High frequency trading: A consequence of payment for order flow
I'm somewhat bemused by the various discussions of high-frequency trading. It's in the news a bit more following the 16-minute panic, but there have been discussions of why it might be fair or unfair for a while.
It looks to me like it's very much related to how the various exchanges compete. The stock exchanges charge a small fee for each stock trade they handle, but that small fee more than pays their costs. So they compete with each other by offering a rebate to brokerages that route lots of trades there. (This is "Payment for Order Flow", the SEC's discussion on trade execution may be useful.) A quirk of this is that the rebate generally goes to the limit order (market maker, often), instead of someone placing a market order.
So, if you're already doing lots of trades, you can collect some extra money by structuring your trades as rapidly-updated limit orders. You can even buy stock and sell it again almost immediately, effectively collecting a small profit that in an earlier time would have been part of the exchange fee.
Of course, not everyone running a trading algorithm does so wisely: If a stock is falling rapidly, placing a market sell order can sell a $17 stock for $0.01 instead. I suspect that some of the high-frequency traders have reinvented the synthetic put, or at the very least used a lot of stop orders. In such an environment, stock prices become unstable: A great opportunity if you're not trading on margin, and if the SEC doesn't subsequently cancel your trades.
But to be honest, any harm due to the form of the high-frequency trading escapes me. Equally foolish trades can and do happen at a slower pace.
It looks to me like it's very much related to how the various exchanges compete. The stock exchanges charge a small fee for each stock trade they handle, but that small fee more than pays their costs. So they compete with each other by offering a rebate to brokerages that route lots of trades there. (This is "Payment for Order Flow", the SEC's discussion on trade execution may be useful.) A quirk of this is that the rebate generally goes to the limit order (market maker, often), instead of someone placing a market order.
So, if you're already doing lots of trades, you can collect some extra money by structuring your trades as rapidly-updated limit orders. You can even buy stock and sell it again almost immediately, effectively collecting a small profit that in an earlier time would have been part of the exchange fee.
Of course, not everyone running a trading algorithm does so wisely: If a stock is falling rapidly, placing a market sell order can sell a $17 stock for $0.01 instead. I suspect that some of the high-frequency traders have reinvented the synthetic put, or at the very least used a lot of stop orders. In such an environment, stock prices become unstable: A great opportunity if you're not trading on margin, and if the SEC doesn't subsequently cancel your trades.
But to be honest, any harm due to the form of the high-frequency trading escapes me. Equally foolish trades can and do happen at a slower pace.