely different businesses.

I agree that the finance industry in general is plagued by pointless complexity and services of dubious value to the economy. I don't think HFT is really the problem here. If anything, automated trading is cutting out the middle man. This year has been a great year for Wall Street trading desks but overall, the trend is unmistakable: trading desks are shrinking. This is partly due to the regulatory climate but also due to other, more organic trends. If it were merely regulation, you would have seen massive growth in hedge funds and proprietary trading shops but that has not been the case.
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Re: Capitalism and Its Discontents

Post by Zack Morris »

Mr. Perfect wrote:
The reason market makers charge a spread is because by both buying and selling (as opposed to trading in one direction, as an individual buying or selling stock typically does), he bears inventory risk. Ideally, a market maker wants to buy low, sell high, and hold no inventory at the end of the day. But 1) that is almost never possible and 2) market prices can change rapidly, leaving the market maker holding a position that is suddenly deeply in the red. As compensation, the market maker charges a premium, which is the spread, hoping to make profit.
You were doing ok till this part, market makers generally hold no inventory risk because almost every trade they make is hedged with a synthetic position of some sort.

http://www.optiontradingpedia.com/market_makers.htm

Market Makers protect themselves from directional risks through "Hedging" and flexible use of synthetic positions. A Market Maker hedges his inventory through buying or selling additional stocks or stock options in order to achieve a position whereby stocks and options falls as much as the other rises in order to maintain the overall value of the account. This is what we call a "Delta-Neutral" position. A Market Maker's positioning strategy, especially in making markets for stock options, is extremely complex and requires to the second calculation and execution. It is because of this complexity in balancing all kinds of risks that some new Market Makers actually lose money to the market despite all the privileges of being a Market Maker.
Of course, hedging is absolutely essential. But the intuitive reasoning for market makers charging varying spreads is inventory risk. Illiquid and risky products will command a higher spread. Hedging is not instantaneous and will not eliminate downside risk against very large and unanticipated price swings. Hedging can also be costly. The quants on a typical automated options market making desk will often devote a large amount of personnel exclusively to the various minutiae of hedging strategies and execution. The fact of the matter is, the value of a market maker's positions can fluctuate dramatically from day-to-day, affecting overall PnL, and theoretically, the hope is that the profit earned from charging the spread will counteract that.
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Re: Capitalism and Its Discontents

Post by Parodite »

Zack Morris wrote:
Parodite wrote:In reply to the rest of your first post:
Itself it is normal that in any ecology, included the financial ecology, competing participants try to have an edge over others. As I said to Mr.P., I don't blame anyone, each species has its own survival strategy. And it can result in wonderful species! Like the deep sea lantern fish that wants you to think it is showing you the light... and then eats you when you believe the message ;)
Terms like "parasite" and "leech" have an intentionally negative connotation in the context of human activities. In an ecosystem, there is no morality and there is no objective. The ecosystem is what it is and if "parasites" and "leeches" are a part of it, then they are a necessary part of it, no better or worse than any other participant, because they are by definition the ecosystem.

That's very different than what you are trying to say, which is implying that parasitic activity is redundant and unnecessary beyond what is required to earn a profit (in other words, economic leeches are extracting economic rent). You can't conflate parasites in an ecosystem with parasites in a market.
Poking some innocent fun at Mr.P. can't be bad since he more than deserves it. He lives in a very bipolar manic depressed reality with only two colors: black and white. Only good people or evil-doers. He truly hates evil-doers: Harvard Democrats (all Democrats), secular leftists, Europeans... and loves to see them die out naturally and won't cry for a single one that is being killed - how doesn't matter. He also is under that superstitious spell that the world is coming to an end.. as prophesized in his holy book.

As for leeches et-al.

Not sure why one type of leech is very different from another when in terms of their survival strategy and behavior they are in fact very similar. That they can live in different eco-systems or niches.. is not a crucial difference.

My view on leeches, pickpockets and the big thieves that live in and off the financial industry and politics, comes from me looking at things from the perspective of people who concern themselves with producing, creating real economic value and wealth. Who are of added value to society as whole. One could argue of course that all crime and all criminals one way or other serve society.. a good example would be the drug war where law and law enforcement make some good money on it too, a neat symbiosis of sorts between "the good" and "the bad".

I would think one first needs to establish how much liquidity is actually needed for what type of product or service. A crop that is harvested and sold once a year.. may need a much lower paced liquidity than the more virtual/hypothetical products like certain derivatives that are sold like scary moments in a bad dream with a certain bad ending, quickly sold to the next potential victim.. where the last one is the sucker as in a Ponzi scheme.
A crop that is harvested once a year is very risky indeed and will require hedging. One party needs to hedge, the other party may want to speculate, and the role of the derivatives market is to match the two in a mutually beneficial arrangement.
I am of the old fashioned generation that loves simplicity and straightforward no-nonsense cut the crap behavior. Why can't harvests be insured in a normal way? People who share the same risk can together throw money in a big box that covers the risk. Isn't that favorable over adding extra players and layers of complexity? Why expose that big box with insurance money to speculators and other financial cowboys that just want to f*ck around for free?
"Too much liquidity" would mean too many suppliers of a service in this case, wouldn't it? Their profits would dwindle.
Supply and demand works fine as it self-adjusts. Adding more and very different players of which many don't add anything of value and are just specializers of gimmick, freeloading or of simple theft that occurs below the radar.
Indeed, that is what's happening to HFT. For the past few years, HFT has become a diminishing business. The easy days are over, the big players remain successful but there are fewer of them. If you want to make money today, HFT with its incredibly high operational cost is not the space you want to be in.
Yea.. it was a hit and run scam on the wings of automation.
The latter of course, it seems to me, is exactly where the markets can suffer most from panic and paranoia. The risk though, is that such paranoia also drags down other more stable an calm markets like crops with it... because the financial Dalton brothers long ago understood that after you destroy Glass & Steagall and can mix and remix all value into sexy new financial products alias "port folios" with a bit of bad real estate, a bit of commodities, a bit of risk insurance, a bit more of disguised dog poo default swaps and waste you needed to get rid of, some future this or that in exchange for a secured gvt bond..in other words... a bad stew where all is connected and made dependent on each other.. no structural compartmentalization, just more extra layers of complexity that allow you to create edge nevertheless in a bad dream.. for as long as it lasts...and all new risk is paid for by others who produce and consume in the real economy when everybody defaults and wakes up again.
I think you're conflating very different things here. Structured products, real estate investment, insurance, etc. have nothing to do with HFT. These are entirely different businesses.
You are probably right I conflate things.. but my point is in the end a bit different: the small thieves and the big ones have the same criminal mindset and engage qualitatively in the same crime: ripping of others. From pickpockets to bank robbers. Where the best strategy to rob a bank is to own one, or being a temp manager and score your pickpocket bonus millions within three years then hop to the next financial host to suck from. Or you become adviser of the US president! Or manager of the European Central Bank! Or work for the FED! Or some regulatory body to make sure the pig remains fed and fat!
I agree that the finance industry in general is plagued by pointless complexity and services of dubious value to the economy. I don't think HFT is really the problem here.
There are people who claim that it also caused unnecessary volatility and also was proven to be abused using rigged algorithms. As with everything in this sick environment: with one hand they do something legit and often even useful, with the other they will always try to find your wallet...always...
If anything, automated trading is cutting out the middle man.
Yes, that seems to be what is happening. I think it is a good thing. HFT was just foreplay.
This year has been a great year for Wall Street trading desks but overall, the trend is unmistakable: trading desks are shrinking. This is partly due to the regulatory climate but also due to other, more organic trends. If it were merely regulation, you would have seen massive growth in hedge funds and proprietary trading shops but that has not been the case.
I think what is needed is structural reform where the compartmentalization as it existed before Glass-Steagall was repealed is restored again in some form or other. Plus a serious pruning away of complexity we can't legally manage.
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Re: Capitalism and Its Discontents

Post by Nonc Hilaire »

A ZIRP market is not an ecosystem. It's a swimming pool.
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Re: Capitalism and Its Discontents

Post by Mr. Perfect »

Zack Morris wrote: Of course, hedging is absolutely essential. But the intuitive reasoning for market makers charging varying spreads is inventory risk. Illiquid and risky products will command a higher spread.
Actually market makers change spread size when there are large changes in volume coupled with changes in price. When volume and price change start surging market makers widen the spread. I have no idea what you mean by illiquid or risky products, I'm talking about things traded on the exchanges. I can't remember a single trade now for several years that wasn't filled inside a second with a spread of a few cents.
Hedging is not instantaneous
For our purpose here it is. A market maker opens a hedge at the moment he takes your trade.
and will not eliminate downside risk against very large and unanticipated price swings.

That is the whole point of a hedge, to offset large and unanticipated price swings. That is what they do. You need to read up on synthetic positions and their utility to a floor trader.
Hedging can also be costly.
Hedging is used all day every day by market makers everywhere and has been the case for decades.
The quants on a typical automated options market making desk will often devote a large amount of personnel exclusively to the various minutiae of hedging strategies and execution. The fact of the matter is, the value of a market maker's positions can fluctuate dramatically from day-to-day, affecting overall PnL, and theoretically, the hope is that the profit earned from charging the spread will counteract that.
That's all very interesting, but the point is earlier you mentioned that a market maker wants to "hold no inventory" at the end of the day and "market prices can change rapidly, leaving the market maker holding a position that is suddenly deeply in the red". This is of course not true, market makers hold inventory just fine, through hedges, and my recollection is that most if not nearly all trades going through the floor are hedged.

This was something you apparently had no exposure to, so I thought I would clear things up. I didn't even beat you up over it and felt I was doing you a favor despite your history of lying and making false charges, since at least you had gone to some sort of trouble to learn something about the subject before commenting on it, which cannot be said for other people here.

So since you have manifested some learning on the topic I would say simply that you may find it interesting to learn about synthetics and how market makers use them on a daily basis to create inventory and hedge it. It was not meant as a criticism in any way.
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Re: Capitalism and Its Discontents

Post by Mr. Perfect »

I'm still waiting, through all the gobbledygook for someone to explain how cheaper faster trading is parasitic or a "destruction of real value". With real world examples. From anyone. In the real world making things cheaper and faster is actually the creation of value. Wondering how in this case it is the opposite. Cheaper and faster (for the consumer) is actually destructive. Why would more expensive and slower be a value creating?

Isn't it interesting P how you represent the creationist in this case, going off hunches, intuitions and uninformed paranoias while I play the role of scientist, dealing with real world observable fact and educated and experienced analysis. Isn't it interesting.
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Re: Capitalism and Its Discontents

Post by Parodite »

Mr. P., I propose a little truce here. You don't need to watch the videos below nor read the document linked... since you know it all already.

Two interesting documentaries that were aired here in the Netherlands.

kFQJNeQDDHA

ed2FWNWwE3I

http://www.scribd.com/doc/162478469/Bodek-Paper
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Re: Capitalism and Its Discontents

Post by Zack Morris »

Mr. Perfect wrote: Actually market makers change spread size when there are large changes in volume coupled with changes in price. When volume and price change start surging market makers widen the spread.
The change in spread you are seeing when this happens is driven by their risk management system. If a market maker starts getting a large volume of fills, risk mitigation kicks in to widen the spread and/or adjust the market maker's predicted price (mid-point between bid/ask) in order to prevent an excessive (i.e., risky) build-up in the position.

Determining what spread to charge is actually a very interesting problem from a theoretical point of view. Many market makers out there are so-called joiners, meaning they do little more than attempt to match the BBO in order to get an allocation of fills (especially on pro rata exchanges). These market makers will often use simplistic regressions on very recent historical spread data to calibrate their own spreads and allow flexibility to join the BBO. Most market makers are thought to employ this general strategy thereby creating a kind of feedback system where everyone is determining their quotes by looking at what everyone else is doing.

More sophisticated strategies look at what is happening in the market right now and will employ some model. I don't know much about the specifics of this but I do know that the big picture theoretical view of spreads is that they are a premium designed to compensate for the downside risk in holding positions. At the very minimum, you have to charge enough spread to compensate for the subsequent change in value of the position throughout its lifetime (this I learned from someone in the automated market making business).
I have no idea what you mean by illiquid or risky products, I'm talking about things traded on the exchanges.
AAPL and SPY are highly liquid (the two most liquid names, in fact). Something like SAFM not so much.
Hedging is not instantaneous
For our purpose here it is. A market maker opens a hedge at the moment he takes your trade.
Nope. Definitely not true for automated options market makers and I would imagine far less likely for equity market makers. HFT shops don't like to hold inventory overnight and are often in a position where they can dump remaining inventory minutes before market close and take the hit because of the accumulated profit over the day. This makes sense given how HFT works from a technical perspective. A lot of these places implement simple algorithms on FPGAs -- quotes come in and orders are fired immediately without even hitting software. You can't implement much of a risk management system that way. Hedging with options? Forget about it. It won't happen unless positions are building up. There would be way too much latency to do this. I don't even think that many equity HFT shops are connected to options exchanges directly, which makes entering into hedges immediately physically impossible.

Options market makers do need to hedge and as you pointed out, the business is inherently more complex. Low latency is desirable but not quite as necessary as in equity HFT. But even so, hedging does not happen immediately due to cost. It really depends on the market maker's system -- some fills are hedged immediately, others can be deferred to minimize trading costs. In some cases, hedging orders are even routed to other firms for "smart" execution over time while option fills continue to accumulate.

Ignoring those technicalities for a moment, delta hedging is not a perfect hedge. Delta as computed by Black Scholes is not always as accurate as it needs to be. Then there is gamma hedging and so forth, which you know more about than me. Another risk mitigation strategy that is employed is to very slightly offset quotes. If a market maker wants to reduce the fill rate in one option, the system can shift the quote upwards while simultaneously shifting some other quote(s) (of different options) downwards. The decision on what to shift and by how much is made by some extremely complicated model that looks at correlations between securities and pools of securities. I guess you might say this is equivalent to creating synthetic positions because in the end, the net result is buying/selling other options to offset risk, but the mechanism is very different than what a human trader would typically do to hedge.
That is the whole point of a hedge, to offset large and unanticipated price swings. That is what they do. You need to read up on synthetic positions and their utility to a floor trader.
What happens to delta when the underlying price changes rapidly? Note that a market maker is processing a huge number of fills across hundreds of thousands of options. If hedges are imperfect, there is risk to bear.
It was not meant as a criticism in any way.
I'm not taking it as criticism, this is just friendly discussion. I'm just sharing what I know about the HFT industry. There are bound to be inaccuracies but much of the information is first and second-hand, not gleaned from any online sources.

You are absolutely right that hedging is done but if you talk to an algorithmic options market making group, they will tell you that despite hedging, their positions do lose value and the market does move against them. On a given day, there is decay in value that offsets profit earned from spread. And they will say that theoretically, they would generally prefer not to hold inventory at the end of the day but it's not feasible in the options space.
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Parodite
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Re: Capitalism and Its Discontents

Post by Parodite »

Zack, how easy/difficult is not nowadays to use a hedge fund for a Ponzi-scheme? Let's say I want to use illiquid assets I can inflate easily for that purpose and relatively long term.. what type would you recommend? Is it possible to hold a huge bulk of derivatives "stock" for that purpose?
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Mr. Perfect
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Re: Capitalism and Its Discontents

Post by Mr. Perfect »

Zack Morris for the purposes of this conversation we've been talking about hft for equities, and trying to keep things as simple as possible. Option market making and options in general have proven to be beyond the scope of the Spenglerverse, excluding Collingwood who used to make markets at the CBOE, out of college IIRC.

Simply put a market maker for stock hedges his trade with you with an opposing synthetic position and therefore does not bear an "inventory risk" as you originally described. Market makers of course have lots of different kinds of trades available to them that all bear some kind of risk, but that is a different subject matter.

Market makers do have risks but it really is more typing than I care to do and does not bear on the fundamental questions, or groping for questions bearing on hft.

Market makers manipulate spreads based on demand and risk, high demand and high risk (volatility) mean higher spreads. In the old days this could be over 50 cents on a $50 stock. In the old days if the trading was heavy you would wait for maybe an hour before trying to get filled.

Nowadays, thanks to hft, spreads are in single pennies, and it doesn't even occur to me to wait around for better prices.

And for some reason Parodite, NH and CS want to screw me over and get spreads really expensive again and have floor traders make more money. Why they wants to do that is beyond me.
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Nonc Hilaire
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Re: Capitalism and Its Discontents

Post by Nonc Hilaire »

Mr. P, it isn't about you. The public arguments against HFT and associated automated trading algorithms are persuasive and convincing, and I am not familiar with a single voice in or out of the industry disputing this analysis.

I was hoping you would make an understandable apologetic for the HFT automated trading crowd. I can see how skimming pennies off each trade helps the guy who owns the computer, but I don't see any benefit for the average investor. Online trading lowered costs and commissions a great deal, but I have not seen any appreciable benefit from HFT.
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Marcus
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Re: Capitalism and Its Discontents

Post by Marcus »

Some few years back, a family member lost 5k in a matter of seconds while attempting a stock transaction online.

He sold all his stocks and paid cash for a rent house which now nets him between 5%-8% on his investment while increasing in value.
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