The cash comes from traders/investors who are impatient. If you want to trade immediately instead of waiting and hoping for someone else to hit your order, you have to pay the spread. Market-makers make money by allowing impatient traders to transact with them, and then holding the inventory until other impatient traders want to buy/sell it.
This requires the market-maker to take a risk. The spread compensates them for the risk. The size of the spread is (currently, with HFT) set by competition between market-makers. Before HFT, there was much less competition between market-makers, and spreads were hence much wider. Back then, this resulted in the transfer of significant wealth from investors to exchange specialists. In modern markets with HFT market-makers instead of specialists, these transaction costs are much lower, which saves you and your pension fund money.
Example:
Suppose the national best bid on stock ABCDE is $15.17 and the best offer is $15.18. The "spread" is $0.01. (These limit orders were almost certainly placed by market-makers using HFT.)
If you want to buy ABCDE, you can do one of two things:
- You can place a limit order to buy at 15.17 and wait and hope that someone sells some to you.
- Alternately, you can place a market order that will cross the spread and buy at 15.18 instantly.
The market order protects you from the roughly 50-50 chance that ABCDE prices start increasing and your order never gets filled. It costs $0.01 per share, which is basically paying the HFT market-maker for liquidity (the ability to trade immediately).
Before HFT, the spread might have been $0.05 or even $0.10. You would still have the same two choices, but instead of $0.01, you would have to pay some human specialist $0.05-0.10+ if you wanted immediacy. His father and grandfather would have also been specialists, and his bonus would have been several million dollars that year. HFT market-makers simply out-competed these parasites. There is no longer a monopoly on market-making, so liquidity has gotten cheaper.
Correspondingly, it is cheaper for you to trade (ditto for mutual funds, pension funds, hedge funds, etc.). This allows you to keep more of your investment profits.
This requires the market-maker to take a risk. The spread compensates them for the risk. The size of the spread is (currently, with HFT) set by competition between market-makers. Before HFT, there was much less competition between market-makers, and spreads were hence much wider. Back then, this resulted in the transfer of significant wealth from investors to exchange specialists. In modern markets with HFT market-makers instead of specialists, these transaction costs are much lower, which saves you and your pension fund money.
Example:
Suppose the national best bid on stock ABCDE is $15.17 and the best offer is $15.18. The "spread" is $0.01. (These limit orders were almost certainly placed by market-makers using HFT.)
If you want to buy ABCDE, you can do one of two things: - You can place a limit order to buy at 15.17 and wait and hope that someone sells some to you. - Alternately, you can place a market order that will cross the spread and buy at 15.18 instantly.
The market order protects you from the roughly 50-50 chance that ABCDE prices start increasing and your order never gets filled. It costs $0.01 per share, which is basically paying the HFT market-maker for liquidity (the ability to trade immediately).
Before HFT, the spread might have been $0.05 or even $0.10. You would still have the same two choices, but instead of $0.01, you would have to pay some human specialist $0.05-0.10+ if you wanted immediacy. His father and grandfather would have also been specialists, and his bonus would have been several million dollars that year. HFT market-makers simply out-competed these parasites. There is no longer a monopoly on market-making, so liquidity has gotten cheaper.
Correspondingly, it is cheaper for you to trade (ditto for mutual funds, pension funds, hedge funds, etc.). This allows you to keep more of your investment profits.