A detailed exposé on how the market is rigged from a data-centric approach

http://www.nanex.net/aqck2/4661.html

by isivaxa • 12 years ago

125 149 12 years ago

Doesn't surprise me the least bit. Where there is something available to exploit (in this case, access to direct, fast feeds), it will be exploited.

Would it be possible, legally and technically, to put a special additional fee/tax onto high-frequency trading while leaving normal high-volume traders alone?

mrgordon• 12 years ago

Its certainly possible technically (and legally in some cases). Italy has a 0.02% tax on transactions lasting less than half a second: http://www.dw.de/italy-first-to-slap-tax-on-high-speed-stock...

noonespecial6• 12 years ago

Go to the router just entering the exchange, type:

  tc qdisc change dev eth0 root netem delay 100ms 10ms

Problem solved.

DevX1013• 12 years ago

what does this do? (non-finance guy here)

harryh17• 12 years ago

Not really no.

High Frequency Traders are selling a service (liquidity). A tax on them is mostly just a tax on their customers.

axanoeychron• 12 years ago

You cannot defend frontrunning of a market.

If I ask for X at Y. Someone else shouldn't have the facility to buy it based on my own trade signal and try sell it back to me.

It is mindblowingly simple theft. The arguments for liquidity do not hold. There is some fascinating cognitive dissonance when it comes to the HFT industry.

hft_throwaway2• 12 years ago

That's not what's happening here. Traders are arbitraging and reacting to public trades and orders on multiple markets.

If you walk through a physical market where 8 apple carts are lined up, all selling apples for $1, buy every apple at cart #1, then buy every apple at cart #2, and so on, would you be surprised to find the price moving up or sellers stepping away as you approached carts #7 and #8?

The same thing happens when trading. Securities trade on multiple markets and multiple exchanges cannot match cross-market trades atomically. It's absurd to suggest that one side of the trade should be expected to close his eyes to what's happening in the world around him and sit tight while a huge trader runs his quote over. Why is one party more deserving of a good price than the other?

If you route to one exchange only there is no way for anyone to see or react to your marketable order before it executes, ever. If you route your orders intelligently, it can be very difficult or impossible for anyone to pull away before you get your fills. That's the executing broker's job. Instead of getting better at his job, this broker would rather complain to a very vocal conspiracy theorist who has been proven wrong many times in the past by people with actual experience and data: http://zacharydavid.com/bad-research/the-hunsader-follies/

simplemath2• 12 years ago

Except that what's happening is that the order is against a "cart" with sufficient inventory to completely fulfill the initial order, and other actors are interrupting the transaction to add carts 2-n. Is that not the case?

DevX1013• 12 years ago

If buyers were to time divide their order and time it so the request ended up at each exchange at the exact same millisecond, would this prevent others from reacting to the big trader?

don_draper• 12 years ago

"If you walk through a physical market where 8 apple carts are lined up, all selling apples for $1, buy every apple at cart #1, then buy every apple at cart #2, and so on, would you be surprised to find the price moving up or sellers stepping away as you approached carts #7 and #8?"

If some guy had a business where his sole service was to sit in the apple cart market waiting to front run me and then immediately sell the apples right back to me, I'd be surprised and super pissed.

prof_hobart2• 12 years ago

If you stood in front of all of those carts simultaneously and said "I'll take all of your stock at the advertised price", I'm guessing you'd be a bit peeves if someone else pushed in front of you and started buying some of the stock (the equivalent of the 1,570 shared bought by some random buyer at the exact point this order was put in).

mmaldacker5• 12 years ago

The trader wanted to buy 20 000 shares at 17.38, that's a bit less than 350 000 dollars, certainly not pocket change. In fact, that was more than any individual exchange could provide, and barely enough with all exchanges combined. You would expect the price to go up with such high demand and limited supply. And indeed you see that, when he starts trading on BOST, other market participants update their price in other markets by cancelling their orders and inserting them at a higher price.

From the article:

Also note how the cancellations rotate through many different exchanges. That's one sure way to throw off, confuse, stall a smart order router.

Or you know, because it's multiple market participants that are updating their prices.

Someone else shouldn't have the facility to buy it based on my own trade signal and try sell it back to me.

What? If you're the owner of a bakery and you see a guy buying every single bread that your competitor is selling, wouldn't you increase the price of your own bread in case this guy comes to you?

k__• 12 years ago

It doesn't sound like anything different from "normal" markets is happening.

You are selling stuff, someone or some people buys a big bunch of it, you think it sells good an rise the price later, now the someone has to buy the stuff for a higher price.

The only difference is the time between the first buy and the second buy for a higher price.

Even if you send your buy-orders at the same time to two different sellers, they don't have to arrive at the same time and if the second seller has "heard" about the first sell, he has enough time to rise the price.

DevX1013• 12 years ago

Can someone explain what's happening with the order cancellations? What causes it? Who is the party that is canceling orders?

Lazare4• 12 years ago

"Holy shit, someone is working there way through every broker, buying ever share of Ford stock they have! ...huh, I've got some Ford stock for sale. Maybe if I quickly pull it out of the shop window, and change the price, I can make some extra cash!"

That's what it is: People are seeing the orders pour through the various exchanges, and are reacting to it. If they were seeing the orders before they hit the exchanges, that would be front running, and it would be illegal. But Nanex appears to be showing people responding to orders after they hit the exchanges, and that would seem to be legal and moral.

The moral is that if you want to buy so much of a single stock that you can't even buy it all from a single exchange, you MAY end up paying a bit of a premium, unless you're quite good at hiding what you're doing. And in this example, the purchaser was not. It's a story as old as markets.

nhaehnle2• 12 years ago

The question, from a society-design point of view, is whether it is useful to have a whole class of people who engage in what is ultimately a zero-sum game and therefore an arms race, and whether it wouldn't be better to design markets in such a way that a large buy order can be placed without having to be an expert at HFT.

After all, the market is supposed to be useful for organizing long-term investments. The short-term stuff is pretty far removed from the progress of society.

barrkel• 12 years ago

But Nanex appears to be showing people responding to orders after they hit the exchanges, and that would seem to be legal and moral.

It's legal, yes, but you can't make a jump to moral so easily.

I don't think it's necessarily immoral either, but morality depends on much more - what the end results are, who is affected, what kind of effect, etc. Morality doesn't exist in the vacuum of an isolated decision.

th3iedkid• 12 years ago

what is market-pricing without arbitrage?

waltherg• 12 years ago

Just in case anyone has time to help me out:

What's the difference between trades and quotes here in this chart? And how are the trader's order and purchases indicated?

sklivvz1971• 12 years ago

A quote is a statement that someone is offering to buy or sell a specific quantity of shares/commodities at a specific price: "I want to sell 10g of gold at 40$ each". Typically the identity of the trader is known only to the exchange (and the trader )

A trade is an announcement that an offer was accepted and a contract was agreed on. "10g of gold have been sold at 40$ each". The identity of the traders is typically known only by the exchange, and each of the trader knows they are part of it, but don't know the counterparty.

data_scientist• 12 years ago

This is the bad part of HFT, the one that is theft and destroy value. It is paid by the big players, and "solved" by imperfect solution like dark pools. A better solution could be to add a hour component to the order, so all commands from an actor in all markets are executed at the exact same time.

This rotted apple should not hide the good part of HFT, which is to reduce spread and inconsistencies between markets and to generate profits from this (positive) action. HFT took the place of traders, who were paid a lot for doing that stupid task.

josephlord9• 12 years ago

If you offer something for sale at a certain price and someone says "I'll buy it!" you have a contract at that moment.

I don't fully understand the conditions under which you can cancel an order but it seems all the cancellations happened on exchanges where no orders had yet been fulfilled so I assume this means that the order had not yet arrived. This seems ethically just about OK to me but a sign that there is not one single stockmarket and that the system could be far better designed.

There is the single front-running trade which is suspicious but it seems plausible (unless it happens every time) that it was just a small random trade that happened to coincide with the timing of the big trade. It should be monitored though.

My conclusions:

1. There is not one single market with a number of available shares but a number of linked markets. Send your trade to a single exchange (first at least) with enough offered shares that it should execute before offers can be cancelled. Wait, repeat.

2. Much of the liquidity supposedly offered by HFT is illusory and disappears if you try to use it.

I think that the market could probably be improved if cancellation weren't free or at least weren't instant. If cancellations took a second (maybe 100ms or 10ms would be enough) to process and the offers could still be accepted in that period the offers made would be more serious and although the spread might be slightly larger it would more honestly reflect reality.

bmelton3• 12 years ago

Plucking from throwaway's example. You have 20,000 copies of a book you just wrote. You put half of them on Amazon, and the other half on eBay, so Amazon has 10,000 and ebay has 10,000 of them.

You see an order come in for 5,000 of them on Amazon. You think "Hot dog, these books are popular. I must be selling them too cheaply!" You immediately raise the price of all the books by 25 cents to capitalize on this.

The books you sold on Amazon are sold, so they're gone. The remaining books on Amazon are slightly more expensive.

The guy who bought the books on Amazon also bought the same number of books on eBay, but the order hadn't arrived there yet, so between when he hit the buy button and the time the order arrived, the price had changed, so those orders aren't filled.

laichzeit02• 12 years ago

Yeah, and if this happened at, let's say, 10 hour intervals, I'm sure the average layman would have no problem with the "fairness" of this. People are getting their panties in knot because it's somehow "unfair" that this can happen at the millisecond level.

I personally don't have a problem with this type of trading activity. A few guys are making easy money. So what?

stevejones3• 12 years ago

The difference would be that you cancel all the orders currently in progress, so a bunch of people who've clicked "buy" are now in the lurch.

josephlord9• 12 years ago

Using the analogy of the books you are raising the price in the milliseconds between the customer clicking buy and packets of that request reaching ebay's servers and all after the user has seen your price and stock availability a second ago. I don't think this acceptable business practice, if you have seen a price and a stock you should be able to place the order and (unless another order that isn't front running has arrived first to deplete the stock) the order should be fulfilled even if you show a different price to the next visitor to the product page.

I can sort of see that but I don't quite understand why there are different exchanges. I can't see the benefit except to those for whom it is an arbitrage opportunity.

I would also expect there to be low cost systems by which you could place simultaneous orders on all exchanges (at the cost of a slight delay in the order starting to allow them all to be posted at the same time as the furthest one.

The HFT still seems to add little real liquidity. The spreads that are shown may be narrower but the real spread seems much higher.

kasey_junk14• 12 years ago

Cancellations aren't free and they aren't instant. Every (reputable) exchange out there requires you maintain a fill ratio or you will be fined. That is, you have to maintain a minimum number of quotes that get filled before they are cancelled.

josephlord9• 12 years ago

I don't know how "fill ratio" is defined. I don't see a problem in unfilled orders at prices that are never reached but if you pull out from the market as soon as someone offers the other side to your trade that doesn't sit well with me. I wouldn't mind companies offering small quantities at the current price and other quantities at progressively higher prices and cancellations/adjustments being made after a particular trade had been processed which would be a transparent way to handle it

What do you mean that the cancellations aren't instant? If they can outrun a bid to accept them that is instant as far as I'm concerned.

erpellan• 12 years ago

A solution: Discrete double auctions. Instead of continuous trading, the exchange can divide up the day into a series of small windows (say 100ms). When you come to trade in the market, you have to wait for the next window to open. You submit your order and you find out what happened at the end of the window. This way nobody has any timing advantage and the delay is barely noticeable to 'normal' traders (waiting 1/5 of a second is hardly an inconvenience). It also stops all the order-book shenanigans that HFT players get up to (where they stuff the book with orders and cancel/resubmit them at high frequency).

So why don't exchanges do this? They make a ton of money in fees, it simply isn't in their interest to prevent HFT at the moment. Change their incentives (ie. regulate differently) and they might actually do something about it.

kasey_junk14• 12 years ago

Actually there are lots of discrete auctions in the electronic trading world. For instance the S&P futures contracts trade this way before the open and depending on your perspective they have more "shenanigans" being played by HFT players. Not less.

There are 2 major issues that no one brings up when they say "simply add discrete auctions". A) what happens when there are more participants on 1 side of a price than on the other, what is the tie breaker after price? B) How does this solve the distributed systems problem of multiple exchanges trading at the same time?

throwaway28371910• 12 years ago

What is happening here is really quite simple, and doesn't deserve an entire blog post.

There are two exchanges, A and B, and a market maker Jill is quoting (say) 10,000 shares on each of those two exchanges for $17.

Big institutional trader Jack sees the 20,000 shares and decides that he wants to buy 15,000 of them, so he sends two orders for 7,500 shares each to A and B. Because of various effects (network latencies, routing switching delays, whatever) his order arrives at exchange A first, and is immediately filled at $17.

Jill, who has her computer co-located at exchange A, sees that she has sold 7,500 shares for $17, and realizes that there is demand for shares. Because of this demand, she decides to raise her prices. She immediately cancels her remaining 2500 shares on exchange A and replaces them with 10,000 shares at $17.05 and sends an instruction to do the same thing at exchange B.

Because Jill has fast computers and low-latency connections, her cancellation arrives at exchange B before Jack's buy order, so Jack is told that there are no longer shares available on exchange B at $17.

RESULT: Jack is filled for 7500 shares at $17 (half of what he requested) and the new market best offer is $17.05. Jack is welcome to submit another order for $17.05 if he wants to buy at that price. Jill is now short 7500 shares at $17, and will try to buy them back at a lower price (she may or may not succeed - until she does, she is exposed to the risk of further price rises).

Jill was able to use her speed advantage to detect that there was additional demand to buy this stock, and raise the price at which she was willing to sell it before Jack had finished buying all that he wanted to. This is exactly the way that an efficient market is supposed to work - it reacts to fluctuating demand (and other information) to set appropriate prices.

I think there are several things that get glossed over while people are working themselves up about this -

1. Jack is upset because he couldn't buy 15,000 shares at the price he wanted to buy them. But Jack has no god-given right to be able to buy shares at the price he likes best. He is subject to the laws of the market, just like everyone else.

2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?

3. If Jack doesn't like this state of affairs, he has several options. He can invest in high-speed infrastructure as well. He can use smarter order-routing logic (e.g. adding delays to his orders so that they arrive at the exchanges approximately simultaneously, or splitting his large order up into multiple smaller orders). Or he can use a broker who will do these things for him. If Jack doesn't want to pay for any of these things, then he has to put up with lower quality execution. As much as he might wish it, the ability to buy as many shares as he wants at the price he wants them is not a universal human right.

carlob2• 12 years ago

There is still something that nags me.

I've heard a bunch of explanation about liquidity and how HFT allows for large orders to be fulfilled, but it seems like this is quite the opposite.

What purpose does this serve? Is society as a whole better off when Jill is able to make this .05 per share more? I wouldn't frame the debate as 'god given rights' and 'competitive advantage'. What I really want to know is why a society where trades and quotes happen on a millisecond scale is better off than one where they happen on a second scale.

It's an honest question. Someone please convince me.

throwaway28371910• 12 years ago

What's great is that we don't have to engage in thought experiments about what would happen if we didn't have trading activity with fast computers on a millisecond scale - we can just look back to any time before the 1990s, when most market making was done by humans, on human time scales.

Before 2001 the minimum tick size on any exchange was 1/16th of a dollar ($0.0625) and before 1997 it was 1/8th ($0.125), so the absolute minimum you would pay for a round trip (buying a stock and later selling it) was that much. Frequently, the bid-offer spread would be many ticks wide, so you could easily be paying $0.25 or $0.50 for each round trip.

The current minimum tick size is $0.01, and there are many stocks which trade at that level. Even if you suffer $0.05 of slippage on a round trip, you're still better off than you would have been under the old regime.

In the old regime, instead of high frequency traders, you had floor brokers who would work orders. Fortunately, floor brokers were paragons of virtue and morality, who would certainly never front run their clients orders, and would take any trade even if it worked to their disadvantage (NB in case you don't get it - this is sarcasm. In the 1987 crash, most brokers wouldn't even pick up their fucking phone because too many people were trying to sell stock, and the brokers didn't want to buy).

I honestly find it hard to believe that some people think that was better than what we have today.

---

Edit: The other thing I don't get is why ordinary investors (by which I mean anyone with less than $100m to invest) care about this. For a small investor, you are actually getting an even better deal because your order for 1000 shares or whatever can get filled instantaneously, in one chunk, for a great price! It's only when you're trying to buy hundreds of thousands of shares in a few minutes that you end up suffering price slippage.

The standard response is that ordinary investors have their money invested in mutual funds and pensions, who are large investors. But in that case you are already paying 0.5-2% per year to your fund manager, and why do you give a shit if they lose 10 basis points (0.1%) in price slippage because the market is more efficient than it used to be?

In fact, why is my pension fund manager trading so fucking much anyway? I don't have a pension because I think the fund manager is some genius stock picker, I have it because it's tax efficient and my employer contributes to it. Just buy the S&P500 and sit on it.

rtpg• 12 years ago

2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?

If we want an efficient market,we need perfect information. Information asymmetry creates inefficient markets.

The moral argument behind free markets is that it leads to "efficient" outcomes. If people are going to do bullshit like this, there's no reason _not_ to set regulations to stop this.

throwaway28371910• 12 years ago

If you want a reasonably efficient market, you need some participants to have close to perfect information.

There is no market anywhere in the world that is 100% efficient, because the costs of getting to efficiency are prohibitively high. It's like trying to reach the speed of light - you can expend more and more effort getting closer and closer, but you can never actually reach it.

I'm not saying that what we have now is perfect, but it's a damn sight better than what we used to have.

noonespecial6• 12 years ago

What if it is a third party who is the HFT? Mary sees Jacks buy on A and uses the speed advantage to buy Jill's shares on B preventing Jack from finishing the transaction and Jill from reacting to increased demand. What if Mary was created solely for this purpose? When does it turn from arbitrage to rent seeking?

gone35• 12 years ago

Same thing: now it is Mary who trades her short exposure risk for a bet that Jack's buy offer of $17.00 is not his maximum willingness to pay, while Jill just gets to fill her original sell order instantly (as opposed to "waiting" a few ms for the offer to arrive at her exchange). In both cases, Jack's is being forced to reveal more about his true valuation of the stock by paying up closer to his best possible offer.

Note in a perfect auction it should be Jill who receive the $17.05; but exchanges are more like (millisecond fast) mail-order catalogues, where the prices you quote are fixed the moment you send off your order. It would piss many people off that you only got half the items you wanted every time because the listed prices "went up" in between the time you mailed your order; but it would also make the whole thing closer to an auction.. so that's that.

ryanjshaw• 12 years ago

But Jack has no god-given right to be able to buy shares at the price he likes best

It seems like the disagreement really lies here. I'm not a finance expert so I'll probably get a few things wrong but is it fair to summarize the two perspectives as follows?

1. Jill is merely quoting a price for independent blocks of shares on independent exchanges. If a buy order is placed against that quoted price, she has the right to reissue quotes elsewhere. This is no different from Jill selling apples at the market on 1st street, as well as at the market on 2nd street, then receiving a large order on 1st street that prompts her to call her sales manager on 2nd street and have him increase the price of apples there. Or for Janice, sitting next to Jill's stall on 1st street, overhearing the sale at $17 and repricing her apples upwards for when the demand inevitably spills over to her stall.

2. Jill is making an offer to sell a combined block of shares at a particular price. Even though her offer is broken up over multiple exchanges, since a single buy order can execute on multiple exchanges her offer should hold across all of these exchanges. Yet she is taking advantage of the physical makeup of the market to bait large orders (thereby revealing market demand) and then switch to higher prices (thereby capturing a larger profit).

I emphasized "quote" and "offer" above because they capture two different concepts in contract law. I'm not sure if the concepts are the same in financial markets but the principle seems to be at the root of the disagreement. If Jill was merely "quoting", unless the rules of the exchange specify otherwise, she is free to reissue her quote and therefore perspective #1 makes sense. If Jill was making an "offer" however, presumably she should be bound to the terms of her offer regardless of the physical details around how she publishes that offer, reinforcing perspective #2.

So: do the market rules have such a distinction? I found the link [1] below which suggests both perspectives are valid - depending on the type of market one is participating in, if I understand it correctly. Is this a matter of people confusing the two types of markets? (I have to say that perspective #2 seems pretty impractical to me in markets with multiple exchanges participating, and #1 doesn't negatively impact the market -- either it makes economic sense for Jack to pay the new price or not, why do we care if he saves a few bucks if we fiddle with the rules?)

[1] http://www.investopedia.com/ask/answers/06/quoteorderdrivenm...

throwaway28371910• 12 years ago

Yes, I think that's a fair summary.

I don't know much about contract law, but it may be interesting to know that a resting order on exchange, with a set price and size, is called a quote.

The terminology offer is used in financial markets for a resting order to sell, distinguishing it from a bid which is a resting order to buy, although many market participants will actually use the terms bid and ask rather than bid and offer. Whether this is to avoid confusion with the contract law term, I have no idea.

It won't surprise you to learn that I also think that your perspective #2 is unworkable in a situation where you have multiple exchanges (how would it work - would you require that quotes on exchange B must remain for a specified period after a quote on exchange A is hit? That doesn't seem sensible).

rahimnathwani3• 12 years ago

Whether she has to honour the quote is irrelevant, as she yanks the quote at the second exchange before it is hit.

downandout6• 12 years ago

2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?

Here's the problem with that: the number of available ultra-close connections to the market is finite. If you carry this out to its only possible conclusion, whomever has the closest connection always wins, and everyone else always loses. The other market participants eventually realize that it is simply not possible for them to win, and that a closer connection is not for sale at any price, so they simply stop participating. This solves one problem - people stop losing money - but also destroys the market.

throwaway28371910• 12 years ago

It's empirically not true that "whomever has the closest connection always wins and everyone else always loses" as is evidenced by the fact that there are multiple competing market makers who are all profitable.

Arguments of the kind "let's carry this to its logical conclusion" are almost always fallacious, because they ignore limiting factors, or alternative explanations.

If your only advantage is speed then you need to have the fastest connection to the exchange, else your business model doesn't exist. If you have other advantages, then speed is less important. Nowadays there are very few market makers whose only advantage is speed, because most of them realized that continually paying through the nose to compete on speed is a mug's game.

growse3• 12 years ago

This is obvious for any market that has a single physical location. People who stand next to the apple seller get local apple price information faster than those standing in the next town.

You've also got a very peculiar definition of winning. A person who wishes to buy 10,000 Ford shares who places an order at $17 only to find that in the meantime the market has shifted to $17.01 and therefore purchases at that price hasn't "lost". They set out to buy Ford stock at market rate, and that's what they ended up doing.

rahimnathwani3• 12 years ago

Jack is not upset because he couldn't buy the shares at the price he wanted. He is upset because someone was offering shares at a specific price, and Jack was willing to pay that price, but the order was not executed. The reason the order was not executed is not because someone else accepted the offer before him, or because Jill cancelled before he tried to accept. It was because Jill was able to see his acceptance in transit and cancel part of her offer as a result of this new information. This isn't how markets are supposed to work. If Jill had posted a single offer for half the number of shares that Jack wanted, it would be different.

Someone shouldn't need to use Thor or some other delaying mechanism to accept open offers. The latency between different exchanges (which was exploited in this example) does nothing to increase market efficiency.

You're right that I shouldn't care about this as a practical matter, as the impact on me is very small, but that doesn't mean it's right.

I really appreciate the clarity in your comments on this thread.

throwaway28371910• 12 years ago

Here is our point of disagreement, then - I think that this is exactly how markets are supposed to work (in the presence of multiple exchanges).

The job of a market maker is to supply liquidity at a price/risk tradeoff that is reasonable to them, subject to the information available to them. If there are multiple exchanges, and someone trades with them on one exchange, then the set of information available to them has changed (specifically, their knowledge of the supply/demand balance for a particular stock has changed). It's only natural that they will want to change their prices in response.

Now, we could change legislation to either (a) go back to having a single exchange or (b) restricting the ability of market makers to move their quotes on one exchange if they trade on another. But that won't necessarily result in a better deal for non-market makers, because instead of quoting 20,000 shares split across 4 exchanges, the market maker now quotes 5,000 shares on 1 exchange.

The benefit is that all market participants have a more accurate idea of the true liquidity available in the market. The disadvantage is that you have removed the element of competition between exchanges, so the exchange is no longer incentivized to offer low fees and keep improving its service.

deathflute• 12 years ago

Excellent analysis. I am sick of seeing these Nanex posts(rants); the lack a basic familiarity of market microstructure mechanisms.

The market maker is not sitting there to let you run him over and thank you for it.

As a price taker, the trader has to incur slippage due to the market impact of his large order.

noxn3• 12 years ago

"Fresh Apples here! Only the best apples for 2 dollars!" - "I would like one, please." - "Thatll be 2.50, sir." - "What? I thought you just said 2?" - "Demand has just gone up."

harryh17• 12 years ago

That's wrong. It's more like:

"Fresh Apples here! Only the best apples for 2 dollars!" - "I would like every single apple you have, please. Also I'm buying all the apples from the guy across the street too." - "Thatll be 2.05 each, sir." - "What? I thought you just said 2?" - "Demand has just gone up."

kasey_junk14• 12 years ago

This is the flawed analogy that keeps being propagated that is completely untrue.

A much better one is to think of a string of gas stations running down the highway. They all have an advertised price. A tanker truck arrives at the first gas station and buys all the gas at the advertised price. It then goes down the road and buys all the next stations gas at the same advertised price. Then the manager of the 2nd gas station calls the 3rd and says hey, we've just gotten wiped out of gas there is a lot of demand. The 3rd manager raises his price accordingly. The tanker truck can then decide if it wants to buy more gas at the new price or just take what they currently have.

throwaway28371910• 12 years ago

I'm glad you brought this up, because this kind of thing happens precisely never on a financial exchange.

If you go to a store, the store owner sees you take your apples up to the counter, and so he can theoretically change his price before you get there (although in practice, if he ever did that he would soon be out of business).

On a financial exchange, the market maker doesn't even find out that you wanted to buy until the trade has already happened. It is literally impossible for the market maker to change his price, because he doesn't find out about your order until it's already occurred.

What is possible is that the market maker is also quoting on another, totally separate exchange, and he decides to change his prices there, in reaction to seeing a big order on the first exchange.

It's like an apple seller who owns two carts in different parts of town. When you come to his first cart and buy all his apples for $2, he guesses that maybe you are going to go over to his second cart and buy all the apples there as well, so he calls his business partner who's running that cart, and tells him to raise his prices to $2.50 - which makes perfect sense as a business strategy, because demand has gone up.

Note that he only raised his prices because you bought all the apples at his first cart. If you just bought one apple out of the hundreds he has (because you're a small investor, not a giant investment bank) then he wouldn't bother to raise his prices.

cbr• 12 years ago

Say there are three exchanges, A, B, C, each with 1k shares of Ford on offer at $20. They are all random numbers of ms away from me, and for simplicity say A is closest and C is farthest. I send out my order for 3k shares at $20, and it hits A then B then C. People who are watching A see my request, and try to make adversarial changes on B and C. They have a low chance of success on B because it's almost as close to me as A is, but they have a higher chance on C because it's pretty far from me.

One way to fix this is to delay your orders carefully so that A, B, and C will all get your order at almost the same time. Now there's not time for someone who sees your order on A to react and send a message to C that will beat your message to C.

I believe this is what IEX does: http://en.wikipedia.org/wiki/IEX

harryh17• 12 years ago

That's not what IEX does. IEX is, to fit within your example merely exchange A. It can't control whether you delay your order to B or C or not.

What A does do is delay the output. When it receives an order it doesn't immediately broadcast that information back out, it waits some small (but relevant) period of time.

willvarfar• 12 years ago

All exchanges should have synced clocks and all messages should have a timestamp up to 2 seconds in the future when they will be published by each exchange. The buffering would be internal to each exchange and not shared with anybody. You can only cancel after what you are cancelling is published. This would allow everyone to make all exchanges publish at once so people with fast cable between exchanges can't beat out those that don't.

ripb• 12 years ago

This would allow everyone to make all exchanges publish at once so people with fast cable between exchanges can't beat out those that don't.

Why is one actor paying for an advantage that is available to anyone who should desire it, and have the means to pay for it, an issue?

harryh17• 12 years ago

What do you think would happen to bid-ask spreads if this was imposed?

throwaway161803• 12 years ago

This article establishes that two things often happen shortly after you place an order to buy shares: 1) Another trader places a similar order on another exchange. 2) A large number of outstanding sell orders are cancelled.

It's not clear to me that either of these are Bad Things, deontologically speaking. [I don't recall Jesus mentioning them.]

The key question is consequentialist: Are there regulatory changes which would improve the lot of the average investor, investing through, say, an index tracker or pension fund? For each potential change, one ought see how it fares w.r.t. this standard, considering, to the extent that it is possible, the induced second-order effects.

Talk of theft, rigging, fairness (you don't owe people like me anything), stolen goods and frontrunning is only useful to the extent that it helps us converge on an answer to this question. These words are tools that we have developed for analysing more familiar situations, where they correspond to actions which are clearly harmful.

Most changes proposed here either lose market efficiency directly (trade buffering / increased tick sizes) or just give us new games to play (if the market clears once a second, we will get our orders in last), potentially resulting in a less direct loss. The question remains.

bakhy• 12 years ago

An interesting contradiction appears here. On one hand, this increases market efficiency, or so we're told. On the other, we are also told that if a big pension fund wants to avoid being played like this, they should spend money on their own HFT equipment.

It seems there is only one clear winner here - the IT people making money off developing HFT systems.

harryh17• 12 years ago

Here's the chief executive of Vanguard (one of the largest investment management companies in the world) discussing how HFT has dramatically lowered their trading costs:

http://www.ft.com/intl/cms/s/0/ff8c6486-cb37-11e3-ba95-00144...

Spreads used to be a quarter, and now they're a penny! That's a huge deal!

thingylab• 12 years ago

I don't see how this proves the market is rigged. What I do see is: 1) One market participant is being less than clever by trying to buy, in one order, 80% of the offered quantity, and 2) Another market participant realizes this, and reacts accordingly.

The post is written as if the world should freeze once the client sends an order. He was 'stolen' shares. Really?

vampirechicken• 12 years ago

As a non-trader, my question is:

Were the 24k shares being offered by one seller/broker, as in "I have 24k shares to sell at 17" or was the 24k just an aggregation of the availability all the smaller offers?

If the former, it seem to me that the seller is cheating, if it is the latter then I can see how the HFT systems would raise the price in response to a sale, but I also see how frustrating that is to the buyer.

I wonder why these trades are not being performed in parallel across the various exchanges, partially preventing this kind of arbitrage?

growse3• 12 years ago

Were the 24k shares being offered by one seller/broker, as in "I have 24k shares to sell at 17" or was the 24k just an aggregation of the availability all the smaller offers?

The shares were being quoted on different exchanges, at the same ask price. 24k was the cumulative volume that the buyer wanted, but that couldn't be fulfilled by a single exchange (the quote was for a smaller volume at that price). Therefore, to buy 24k shares, the buyer needs to trade twice, once at each exchange.

I wonder why these trades are not being performed in parallel across the various exchanges, partially preventing this kind of arbitrage?

As has been pointed out, this is what a good broker will do - they will compensate for latency to make sure that bids arrive at differing venues at the same time to prevent the market shifting underneath them. A naïve broker will simply send out the bids at the same, and latency means that they arrive at different exchanges at different times. This lets the sellers at the more distant exchange move the market in response to the information of the trade being executed at the closer exchange.

A detailed exposé on how the market is rigged from a data-centric approach

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