"As far as narrowing spreads, that’s absolutely true, but in absolute terms what does it translate into? For the individual investor it might save them a quarter a month."
In a properly designed, information age stock market there should not be a spread. All stocks should trade via a programmed, black box auction that runs on an interval. The HFT practice of creating phony orders that are immediately canceled, just to gain visibility into the current bids and asks, would be eliminated. No seeing other people's bids, and then front running them, no canceling orders. You put in a limit order for the value of the stock, and the stock goes to the highest bidder. All the extra pennies and quarters go to the shareholder, nothing to the HFT algorithms (unless they provide actually value such as market making or smoothing irrational volatility). It's the most efficient design for stock market trading possible.
In theory, if this system were to be adopted, the Stock Exchange Operator could charge a small tariff so that some of the money that now goes to HFT's goes to the stock exchange, with the rest going to the shareholders. So in theory, adopting this more optimal system would be financially beneficially to both the corporations and the Stock Exchange (and in theory, those two are the only two players who's agreement is needed to change the system). So I wonder why the optimal, auction based system does not get adopted - is there some reason for the status quo other than the normal inertia and stupidity of large institutions?
Not a good theory. All the players in this game believe they are above average among players in this game.
They all want the system to be exploitable because they all believe they will exploit it better than their peers.
At the very least better than the investors (the real suckers here).
You are falling into the game theory economics trap. People are highly irrational actors who don't even act in their own self interest most of the time, nevermind some form of optimal rational behavior.
You are falling into the behavioral economics trap. In general, the big movers and shakers in financial markets act in quite economically rational ways. There is a natural selection process at work where the people who are good at using their brain to accumulate money, accumulate money, and thus have more impact in the market. If you look at many cases where wealthy market players appear to be acting irrationally, what you'll often see is they are acting in a personally rational manner, but are operating in a context with very perverse incentives. So I am curious if anyone in the HN commentariat knows the specific perverse incentives involved that prevent this more optimal system from happening. ( Joe Retail investor can be quite irrational. But I'm wondering why the Stock Exchanges and big corporations accept the status quo with regards to HFT.)
"In general, the big movers and shakers in financial markets act in quite economically rational ways"
They are certainly more intelligent, knowledgeable and invest more rationally but I've seen nothing to make me believe that they lack or compensate for the types of positivity biases that makes everyone think they are above average and can beat their peers.
We weren't talking about the contexts of the investment choices they make (where I mostly agree with you) but about changing to a system where the winners can't exploit the system to extract far more money than the value they put in.
If they are A-type human beings they have a positivity bias if they have a human brain. You don't need perverse incentives to keep a system that over-rewards winners if everyone thinks they are, or soon will be, the winners.
That said, I would also be interested in knowing about any perverse incentives here, I just don't think they are necessary.
How would this be better than what we have now? Right now stocks already go to the highest bidder - if there is a seller willing to sell at that price. how would you run an auction if there are 40 firms trying to sell the same stock?
The ad market is well suited towards auctions because you have one seller for many buyers, but in finance you have a symmetric relationship between buyers and sellers.
Google "HFT frontrunning". The issue is that HFT algorithms can use their superior speed and the ability to cancel orders to essentially figure out what institutional buyers are bidding, and then front run the market to buy up shares in front of them. This would be prevented in my system by the black box auction and trading on an interval.
There are many opportunities for institutional investors to trade in exactly the manner you suggest. NASDAQ runs the opening and closing cross as well as other intra-day crosses. Other platforms allow private crosses, dark pools allow crossing not in public and today 1/3 of all shares are crossed internally on brokerage platforms. Institutional investors have many opportunities to trade in the dark. There is a price to be paid for instantly accessing liquidity in the market, and it is much cheaper than it used to be.
This is not efficient. If you use interval bidding, there will frequently be gaps in market prices. Remember that at any instant, the order book (bids and asks) represents only a small portion of market sentiment (real demand and supply). The market prices move smoothly when people are able to react to order changes and price spikes. If it's a black box, it's very easy to manipulate the market in a massive scale.
For example, AAPL is $600 now. Under your system, $600 is the price that generated the highest volume in previous bidding event. (There will be sellers placing orders under $600, and buyers over $600 - they'll all be settled at $600 and the exchange obviously wants to maximize this overlap, hence the price). If a large institutional investor wants to manipulate the price, he can place huge buy and sell orders at $700. And very likely in the next bidding event the price of AAPL will move to close to $700, because that will be the price that maximizes the overlap. This is almost impossible in current market system, because you have to continuously buy from all the sellers who are willing to sell at $700 to get the price. Meanwhile, traders (especially day traders) will add to the order book to take advantage of this irrational move. In a black box, irrational moves can't be detected and corrected by other market participants. So you can't really get the idea of the actual matching price in a black box system.
When you place a buy order, if there's overlap with any sell orders, it should be matched and executed instantly. Otherwise it will stay in the book to wait for sell orders. The market equilibrium is reached when the spread is minimal and no trade occurs. (Yes, this is in theory.) However, in your "efficient" system, there's no market equilibrium, because buyers and sellers are discouraged from making their real demand and supply invisible. The exchange has the incentive to maximize trade volume, so the only way to result in zero volume is no overlapping orders in the entire interval, even when the buyers are sellers have no knowledge of any orders. This only happens when people have no confidence or interest to trade at all. Again, it makes market vulnerable to be manipulated.
In China, stock exchanges partially adopted your idea. In Shanghai Securities Exchange, the first 10 minutes (9.15am to 9.25am) of the day is set to be non-continuous bidding period. In Shenzhen Securities Exchange, the first 10 mins and last 3 mins are the same. This was introduced to reduce market manipulation because the order book is empty at the beginning of the day. However, after the period, trade starts continuously and all remainder orders in the bidding event will automatically enter the order book. This way, the price movement of the whole day is smooth with minimal spikes, while the opening and closing prices reflect market sentiment more accurately.
Generally, the more the visible orders, the more smoothed the price. Interval bidding discourages order placement because the next price is absolutely unpredictable. It can be adopted in extremely illiquid market situations though.
This is why we have Game Theory and Mechanism Design. Mathematicians and computer scientists study the different types of auction methods for their properties. Let's take a look at your example:
AAPL is $600 now. (...) If a large institutional investor wants to manipulate the price, he can place huge buy and sell orders at $700.
All your example shows is that a good auction mechanism should avoid this possibility of manipulation. But that's easy enough: the investor's buy at $700 will be matched with sells that are closer to $600, the same as in the current system. The sell at $700 doesn't affect anything.
So in fact the price will move the same as it would in continuous buying.
Not exactly. In a black box, there will be less orders because market participants are discouraged to be market makers, because the point their orders have been triggered is also likely the point the market deviates significantly and they have no chance to cancel or stop loss immediately in a non-continuous market. Market makers are resistance of such manipulation. And most market makers place orders to fill the "gaps" in the order book. Without a visible order book, it's much more risky to provide liquidity without any actual demand or supply for the shares. I think it's okay to assume that less than 1% of traders place orders based on real supply and demand. You know you would sell AAPL if it spikes to $700 today, but you won't place an order until that happens. (The financial market is an incomplete coverage of demand and supply anyway, so the more liquidity, the better.)
AAPL is $600 now. (...) If a large institutional investor wants to manipulate the price, he can place huge buy and sell orders at $700.
To what profit? The investor would lose their shirt. Let's say period A had 20 shares sold and 20 shares bought at around ~$600. Period B the investor enters with 50 shares being sold at min price $700.00 and 50 shares being bid on at max price $700.01. In period B there are also another 20 shares from other people being offered at min price $600.10 and 20 being bid on at $600.00. The auction runs and the most seller advantageous clearing price is $700. The institutional investor gets 20 shares from the $600.10 but at the clearing price of $700. The investor exchanges 30 shares between his right and left hands. So overall, the investor has on net bought 20 shares at a ridiculously inflated price. This was a stupid, money losing strategy for the investor.
You know you would sell AAPL if it spikes to $700 today, but you won't place an order until that happens.
Why not? Under my system, at every interval you could simply put a limit order in for selling at a minimum $700. In fact, I suspect a few hedge funds would pop up that specialize in figuring out a true and accurate price of a stock according to the fund's analysis, and then placing, constant, across the board limit orders that would automatically snap up shares in the case of irrationality. If the market was as jump and irrational as you think it would be hedge funds would make a killing by being smart and rational, until enough entered the market with standing limit orders that the price smoothed out.
Without a visible order book, it's much more risky to provide liquidity without any actual demand or supply for the shares.
And yeah, under my system market making actually requires work/risk, not just riskless front running. The free lunch is gone. That is the point. There would be less volume. Buyers and sellers would trade slightly slower trade execution (waiting for the auction interval) for the benefit of not paying any tax to market makers.
> And yeah, under my system market making actually requires work/risk, not just riskless front running. The free lunch is gone. That is the point. There would be less volume. Buyers and sellers would trade slightly slower trade execution (waiting for the auction interval) for the benefit of not paying any tax to market makers.
The spread earned by market makers is definitely not a tax. They earn the money from (increased volume * reduced spread). Suppose you anticipate AAPL will rise from $600 to $601 based on your fundamental/technical analysis. If there're no market makers, the wouldn't be enough liquidity to inspire any confidence to take the trade. The order book would be like:
601.00 3
600.50 1
5 600.00
2 599.00
There's no point to make that $1. It's simply too risky. If there are a buyer and a seller they both want to trade 1 share instantly. They pay $0.50 in total to liquidity providers in the market (compared to private settling).
If there are lots of market makers, the order book would look like this:
600.10 950
600.05 401
1200 600.00
450 599.95
Of course, you will choose to trade and make the $1 if market moves as expected (and a lot of people will make similar decisions). At this time, if a buyer and a seller comes, they will pay $0.05 in total to market makers compared to private settling.
I know that your original intent is to make the "private settling" option available in the market by aggregating all orders in an interval and execute at once. If that really happens, the order book (which is hidden from public) will look like this:
600.50 2
600.00 3
5 601.00
2 600.00
Execution price: $600.60 (Weighted average of overlapping orders). Volume: 5 shares.
In this case, it seems that both the buyer and the seller received a benefit. But actually it's not true. If your aim is to make profit by selling at $601, rationally you will keep buying until the price reaches $601. The maximum price you're willing to pay is actually $601. However, when you see a selling order at $600, you will place a $600 buy order instead (and you pretend to have a demand only at $600 or below because you know it will be fulfilled anyway). In a non-continuous system, you're forced to signal your true demand at $601 so that you are able to take advantage of favourable prices when you're lucky (and orders get executed only when you're lucky).
> If the market was as jump and irrational as you think it would be hedge funds would make a killing by being smart and rational, until enough entered the market with standing limit orders that the price smoothed out.
They are exactly market makers. The market will be "jump and irrational" without these market makers, especially when everyone signals their true demand. That's why black-box auctions usually yield much higher prices than public auctions when people are rational (i.e. not counting the emotional effects of public bidding). It's just how market works. Similar concepts can apply to free rider problem as well (for public goods). You know that the national military can provide you security worth $1,000 a year, but obviously you pretend to be unwilling to pay anything when the service can only be provided for free. Market equilibrium price quickly reaches $0 with no guess work.
The way market works makes the prices very predictable. Even the flash crashes are smooth (with the market makers). The "riskless front running" is a symbol of market competition. Yes, some guys are going to offer you one cent better, they should have the priority in the queue.
I don't want to comment on the influence in economic activity. What I know is, more liquidity = less risk for holding shares. What market makers earn is not a tax. It comes from the money that bigger market makers will earn anyway ($0.01 spread with 50 shares traded vs $0.50 spread with 1 share traded).
You might have different auction interval times based on the volume of the particular market or stock. An AAPL auction happens every minute, but some low volume securities might trade once an hour or even once a day.
In a properly designed, information age stock market there should not be a spread. All stocks should trade via a programmed, black box auction that runs on an interval. The HFT practice of creating phony orders that are immediately canceled, just to gain visibility into the current bids and asks, would be eliminated. No seeing other people's bids, and then front running them, no canceling orders. You put in a limit order for the value of the stock, and the stock goes to the highest bidder. All the extra pennies and quarters go to the shareholder, nothing to the HFT algorithms (unless they provide actually value such as market making or smoothing irrational volatility). It's the most efficient design for stock market trading possible.