We know, empirically, that a lack of liquidity increases trading costs, which in turn is directly channeled to the prices of goods and services that rely on this liquidity (more or less everything in the world, even more indirectly ones like education).
It's difficult to say 'things would be X% more expensive' because of the interconnected complexity the GP was talking about, but there is definitely a very apparent benefit.
I think the question is at what point does liquidity have diminishing returns?
If a security could only be traded once per 10 years then it's obvious that its lack of liquidity would make it less valuable. Holding it would tie up your capital quite significantly.
However, if you had a turn-based market where every trade got cleared at the top of the minute it's not clear to me at all whether that would effectively be less liquid than what we have now.
It seems to me that a model where traders all compete for how many nanoseconds away their HFT servers are from the action doesn't really benefit the market as a whole. If anything it just makes things like flash crashes more likely.
> I think the question is at what point does liquidity have diminishing returns?
The general consensus at this point is - no one actually knows - and it's up for serious debate. We know lack of liquidity absolutely has negative effects (because we've experienced it), but we don't how much liquidity is "too much".
> If it's bad, we can always turn the knob back.
Sure, but by then maybe some people or organizations have made/lost millions. So we can't realistically experiment with that (even though I would absolutely love to)
If a businessmodel is questionable from a societal viewpoint, then they shouldn't be surprised that some regulation hits them. See for instance Airbnb, where the businessmodel has become impossible in many cities already.
I feel like we do know how much liquidity is too much, in the sense that the HFT traders are siphoning profits from value-seekers to rent-seekers. The total of their profits is the amount by which there is too much liquidity.
It's not necessarily clear whether it could be reduced to seconds of liquidity, or minutes, but it's clear that milliseconds is too short. The money isn't remaining in the market long enough to provide value -- especially when the market has already been made and they're just trying to figure out who gets the surplus between ask and bid.
> However, if you had a turn-based market where every trade got cleared at the top of the minute it's not clear to me at all whether that would effectively be less liquid than what we have now.
The primary problem with that is that it pools order flow into a homogenous, undistinguished pool.
HFT heavily rely on profiling order flow into the informed and uninformed. A typical uninformed trader is Joe Sixpack who's rebalancing his 401k. A typical informed trader is a hotshot hedge fund manager, who's invested enormous resources in gaining an informational edge. If Joe's buying a stock that doesn't tell you anything about the value of the stock. If hotshot hedge fund manager is buying a stock, that in and of itself is a credible signal that the stock's worth more than you thought it was.
Liquidity providers love being the counterparts to Joe, and hate being on the other side of the hotshot hedge fund managers. The more you can profile the order flow, the better prices and more liquidity you can offer to Joe, by charging the hotshots more. Think of how life insurance companies can offer better premiums, particularly to the healthy, if they require a physical exam before underwriting a policy.
Even on a millisecond by millisecond basis, there's a ton of distinguishing characteristics regarding the informational content of order flow. Uninformed flow basically looks like a bunch of small, randomly spaced trades. Informed flow is more likely to cluster together in small time windows, move sequentially in the same direction, try to sweep liquidity with huge trades, and immediately follow similar moves in other securities among other things.
If you pool all orders into a homogenous one minute pool, HFTs would lose much of their ability to segment order flow. The end result would mean that the hotshot hedge fund manager would see his trading costs reduced, and Joe Sixpack would see his trading costs increase.
However, you postulate that the introduction of a turn-based system would effectively transfer money from Joe Sixpack (who'd face higher costs) to hotshot hedge fund manager (who'd face even lower costs).
Maybe, though, we'd see HFT shops go out of business (and not building micro wave towers between Chicago and NY anymore), and see a transfer from HFT shops to hotshot hedge fund manager and Joe Sixpack, both facing lower costs.
I think part of the problem is that "liquidity" is an imprecise term. It implies both velocity and flexibility. HFT definitely increases velocity, but it can make the market either more or less rigid depending on the circumstances.
A turn based system seems like a horrible idea. First the major players would have a legitimate excuse to make sure their trades were first in the queue. Second they would immediately game this so that everyone in the line behind them had to watch as they triggered market changes one minute they were then in a perfect position to take advantage of the next minute.
In a turn based market your place in the queue is determined only by the price you bid. Everyone trades at the same price, except for those who bid too high/low, they don't trade.
These systems are already running in many markets, typically at a rate of one trade round per day, but using them is optional.
In reality the way that markets are cleared wasn't necessarily so much more different than a turn-based one, even in one where the clearing happens by the minute. The issue is, indeed, mostly with HFT. However, you shouldn't consider HFTs to be market participants in the traditional sense. Most of them focus solely on moving stuff around very fast instead of actually trying to purchase or sell things for a separate economic goal (e.g. production, hedging, short- and long-term investments).
Once you disregard the rapid transactions that do not have a significant effect on the price, your average human investor is probably putting down some fill-or-kills or limit orders and actually benefits from HF liquidity trading.
It's hard for me to understand, let alone explain, why milliseconds would matter for the human investor, but I what I can tell you is that GS is not investing 100M USD just for buying derivatives every other minute.
Not all liquidity is the same. I've seen calculations that stated that HFT doesn't actually add valuable liquidity to markets because the moments you need that extra liquidity are price uncertainty moments where HFT traders disappear. I don't have the reference on hand though.
Sure, that's almost tautologically true, but that does not mean that the benefits to society materialise:
* Traders getting faster access to an exchange have an advantage against other traders (and might make more money), but that does not imply at all that the market will be more liquid.
* The volume of actual utilitarian trades (investing, borrowing, asset exchanging, hedging) is relatively small compared to overall trading activity. A pension fund investing, someone taking out a mortgage, people exchanging currency for the holidays, the often cited farmer hedging his crop - they trade infrequently, and certainly don't care about some milliseconds.
* The dynamics are those of an arms race. Arms races are wasteful, by and large. Building a "straighter" fibre glass connection between NY and Chicago, and then building a series of micro wave towers (because the speed of light in the air is greater than in the fibre) - how does that benefit society? Just postulating higher liquidity and lower costs is not enough to justify it, I think.
(I am reminded of the earlier discussion about advertising - once Cola does it, Pepsi has to do it, too. Are we thus better off, or would we get cheaper sodas if both didn't?)
Yes, and I'll tell you exactly why. Markets consist of informed and uninformed traders.
For example your typical Joe Sixpack rebalancing his 401k is uninformed. His trading does not tell you anything about the underlying value of the stocks. The typical informed trader is a hedge fund manager, who's investing tons of resources in gaining an informational edge. If he's buying a stock at a particular time that is in and of itself a signal that said stock is worth more than you thought it was otherwise.
Liquidity providers love trading with uninformed traders. The problem with informed traders is that you don't want to be on the other side of their trades. Since liquidity providers are the immediate counterparties to most order flow, they're the ones that primarily eat this cost.
To counter this, liquidity providers invest enormous resources in profiling order flow to try to identify when to what degree its informed. This allows them to provide lower costs and more liquidity to uninformed traders, like Joe Sixpack. It's analogous to how requiring a checkup allows life insurance companies to provide lower premiums, particularly to those who are healthy.
One of the most important ways to profile order flow is to quickly adjust quotes as market conditions evolve. For example said hedge fund manager may be trading a thesis that the chipmakers are all undervalued. He may come in and buy Intel, AMD and Nvidia in one swoop. If an HFT sees a huge buy hit Intel, it can bump its quotes on AMD for a few milliseconds.
If its a cigar-chomping hedge fund manager executing a basket algorithm, it's quite likely that he'll try to hit AMD and thus pay the higher price. But if its Joe Sixpack the probability that his trade just coincidentally lands in a 5 millisecond time window is vanishingly small.
You have to consider some form of multiplier effect that comes into play. Because the prices of assets are derivatives of others (incl. many, many other variables, of course) these millisecond savings end up turning into seconds, even minutes en masse.
Not a hostile question, I'm genuinely trying to understand this: How is liquidity provided by, for example, someone interjecting themselves into a trade that was already going to happen?
If you want to move a large amount of money into an asset, you either have to place bids and wait for people to take your order at a particular price, or you have to pay a slight premium to dig into the ask side of the book and pay more money as you consume orders and liquidity.
If you place an ask and the price moves down it might not fill, so you have to move it over time while the price slips.
People provide liquidity by seeing your new sell order and filling it quickly, or by leaving a large number sell orders that people can take immediately, which results in money moving more quickly and consistently.
The comment directly above is the parent, and the comment above the parent is the grandparent—in this case the GP they’re referring to was 1e-9’s comment.
It's difficult to say 'things would be X% more expensive' because of the interconnected complexity the GP was talking about, but there is definitely a very apparent benefit.