HFT Isn’t The Elephant In the Room

It seems all the attorney generals of the country read Michael Lewis book and subpoenaed high frequency traders.  Populism is not a way to regulate a market.  Nobel prize winning economist Joe Stiglitz put out a hasty paper encouraging a transaction tax as a solution to the problem.

What I find when I look at the analytical differences between fresh and salt water economists is salt water economists (Stiglitz, Kruger, Schiller, Tobin, DeLong) think they can control things with regulation.   They view the world as a puppet and they are the puppet masters.  Pull this string, this happens.

When I read fresh water economists (Fama, Cochrane, Becker, Murphy, Rajan, Hansen, Lucas, Coase, Friedman), they layout the economic incentives and then the market decides the outcome.  Whatever the market says is the correct solution-even if we don’t like it.

Everyone analyzing HFT is chasing shiny objects, and no one is confronting the real problem, except startup exchange IEX.  I really like what they are doing.  It is too bad that US regulation is so archaic, expensive and intrusive that it’s simply too expensive and difficult to set up competing exchanges.

Here are things in the debate over high frequency trading that are NOT problems:

  1. Speed.  It doesn’t matter how fast the market is as long as everyone goes at the same speed.  There is an argument to be made for speed creating more efficiency if administered properly, not less.
  2. If an agent is a liquidity provider or taker.   This is very difficult to prove and every single person in the market thinks they provide liquidity.
  3. How long someone holds a trade-who cares? As long as they are assuming real risk when they trade and the market is competitive.
  4. Speculation-it doesn’t matter why people trade in a marketplace.  All that matters is everyone is treated the same.  There is a very good argument to be made that speculation improves transparency and price discovery.
  5. Price discovery.  The only thing that matters is everyone finding out information at the same time.  HFT doesn’t hurt or help price discovery.  If markets over react one way on information, efficient market theory would tell you that there is an opportunity to use that to make risk free arbitrage profit.

Stiglitz correctly points out markets are more volatile today than they used to be.  But it’s not total volatility but marginal volatility.  The reason isn’t HFT, but the way the market incentives and structure are formed.  There is simply less on the bid/ask than there used to be and more slippage.

Everyone’s solution to the problems on the salt water side ends up as a tax.  That is the wrong solution.  It is also vitally important to know what marketplace is being analyzed. Futures are not at all like equities.  They have different reasons for existence, and different regulatory structures.   For example, there is only one data feed in futures.

The problem we have is the market structure and regulatory framework.  Let us fix that first.  Create a system where the end user is closer to the market, eliminating middlemen.  Make the market more competitive, without ways to circumvent it or seek rents through dark pools, pay for order flow, maker/taker, price rebates etc.  Exchanges have created a tiered system within their own ecosystems to create new streams of profit.

Once we fix regulation, we can see if HFT has the same effect.  Let the market decide.  My bet is HFT won’t matter at all then.


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