What is happening here is really quite simple, and doesn't deserve an entire blog post.
There are two exchanges, A and B, and a market maker Jill is quoting (say) 10,000 shares on each of those two exchanges for $17.
Big institutional trader Jack sees the 20,000 shares and decides that he wants to buy 15,000 of them, so he sends two orders for 7,500 shares each to A and B. Because of various effects (network latencies, routing switching delays, whatever) his order arrives at exchange A first, and is immediately filled at $17.
Jill, who has her computer co-located at exchange A, sees that she has sold 7,500 shares for $17, and realizes that there is demand for shares. Because of this demand, she decides to raise her prices. She immediately cancels her remaining 2500 shares on exchange A and replaces them with 10,000 shares at $17.05 and sends an instruction to do the same thing at exchange B.
Because Jill has fast computers and low-latency connections, her cancellation arrives at exchange B before Jack's buy order, so Jack is told that there are no longer shares available on exchange B at $17.
RESULT: Jack is filled for 7500 shares at $17 (half of what he requested) and the new market best offer is $17.05. Jack is welcome to submit another order for $17.05 if he wants to buy at that price. Jill is now short 7500 shares at $17, and will try to buy them back at a lower price (she may or may not succeed - until she does, she is exposed to the risk of further price rises).
Jill was able to use her speed advantage to detect that there was additional demand to buy this stock, and raise the price at which she was willing to sell it before Jack had finished buying all that he wanted to. This is exactly the way that an efficient market is supposed to work - it reacts to fluctuating demand (and other information) to set appropriate prices.
I think there are several things that get glossed over while people are working themselves up about this -
1. Jack is upset because he couldn't buy 15,000 shares at the price he wanted to buy them. But Jack has no god-given right to be able to buy shares at the price he likes best. He is subject to the laws of the market, just like everyone else.
2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?
3. If Jack doesn't like this state of affairs, he has several options. He can invest in high-speed infrastructure as well. He can use smarter order-routing logic (e.g. adding delays to his orders so that they arrive at the exchanges approximately simultaneously, or splitting his large order up into multiple smaller orders). Or he can use a broker who will do these things for him. If Jack doesn't want to pay for any of these things, then he has to put up with lower quality execution. As much as he might wish it, the ability to buy as many shares as he wants at the price he wants them is not a universal human right.
Jack is not upset because he couldn't buy the shares at the price he wanted. He is upset because someone was offering shares at a specific price, and Jack was willing to pay that price, but the order was not executed. The reason the order was not executed is not because someone else accepted the offer before him, or because Jill cancelled before he tried to accept. It was because Jill was able to see his acceptance in transit and cancel part of her offer as a result of this new information. This isn't how markets are supposed to work. If Jill had posted a single offer for half the number of shares that Jack wanted, it would be different.
Someone shouldn't need to use Thor or some other delaying mechanism to accept open offers. The latency between different exchanges (which was exploited in this example) does nothing to increase market efficiency.
You're right that I shouldn't care about this as a practical matter, as the impact on me is very small, but that doesn't mean it's right.
I really appreciate the clarity in your comments on this thread.
Here is our point of disagreement, then - I think that this is exactly how markets are supposed to work (in the presence of multiple exchanges).
The job of a market maker is to supply liquidity at a price/risk tradeoff that is reasonable to them, subject to the information available to them. If there are multiple exchanges, and someone trades with them on one exchange, then the set of information available to them has changed (specifically, their knowledge of the supply/demand balance for a particular stock has changed). It's only natural that they will want to change their prices in response.
Now, we could change legislation to either (a) go back to having a single exchange or (b) restricting the ability of market makers to move their quotes on one exchange if they trade on another. But that won't necessarily result in a better deal for non-market makers, because instead of quoting 20,000 shares split across 4 exchanges, the market maker now quotes 5,000 shares on 1 exchange.
The benefit is that all market participants have a more accurate idea of the true liquidity available in the market. The disadvantage is that you have removed the element of competition between exchanges, so the exchange is no longer incentivized to offer low fees and keep improving its service.
OK. So it's because there are multiple markets. We want multiple markets because competition, but multiple markets mean latency which means HFT using info from one exchange as a signal in another exchange.
If I could wave a magic wand then we would have one exchange which was run as a public service, by some beneficent person with no profit motive. I don't have a magic wand :(
I agree that the current situation is the result of the market structure (multiple competing markets) but I don't agree that this is how markets are supposed to work. The reason I say this is that people with no knowledge of market microstructure (e.g. ordinary people or people with undergraduate degrees in economics) would not expect this kind of 'arbitrage' to be possible. I hesitate to call it front-running because this is a term better reserved for instances where a client relationship and non-public information exists.
I take your point that the situation we have now (multiple exchanges without specialists) may be better than we had before (a single exchange with specialists) but I still don't think it's _fair_.
I wonder what would happen if I could wave my magic wand and have multiple exchanges with no specialists and zero latency...
If you could wave that magic wand big players with proprietary information (like hedge funds) would win a bit and everyone else (which includes you by the way) would lose because of slower price discovery.
Do you have opinions about a third proposal that's occasionally floated, (c) discretize the market's timeline to something smallish but not miniscule? For example, the market maker can move their quotes however often they want, but changes take effect on the next tick, which happens every (say) 1 second. So therefore you can't trade on advance knowledge in the sub-second range, and market makers can't gain a trading advantage vis-a-vis investors solely by having a slightly lower latency connection to the exchange.
It's possible there's some massive downside to that, but afaict the advantages of liquidity that market-makers provide mostly accrue at larger timescales. So it's not clear the millisecond-shaving game is really improving markets (though it provides interesting challenges for technologists).
How do you pick the timeframe? Seconds are still too fast for humans. Minutes would be too fast for people who are not professional traders, hours would be too fast for people who can't be near a computer all day.
There is always a locality advantage in the market, this has been true as long as there have been markets, and it will be true forever. Why do we as market participants care?
The other problem with your scenario is that you make market making more risky. The riskier it is, the higher the profits must be. This means that the market makers must keep the bid/ask spread higher (their means of making a profit). This cascades to all of us in the form of higher execution costs.
> The other problem with your scenario is that you make market making more risky.
The problem with the current scenario is that it makes market making more expensive, as it requires a lot of technological investment into the microsecond arms race. This means the market makers must pull in more revenue from their trading to cover these expenses, before they even get to thinking about making a profit. This cascades to all of us in the form of higher execution costs. The huge amount of money being spent on HFT infrastructure, software development, etc. is ultimately being paid by market participants. It's worth considering if this is an arms race worth funding to the max, or if 99% of the benefits could be had much more cheaply just by putting a floor on execution latency, thereby rendering this whole millisecond-shaving industry unnecessary.
At the very least, I'd be interested in seeing rigorous models that show a benefit to, say, markets that can trade at 1-microsecond granularity vs. 1-millisecond vs. 1-second.
The claim that market makers pass costs on to end users is only true if they have pricing power. In reality, on-exchange liquidity provision is basically the kind of perfect competition that only exists in economics textbooks. Market makers are selling a commodity product (you don't care or control who you trade stocks with) in a market where buyers are purely sensitive to price (tightest market always wins and is enforced by exchange matching rules).
So what actually ends up happening in a market with multiple competitive market makers? To make money, a market maker needs to trade a lot of volume. The only way to trade a lot of volume is to put up the most aggressive (worse for the market maker, better for end users) prices at any time. Market makers can only do this by charging a smaller spread than their competitors. They can only charge a smaller spread by either reducing their margins or getting smarter at deciding when to be in or out of the market, usually a combination of both. The end result is extremely tight markets that react to information very quickly (i.e. cheap to trade and very efficient).
Competition keeps markets honest. If you had one very fast guy, he would clean up, but when you have a dozen guys who are roughly equally fast, they all compete one another down to barely making profit above their cost of doing business. Only the most efficient can survive. If anything, we want more HFT by removing barriers to entry rather than creating a lot of regulations that would ironically help incumbents by killing off weaker competitors.
Except thats demonstrably not what has happened. Market making has gotten cheaper, not more expensive. Spreads have tightened, not gotten wider. Fees have gone down not up. Literally every cost to trading has been reduced.
The single biggest cost to any market maker is their market risk. Latency is exceedingly cheap in comparison. Any increase in latency raises market risk thereby raising their biggest cost.
Moving to a 1 second tic wouldn't save money on infrastructure because HFTers would still have an incentive to wait for the last possible moment before the tic to update their orders to make sure that they had access to all possible information when making their decisions.
I've heard a bunch of explanation about liquidity and how HFT allows for large orders to be fulfilled, but it seems like this is quite the opposite.
What purpose does this serve? Is society as a whole better off when Jill is able to make this .05 per share more? I wouldn't frame the debate as 'god given rights' and 'competitive advantage'. What I really want to know is why a society where trades and quotes happen on a millisecond scale is better off than one where they happen on a second scale.
It's an honest question. Someone please convince me.
What's great is that we don't have to engage in thought experiments about what would happen if we didn't have trading activity with fast computers on a millisecond scale - we can just look back to any time before the 1990s, when most market making was done by humans, on human time scales.
Before 2001 the minimum tick size on any exchange was 1/16th of a dollar ($0.0625) and before 1997 it was 1/8th ($0.125), so the absolute minimum you would pay for a round trip (buying a stock and later selling it) was that much. Frequently, the bid-offer spread would be many ticks wide, so you could easily be paying $0.25 or $0.50 for each round trip.
The current minimum tick size is $0.01, and there are many stocks which trade at that level. Even if you suffer $0.05 of slippage on a round trip, you're still better off than you would have been under the old regime.
In the old regime, instead of high frequency traders, you had floor brokers who would work orders. Fortunately, floor brokers were paragons of virtue and morality, who would certainly never front run their clients orders, and would take any trade even if it worked to their disadvantage (NB in case you don't get it - this is sarcasm. In the 1987 crash, most brokers wouldn't even pick up their fucking phone because too many people were trying to sell stock, and the brokers didn't want to buy).
I honestly find it hard to believe that some people think that was better than what we have today.
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Edit: The other thing I don't get is why ordinary investors (by which I mean anyone with less than $100m to invest) care about this. For a small investor, you are actually getting an even better deal because your order for 1000 shares or whatever can get filled instantaneously, in one chunk, for a great price! It's only when you're trying to buy hundreds of thousands of shares in a few minutes that you end up suffering price slippage.
The standard response is that ordinary investors have their money invested in mutual funds and pensions, who are large investors. But in that case you are already paying 0.5-2% per year to your fund manager, and why do you give a shit if they lose 10 basis points (0.1%) in price slippage because the market is more efficient than it used to be?
In fact, why is my pension fund manager trading so fucking much anyway? I don't have a pension because I think the fund manager is some genius stock picker, I have it because it's tax efficient and my employer contributes to it. Just buy the S&P500 and sit on it.
I see a false dichotomy here. The fact that floor brokers were dishonest doesn't imply we need to have continuous computerized trades. We could still have discrete steps and computers filling orders, right?
Right, and maybe one day the market will work that way. But
(a) what we have at the moment is still a lot better than what we had before - incremental progress!
(b) it's not at all obvious (to me) that discrete time steps would be better than what we have now. Market makers would be taking more risk, so that would quote in smaller size and at wider spreads, which could make trading more expensive for everybody.
2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?
Here's the problem with that: the number of available ultra-close connections to the market is finite. If you carry this out to its only possible conclusion, whomever has the closest connection always wins, and everyone else always loses. The other market participants eventually realize that it is simply not possible for them to win, and that a closer connection is not for sale at any price, so they simply stop participating. This solves one problem - people stop losing money - but also destroys the market.
It's empirically not true that "whomever has the closest connection always wins and everyone else always loses" as is evidenced by the fact that there are multiple competing market makers who are all profitable.
Arguments of the kind "let's carry this to its logical conclusion" are almost always fallacious, because they ignore limiting factors, or alternative explanations.
If your only advantage is speed then you need to have the fastest connection to the exchange, else your business model doesn't exist. If you have other advantages, then speed is less important. Nowadays there are very few market makers whose only advantage is speed, because most of them realized that continually paying through the nose to compete on speed is a mug's game.
>there are multiple competing market makers who are all profitable.
That doesn't disprove my statement. The "multiple competing market makers who are all profitable" all have extremely fast connections to the market. They compete on relatively equal footing speed-wise, and so other factors come into play. But everyone outside of the small group of players with that speed advantage will always be paying a tax to those who do. And good luck compensating for your lack of speed by out-predicting large teams of MIT-educated quants with unlimited technology budgets. As an individual investor, your only hope for profit is that market values of the stocks you invest in rise by more than the tax you have to pay to HFT's. You better buy and hold, because with every transaction, you're paying them an additional tax.
When market values are rising, these effects go unnoticed because everyone is generally making money. That doesn't make the tax we are paying to these HFT's any more fair or less damaging to the market.
You aren't paying a tax to HFTs. You are receiving a substantial discount to trade due to them being there. Fees are lower than they've ever been, spreads are tighter and technology is cheaper. You are in fact reaping the "peace" dividend of the HFT wars.
This is obvious for any market that has a single physical location. People who stand next to the apple seller get local apple price information faster than those standing in the next town.
You've also got a very peculiar definition of winning. A person who wishes to buy 10,000 Ford shares who places an order at $17 only to find that in the meantime the market has shifted to $17.01 and therefore purchases at that price hasn't "lost". They set out to buy Ford stock at market rate, and that's what they ended up doing.
>You've also got a very peculiar definition of winning
Not really. The stock market is a giant pool of money. These parasite traders are nothing more than leaks in that pool. With enough of these leaks, the pool runs out of water. Additions of water to the pool (through a combination of rising market values and more investment) at various times will overshadow the effect of the leaks, but they are there nonetheless.
A person who wishes to buy 10,000 Ford shares who places an order at $17 only to find that in the meantime the market has shifted to $17.01 and therefore purchases at that price hasn't "lost"
Actually, they have lost. They lost 10,000 pennies, or $100, and received absolutely no value in return. That money is gone, never to return, into the pocket of an HFT. It has simply evaporated from the market.
What does this even mean? "Eventually the pool runs out of water". What?
Last I checked, the stock market was a market. Anyone is allowed to play, and like most things in life, you can pay to upgrade (either your connection, your analyst talent, etc. etc.). Look at the recent Barclays dark pool fiasco to find out what the liquidity in a market without HFT and transparent books looks like.
>What does this even mean? "Eventually the pool runs out of water". What?
Well, when you have a pool, and water is constantly being sucked out of it, even a tiny bit at a time, eventually you will have no water left in the pool. Not a hard concept.
Well, let me say it's not backwards, it is just nonsensical. Market making HFTs don't have any built in mathematical edge like a roulette wheel. Further, they lower the cost of trading, they add money into the pool in the form of the risks they take and the infrastructure they create.
As I look around the markets, I don't see a lot of participants that are there to lose money. The ability to make a profit from market activities is central to a correctly working market.
>2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?
If we want an efficient market,we need perfect information. Information asymmetry creates inefficient markets.
The moral argument behind free markets is that it leads to "efficient" outcomes. If people are going to do bullshit like this, there's no reason _not_ to set regulations to stop this.
If you want a reasonably efficient market, you need some participants to have close to perfect information.
There is no market anywhere in the world that is 100% efficient, because the costs of getting to efficiency are prohibitively high. It's like trying to reach the speed of light - you can expend more and more effort getting closer and closer, but you can never actually reach it.
I'm not saying that what we have now is perfect, but it's a damn sight better than what we used to have.
> If you want a reasonably efficient market, you need some participants to have close to perfect information.
Is this proven somewhere or you just assume the optimal strategy for markets is continuous?
I mean, it's not clear that the optimal strategy for "slightly imperfect markets" is at all close to the optimal strategy for markets with perfect information. And I actually doubt it can be proven, in the general case.
Not only is it not clear, intuition from other areas of optimization would suggest it's unlikely to be true.
I've asked a couple of economists about this, but didn't get a satisfying answer. To be fair, it wasn't their area at all - and I may just have misunderstood what they were saying.
I am not a game theorist, but take Centipede game for instance. If you know the exact number of rounds in advance, the optimal strategy is markedly different than if you don't know it. And I think there are many weird behaviors like that in iterated games, where optimal solution for infinite time horizon is not the same (or doesn't even exist) as the limit of optimal solutions for finite horizons approaching infinity.
> If you want a reasonably efficient market, you need some participants to have close to perfect information.
I don't think this follows at all. It isn't clear that if the assumptions are almost true the outcome reasonably close to that if the assumptions were true.
Even if it does hold true remember that economists view monopolies as perfectly efficient solutions but that in that scenario it is efficient because the monopoly captures all the available value not the consumers. I also believe that the maths behind the efficient market hypothesis break down if its assumptions don't hold.
> But Jack has no god-given right to be able to buy shares at the price he likes best
It seems like the disagreement really lies here. I'm not a finance expert so I'll probably get a few things wrong but is it fair to summarize the two perspectives as follows?
1. Jill is merely quoting a price for independent blocks of shares on independent exchanges. If a buy order is placed against that quoted price, she has the right to reissue quotes elsewhere. This is no different from Jill selling apples at the market on 1st street, as well as at the market on 2nd street, then receiving a large order on 1st street that prompts her to call her sales manager on 2nd street and have him increase the price of apples there. Or for Janice, sitting next to Jill's stall on 1st street, overhearing the sale at $17 and repricing her apples upwards for when the demand inevitably spills over to her stall.
2. Jill is making an offer to sell a combined block of shares at a particular price. Even though her offer is broken up over multiple exchanges, since a single buy order can execute on multiple exchanges her offer should hold across all of these exchanges. Yet she is taking advantage of the physical makeup of the market to bait large orders (thereby revealing market demand) and then switch to higher prices (thereby capturing a larger profit).
I emphasized "quote" and "offer" above because they capture two different concepts in contract law. I'm not sure if the concepts are the same in financial markets but the principle seems to be at the root of the disagreement. If Jill was merely "quoting", unless the rules of the exchange specify otherwise, she is free to reissue her quote and therefore perspective #1 makes sense. If Jill was making an "offer" however, presumably she should be bound to the terms of her offer regardless of the physical details around how she publishes that offer, reinforcing perspective #2.
So: do the market rules have such a distinction? I found the link [1] below which suggests both perspectives are valid - depending on the type of market one is participating in, if I understand it correctly. Is this a matter of people confusing the two types of markets? (I have to say that perspective #2 seems pretty impractical to me in markets with multiple exchanges participating, and #1 doesn't negatively impact the market -- either it makes economic sense for Jack to pay the new price or not, why do we care if he saves a few bucks if we fiddle with the rules?)
I don't know much about contract law, but it may be interesting to know that a resting order on exchange, with a set price and size, is called a quote.
The terminology offer is used in financial markets for a resting order to sell, distinguishing it from a bid which is a resting order to buy, although many market participants will actually use the terms bid and ask rather than bid and offer. Whether this is to avoid confusion with the contract law term, I have no idea.
It won't surprise you to learn that I also think that your perspective #2 is unworkable in a situation where you have multiple exchanges (how would it work - would you require that quotes on exchange B must remain for a specified period after a quote on exchange A is hit? That doesn't seem sensible).
It is supposed to be the case that you do not place orders on an exchange that you have no intention of executing. i.e. if you place an offer which you intend to withdraw then replace with a higher one the moment you detect interest in the offer then you are breaking the rules.
In general it's also pretty scummy to do it. Imagine a shop seeing you taking items from shelves at an advertised price and saying "Well that shows there's demand in these goods so we're raising the prices on everything in the customers basket before they get to the checkout."
That is not at all true. It is perfectly legal and valid to place quotes at a price that you expect is valid and change them once interest is detected. This is a standard market dynamic and one that makes the markets work.
Your analogy is not all how HFT works. A better analogy would be a string of gas stations going down the highway. A tanker truck comes to the first one and buys all it's gas. Then the second one, and then the third. The manager at the third station calls the fourth and tells them to raise their prices. How is it scummy to do that, but not to buy up all the gas at what is clearly a too low price?
Best Buy runs a flier with a price. You walk in, and Best Buy tells you they're not selling that product at that price... but they do have it in inventory at a higher price.
You drive up to a gas station, listing one price on its sign. By the time you pay, they've changed the price.
You see a house for sale. You make an offer, at that exact amount. There are no higher competing offers, but they want to back out.
You have legal recourse in each of those situations.
1) That's not because Best Buy isn't allowed to change prices. There's even fine print on their marketing that says the prices on the flyer are marketing only and may or may not match pricing when you get to the store. They just choose not to most of the time for marketing reasons.
2) Actually, at least in New York there are no regulations that discuss the large roadsign pricing signs at gas stations. The law just says the price on the pump must match what you get charged. If they change the price at the pump but get behind on updating their big sign you are SOL.
3) People back out of selling houses all the time.
And for all of these it's worth pointing out that what we're really arguing about is time scale. No one would argue that the gas station (for example) wasn't allowed to sell gas for a different price today than it charged yesterday right?
Bid and ask prices for securities just change prices faster than what we're used to for retail products.
To really expand the scope of this discussion it's worth noting that time scales for retail product price changes are actually shrinking. Walmart has experimented with electronic labels in stores that allow them to change prices in real time. Uber changes prices in real time based on demand. It's interesting to watch consumer reaction to these new trends.
There's still bait-and-switch lawsuits... so advertising has some legal binding. I guess all advertisers know how to write in enough small print to get around it now, huh?
And I guess securities don't have any "this offer good for [x seconds]" on them. That's totally counter-intuitive to laymen, and speaking as a professional layman, I'm pretty sure I'm getting screwed because of it.
Electronic labels - you should be able to reserve a price for a time. Like, you want that shaving cream for $1.45, then you should be able to scan your Walmart member card at the electronic label to reserve that price. Should be valid for an hour, or a day, for up to X number of them.
...because the nightmare of picking it off the shelf, and the price is different when you check-out is just awful for consumers.
...and just to ramble a bit more... Sometimes it's cheaper for me to DRIVE to City A, fly back to my town, and then fly to my real destination than it is to book a flight from my town to my real destination. That's crazy, and I'm totally getting screwed, and I hope laws are enacted to stop that.
Ya, I get the whole "as a professional layman, I'm pretty sure I'm getting screwed because of it" when it comes to HFTs. But if you look at the actual data it's blindingly obvious that the exact opposite is happening. Trading costs have come down enormously!
Iit would be nice if folks looked at the data instead of falling back on their irrational gut logic.
Huh? The rule is you can't place orders that you have no intention of executing at the time you place them. You're perfectly entitled to change your mind afterwards, or adjust your price as new information becomes available. You just can't place orders when it is your goal to not have them execute, and that was your goal before you even sent them.
What if it is a third party who is the HFT? Mary sees Jacks buy on A and uses the speed advantage to buy Jill's shares on B preventing Jack from finishing the transaction and Jill from reacting to increased demand. What if Mary was created solely for this purpose? When does it turn from arbitrage to rent seeking?
Same thing: now it is Mary who trades her short exposure risk for a bet that Jack's buy offer of $17.00 is not his maximum willingness to pay, while Jill just gets to fill her original sell order instantly (as opposed to "waiting" a few ms for the offer to arrive at her exchange). In both cases, Jack's is being forced to reveal more about his true valuation of the stock by paying up closer to his best possible offer.
Note in a perfect auction it should be Jill who receive the $17.05; but exchanges are more like (millisecond fast) mail-order catalogues, where the prices you quote are fixed the moment you send off your order. It would piss many people off that you only got half the items you wanted every time because the listed prices "went up" in between the time you mailed your order; but it would also make the whole thing closer to an auction.. so that's that.
"Fresh Apples here! Only the best apples for 2 dollars!" -
"I would like one, please." -
"Thatll be 2.50, sir." -
"What? I thought you just said 2?" -
"Demand has just gone up."
I'm glad you brought this up, because this kind of thing happens precisely never on a financial exchange.
If you go to a store, the store owner sees you take your apples up to the counter, and so he can theoretically change his price before you get there (although in practice, if he ever did that he would soon be out of business).
On a financial exchange, the market maker doesn't even find out that you wanted to buy until the trade has already happened. It is literally impossible for the market maker to change his price, because he doesn't find out about your order until it's already occurred.
What is possible is that the market maker is also quoting on another, totally separate exchange, and he decides to change his prices there, in reaction to seeing a big order on the first exchange.
It's like an apple seller who owns two carts in different parts of town. When you come to his first cart and buy all his apples for $2, he guesses that maybe you are going to go over to his second cart and buy all the apples there as well, so he calls his business partner who's running that cart, and tells him to raise his prices to $2.50 - which makes perfect sense as a business strategy, because demand has gone up.
Note that he only raised his prices because you bought all the apples at his first cart. If you just bought one apple out of the hundreds he has (because you're a small investor, not a giant investment bank) then he wouldn't bother to raise his prices.
I accept that your explanation makes sense, but the fact that this can happen automagically in an intransparent way when someone just wants to buy a number of shares at a quoted price just feels wrong. And reading a few other articles on Nanex also give me weird image of what happens in stocks in general.
Then again, I have no idea about these things and should probably shut up.
"someone wants to buy a number of shares at a quoted price"
what you really mean is
"a giant investment bank or hedge fund with some privileged
information about a stock wants to buy so many shares that
they actually need to go to multiple exchanges to satisfy
their demand"
This is the flawed analogy that keeps being propagated that is completely untrue.
A much better one is to think of a string of gas stations running down the highway. They all have an advertised price. A tanker truck arrives at the first gas station and buys all the gas at the advertised price. It then goes down the road and buys all the next stations gas at the same advertised price. Then the manager of the 2nd gas station calls the 3rd and says hey, we've just gotten wiped out of gas there is a lot of demand. The 3rd manager raises his price accordingly. The tanker truck can then decide if it wants to buy more gas at the new price or just take what they currently have.
"Fresh Apples here! Only the best apples for 2 dollars!" - "I would like every single apple you have, please. Also I'm buying all the apples from the guy across the street too." - "Thatll be 2.05 each, sir." - "What? I thought you just said 2?" - "Demand has just gone up."
"Fresh Apples here! Only the best apples for 2 dollars!"
"I would like 1000 apples, please."
"Sir, I only have 600 apples in the shop. I can give you those now, and I'll ask the guy across the street if he has any."
"How much will that cost?"
"I think he's also selling them at 2 dollars each. Let me just look - oh, nope, he's seen us talking and changed his sign. Well. Have these 600 at the quoted price, and if you want more you'll have to pay the new price."
There are two exchanges, A and B, and a market maker Jill is quoting (say) 10,000 shares on each of those two exchanges for $17.
Big institutional trader Jack sees the 20,000 shares and decides that he wants to buy 15,000 of them, so he sends two orders for 7,500 shares each to A and B. Because of various effects (network latencies, routing switching delays, whatever) his order arrives at exchange A first, and is immediately filled at $17.
Jill, who has her computer co-located at exchange A, sees that she has sold 7,500 shares for $17, and realizes that there is demand for shares. Because of this demand, she decides to raise her prices. She immediately cancels her remaining 2500 shares on exchange A and replaces them with 10,000 shares at $17.05 and sends an instruction to do the same thing at exchange B.
Because Jill has fast computers and low-latency connections, her cancellation arrives at exchange B before Jack's buy order, so Jack is told that there are no longer shares available on exchange B at $17.
RESULT: Jack is filled for 7500 shares at $17 (half of what he requested) and the new market best offer is $17.05. Jack is welcome to submit another order for $17.05 if he wants to buy at that price. Jill is now short 7500 shares at $17, and will try to buy them back at a lower price (she may or may not succeed - until she does, she is exposed to the risk of further price rises).
Jill was able to use her speed advantage to detect that there was additional demand to buy this stock, and raise the price at which she was willing to sell it before Jack had finished buying all that he wanted to. This is exactly the way that an efficient market is supposed to work - it reacts to fluctuating demand (and other information) to set appropriate prices.
I think there are several things that get glossed over while people are working themselves up about this -
1. Jack is upset because he couldn't buy 15,000 shares at the price he wanted to buy them. But Jack has no god-given right to be able to buy shares at the price he likes best. He is subject to the laws of the market, just like everyone else.
2. The only reason that Jill has a speed advantage over Jack is because she has paid for it! She has paid to co-locate her server at the exchange, and she has paid to use high-speed connections between exchanges. Are we going to declare that paying for a competitive advantage is suddenly immoral?
3. If Jack doesn't like this state of affairs, he has several options. He can invest in high-speed infrastructure as well. He can use smarter order-routing logic (e.g. adding delays to his orders so that they arrive at the exchanges approximately simultaneously, or splitting his large order up into multiple smaller orders). Or he can use a broker who will do these things for him. If Jack doesn't want to pay for any of these things, then he has to put up with lower quality execution. As much as he might wish it, the ability to buy as many shares as he wants at the price he wants them is not a universal human right.