A detailed data-centric exposé on how the market is rigged (2014)
I think where Eric Hunsader (and Michael Lewis) go wrong is that they have a big flaw in their mental model of the market. They make the assumption that if say 500 shares are offered at exchange A, and 500 shares at exchange B, then they are entitled to sum those two numbers together and assume that there are 1000 shares on offer.  This is wrong.  This is the basic mistake that they just can&#x27;t wrap their heads around.  I will try to explain as simply as I can from the point of view of a market maker.<p>Imagine you are a market maker trying to make the spread and provide liquidity back in the old days. There is only a single stock exchange.  Your firm obviously has a limit on how much risk it can take.  How much capital&#x2F;money it has available.  So let&#x27;s say you are allowed to post 1000 shares on the offer and 1000 shares on the bid.  You are not allowed to hold a position of more than 1000 shares long or short.  Life is simple.<p>Then things get complicated.  A competing exchange is now set up and begins to thrive.  Yay for competition! Yay for the free market! But you still have the same limits on your capital and risk.  What do you do?  Do you now post 500 shares on the first exchange and 500 shares on the second?  You could do that.  Then you are guaranteed that you will never be long or short greater than 1000 shares.  You&#x27;ll never break your limit.  But what happens when there are 10 different stock exchanges? Do you post only 100 shares at each one?  Should the available liquidity in the market be fragmented into 10 pieces?  Of course not.<p>So what you do is post your bids and your offers for your full amount on each exchange. And then if you get filled on one exchange, you cancel your orders on the other ones.  This isn&#x27;t crazy, this isn&#x27;t radical, this isn&#x27;t some nefarious plot.  It happens every day in all sorts of markets.  I might put my house for sale on three different real estate websites.  When it sells on one, I cancel the listing on the other two.  No big deal. Or if I am a fisherman in India, I might send my sons to three different markets to sell my catch.  When one finds a buyer, he phones the other two and tells them. (<a href="http:&#x2F;&#x2F;qje.oxfordjournals.org&#x2F;content&#x2F;122&#x2F;3&#x2F;879.abstract" rel="nofollow">http:&#x2F;&#x2F;qje.oxfordjournals.org&#x2F;content&#x2F;122&#x2F;3&#x2F;879.abstract</a>).  This is simple stuff.<p>In more technical terms, the offers and bids are all <i>bona fide ab initio</i>.  They are all bona fide when initiated. When posted, you do actually want to sell or buy at that price.  When you get filled at one exchange, circumstances (your inventory) have now changed, and you are entitled to cancel.<p>Note in my explanation, the market maker isn&#x27;t front-running, or even back-running, they are just responding to their own personal changes in inventory level (position) that means they can no longer offer those shares at the other exchanges.  Electronic market makers may well have sophisticated models that predicts the short term price move causing them to pull orders at other exchanges, but we need not even consider those models to explain this behaviour.  Changes in inventory is ample explanation.<p>Of course, by posting their full available inventory on each exchange, market makers expose themselves to a new risk.  Someone might come along at the exact same instant and fill them on every exchange!  Then they will be over their limit and massively exposed.  Luckily, they have very fast systems and low latency lines to help protect them from this.  If they didn&#x27;t, they would be forced to offer 1&#x2F;n times their current liquidity, where n is the the number of exchanges.  That would suck for all liquidity consumers.<p>Which brings me to the most amusing part of this whole story, is that when the &#x27;hero&#x27; of Flash Boys Brad Katsuyama figured out he could precisely fire off orders so that they hit all exchanges at the same instant in time with his &#x27;thor&#x27; program, the SEC came knocking. Because behaviour like that, ambushing market makers on multiple exchanges, could in fact force market makers to offer much less liquidity.  I don&#x27;t have a problem with it, but it amuses me that the supposed hero was the one probably endangering market structure.