ELI5: Why is high frequency trading allowed?

If you strip things back, the most fundamental point of a market is to bring buyers and sellers together and to enable price discovery.

The price of a financial instrument you see on a stock exchange or similar is simply the last traded price between a buyer and a seller. If you want to buy or sell something, then the price you get depends on who wants to sell/buy on the other side and what price they have put an order in for.

The more trades going on in the market, the more likely it is that you will be able to buy at a price close to what you see as the last price in the market.

If you only allow trading every hour, then you lose some of that price discovery.

Additionally, as already mentioned, trades would likely still happen, but away from the designated marketplace. If I want to sell something, then I may just ask who else has the thing I want to sell and try to negotiate a price directly with them.

That way, fewer trades happen in the marketplace and more trades happen in private away from there.

That sort of limited trading does happen for some very niche products that don’t have a lot of potential buyers and sellers. For common financial instruments, have a lot of participants wanting to trade, having a centralised marketplace helps avoid the issues that would come otherwise.

Now, you can argue that in practice it doesn’t work as well as the theory, and I would agree there. If you are a HFT, then you can make money by getting in milli or microseconds ahead of others.

For a lot of market participants, that doesn’t really matter though. The big banks typically don’t do that sort of trading. They are buying and selling on behalf of their clients, both individuals and companies that want access to the market. The bank makes their money by charging a margin to their client (similar to how it works for pretty much any retailer), and the fact that the HFTs are making all these trades helps them with price discovery and liquidity (ensuring there is someone to buy what they want to sell, or sell what they want to buy)

It's a benefit to trading companies by allowing them to make marginal monetary gains off the minor stock price fluctations as they occur. Once you pay for the setup it's largely automatic passive income, at least until something happens and you have to mess with the algorithm.

"Free" money, no matter how relatively small, will always be attractive to a certain segment.

There's also the "power"/elitism aspect as this revenue stream isn't accessible to the average joe.

Edit: I'm not saying these are particularly good reasons, but the people with the money make the rules. It benefits them in the form of more money, so there you go.

Maybe we could charge a minor fee per transaction, too small to matter for most stock traders. High frequency traders though would have to pay quite a lot simply by making lots of transactions.

Usually everything is allowed until there's a reason to think it's bad. This is no exception. I'd be surprised if the resources wasted are that massive, even - speed is the name of the game, not FLOPs.

I was going to ask how your batch system would work, but I'm realising I don't know how the servers at the NYSE or whatever work either. It takes two parties to trade, so there must be some kind of back-and-forth protocol.

Edit:

Ah, here we go! So as you can see, it works pretty much because orders are filled as soon as possible. If you did the same thing in hourly batches, people would try to get a better deal by snooping on other orders during the hour, and you could get stupid Mexican standoffs happening where nobody wants to name a price.

You could probably still figure out some kind of system to make it blind, but allowing a number of servers that trade "between the trades" is a solution that works too, and like other markets has the ability to do very complex things without you, the policymaker, having to design it.

It’s not disallowed and it makes money

No one cares about anything else

I know people who do HFT cards, it's FPGA decoding ethernet packet when they enter, and send the answer at the same time, when the bytes for price enter, FPGA algorithm takes decision in a few nanoseconds to output the byte for buy or sell. It does this millions times per second

day trading has more tax

Because that's how owners of the country fleece retail investors.

I think one reason is that the stockbrokers make profit off of every trade through commission. The more trades, the more money they make. Thus, they would lobby to make it legal. Furthermore, limiting number of trades would upset traders by restraining their ability to trade, which would upset a voter base. There's really no one that would care enough to provide the political capital necessary to implement the limitation.

HFT is not what you think it is.

High frequency traders are like a grocery store.

Without a grocery store, you would have to drive around to multiple farms to source all the food you want to buy, burning gas all the way and when you get there theres 5 other people fighting over the last egg and bidding it up to silly prices.

HFT matches up buy and sell orders efficiently, and the people who run these operations take a cut. If they take too much, someone else will undercut them in a race to the bottom (which is good for regular customers)

Trades once per hour? But that would be fair for everyone, can't have that. People pay thousands or millions to get stock prices 30 seconds faster, because there are fortunes to be made with 30 seconds of advantage.

It adds liquidity and that does more good than bad for everyone, whether you're a retail investor looking to enter or exit a position without facing a hefty 'tax' from a wide bid-ask spread, or you're managing an ETF and need to dump 300k shares of something while rebalancing.

Without HFT a lot of tickers would look like options and futures contracts - no volume, wide spreads, and rife with abuse from people walking orders up and down

it's not guaranteed they make profits. HFT is a huge gamble, like all stock trading, but the stakes are even higher, because they can spend more with that higher frequency.

You're probably right. Our system was not designed from the ground up to make sense though, instead its a pile of rules and customs that accumulated one by one over the past few centuries.

Our default position is always to allow something. We have to take action to make something illegal if we want to change from this default setting of "allow all" on everything. So, essentially, nobody has changed it yet.

Now, with people making money from it, there's also going to be lobbyist money resisting any sort of change, combined with general political inertia where most people just don't really think about it very much. Ultimately any politician that could change it is going to consider how it would impact their election chances, including things like public popularity and how it would impact doner money. Someone like AOC could take action if she felt it was important, she doesn't need investor donations, since she funds mainly through crowd funding. A republican from middle America does need big doner money though, and would be reluctant to piss off investors and risk them supporting someone else.

So, basically we haven't bothered to change it, and not many politicians have strong reasons to do so.

Pretty hard to boil legal, political and economic realities to a 5 year old level, but this is more an eli14 I suppose.

It's more like it has to exist as a logical consequence of the technologies used, particularly the way that stock exchanges are implemented. Exchanges are built on the premise of fast and scalable technology, just like most other kinds of network service. There have been some attempts to build a new kind of exchange that does not have the inherent problems that allow for the possibility of HFT.

I highly recommend the book Flash Boys by Michael Lewis (author of The Big Short and Moneyball) if you want to learn more about this subject. It tells the story of the creation of Trader's Exchange, which is an exchange that tries to defeat HFT by introducing delays. It's a surprisingly fun read for a story about financial markets (I feel like that sentence could be used to describe all of Lewis's work)

People would trade stocks with each other in between those hour intervals. It'd become another after hours trading. It might cut down on the change rate though since it'd make high frequency trading more annoying and cumbersome.

But slowing the refresh rate of trading I think would also make it take longer for stocks to settle after a shock. I think the limited trading windows is one of the things driving Bitcoins volatility? Increasing the time between when something happens and when the effect is felt would decrease the damping on the system.

Edit: sorry I missed the eli5, this is not a super simple answer