> How does the HFT know that someone is crossing the spread?
So suppose the bid for some particular stock is $100.00 and the ask is $100.10 in both Chicago and New York. They could be different between the two exchanges, but the prices between exchanges will generally be the same or very close to each other at any given time because any significant divergence is an arbitrage opportunity.
Now somebody wants to buy some shares of that stock in Chicago, so they cross the spread and put in a bid for $100.10. They immediately buy all the shares in Chicago that are available at $100.10. Now the ask in Chicago will go up because all the shares available for $100.10 in Chicago have been purchased, so now the bid in Chicago is $100.10 and the ask is, say, $100.20. At the same time, in New York, somebody wants to sell some shares of the same stock. So they cross the spread and make shares available for the bid price in New York, which is $100.00. That seller sells to everyone in New York who is willing to pay $100.00, so now the ask in New York is $100.00 and the bid is, say, $99.90. Both the buyer in Chicago and the seller in New York are still willing to buy and sell more shares at $100.10 and $100.00 respectively, i.e. the new bid in Chicago is higher than the new ask in New York.
The HFTer sees the new prices before most other traders because their computers are faster and closer to the exchanges. As soon as the buyer at $100.10 learns there is a seller at $100.00 or vice versa, they would get together and trade all the shares they want to trade at some price in that range. But the HFTer learns the pricing information first and, before the buyer and seller find out about each other, the HFTer buys the seller's shares in New York at $100.00 and immediately resells them to the buyer in Chicago at $100.10.
Assuming things work the way you describe (they don't, but I'll play along) if there is no HFT involved how would you propose that this situation be resolved?
There is $.10 of surplus here. Who (if anyone) should get it, how, and why?
> Assuming things work the way you describe (they don't, but I'll play along)
By all means educate us then.
> There is $.10 of surplus here. Who (if anyone) should get it, how, and why?
That seems like kind of a philosophical question. Who ever should get any surplus? A better question might be, how can non-HFT traders arrange to capture the surplus currently claimed by HFT?
> if there is no HFT involved how would you propose that this situation be resolved?
The situation now is that whoever is fastest gets the surplus, even though being milliseconds faster provides very little utility. If you remove all HFTers somehow by magic but the situation remains that whoever is fastest gets the surplus then whichever of the buyer and seller can adjust their prices faster would get it. But suppose we go a different way and have the exchanges sort it out: Automatically send all offers to buy or sell to every exchange where that security is traded and allow the other exchanges several seconds to match bids with asks. The highest bid is always matched with the lowest ask on any exchange and the price paid is the midpoint between them. That seems inherently more efficient than creating a huge financial incentive for private actors to shave invisibly small slices from the amount of time it takes to trade between exchanges.
In your example both NY and Chi would be "crossing" the market (bid above offer) which is not generally allowed. The displayed quote on both exchanges is "protected" and another exchange can't lock or cross the market without first dealing with the protected quotes (usually by routing orders to fill against it, see #2 below).
What would have really happened in your scenario would have been on of the following:
1. The orders would have been partially filled and the balance would be cancelled (order were Immediate Or Cancel)
2. The orders would be partially filled and the balance routed to other exchanges which are displaying the same price (Orders were routable)
3. The orders would be partially filled and remain active (but undisplayed) at the exchanges (this is dependent on what order type is used and at what exchange).
> how can non-HFT traders arrange to capture the surplus currently claimed by HFT?
By posting their order and waiting to be filled. In a two sided market your options are to pay up and be filled immediately or to get in line with everyone else that wants to keep that extra $.01 and wait for someone more impatient (or informed) to come along and sell to you. By providing liquidity you take time and price risk (you don't know when you will get filled, if ever, and the market may move away from you requiring you to have to pay more later) and by taking it you don't (but you pay the liquidity provider for the privilege).
"Someone will always be faster." That will always be true no matter what new trading format is being considered. There will always be a way for someone to get relevant information more efficiently and act on it. Always. Slowing down markets or obscuring/delaying quotation hurts price discovery and increases uncertainty. This increases volatility, widens spreads, and in all likelyhood actually tilts the playing field in the favor of high-speed computerized trading rather than away from it.
Yes, one of the things people do is arbitrage price differences between exchanges. That's great though! The fact that people are constantly doing this means that I can trade on any given exchange and be really confident that I'm getting the best price.
Except that the continued profitability of HFT is proof that you aren't getting the best price. The HFTer is getting the best price and profiting by buying from or selling to you at something other than the best price.
You misunderstand what HFTs are doing. They are in the business of selling liquidity. You have to pay them for that. Luckily the cost of liquidity (due to automation & competition) has gone down by a factor of 10 which is great for you (and everyone else)!
Brad Katsuyama (weirdly the hero of the Michael Lewis book) is in the business of making sure you DON'T get the best price. The HFTs are working against him to make sure you do.
So suppose the bid for some particular stock is $100.00 and the ask is $100.10 in both Chicago and New York. They could be different between the two exchanges, but the prices between exchanges will generally be the same or very close to each other at any given time because any significant divergence is an arbitrage opportunity.
Now somebody wants to buy some shares of that stock in Chicago, so they cross the spread and put in a bid for $100.10. They immediately buy all the shares in Chicago that are available at $100.10. Now the ask in Chicago will go up because all the shares available for $100.10 in Chicago have been purchased, so now the bid in Chicago is $100.10 and the ask is, say, $100.20. At the same time, in New York, somebody wants to sell some shares of the same stock. So they cross the spread and make shares available for the bid price in New York, which is $100.00. That seller sells to everyone in New York who is willing to pay $100.00, so now the ask in New York is $100.00 and the bid is, say, $99.90. Both the buyer in Chicago and the seller in New York are still willing to buy and sell more shares at $100.10 and $100.00 respectively, i.e. the new bid in Chicago is higher than the new ask in New York.
The HFTer sees the new prices before most other traders because their computers are faster and closer to the exchanges. As soon as the buyer at $100.10 learns there is a seller at $100.00 or vice versa, they would get together and trade all the shares they want to trade at some price in that range. But the HFTer learns the pricing information first and, before the buyer and seller find out about each other, the HFTer buys the seller's shares in New York at $100.00 and immediately resells them to the buyer in Chicago at $100.10.