In Modern Principles Tyler and I explain that price floors create wasteful increases in quality. The classic story is the Civil Aeronautics Board’s regulation of airline prices between 1938 and 1978. Through entry, exit and price regulation, the CAB kept prices above market levels and airlines earned excess profits with every customer. Although the airlines were not allowed to compete on price they could compete to attract customers by offering better meals, wider seats and more frequent flights. Airline quality, as a result, was high but it was inefficiently high; for example, too many flights flew half empty. More fundamentally, if airlines compete by lowering prices by $100, customers are automatically better off by $100. But when airlines have no choice but to compete by spending $100 on “quality” customers are not necessarily better off by $100. Indeed, enforced non-price competition will always result in more spending than value creation on the margin. If given the choice, customers would have preferred lower prices to higher quality but until deregulation in 1978 they were not given the choice. Thus, price floors create wasteful increases in quality.
Ok, so where does stock pricing come into play? Chris Stucchio, a high-frequency trader, argues that the sub-penny rule, SEC Rule 612, “essentially acts as a price floor on liquidity – it is illegal to sell liquidity at a price lower than $0.01.” As a result, traders compete on speed (latency) rather than on price.
As with a classical minimum wage, two parties are harmed – the purchaser (who must pay extra) and the lower priced seller (who is pushed out of the market).
Similarly, at prices higher than $0.01, it makes price movements lumpy – on a bid ask spread of $0.05, it is illegal for someone to enter the market at price $0.049 or $0.045. Thus, at any price point, speculators are forced to compete on latency rather than on price. Price competition is only possible if one market maker is willing to offer a price at least $0.01 better than another, which is often not the case.
When price competition is impossible, market makers must compete for business via other methods – in this case latency.
As with the airlines, the increase in speed–now such that 40,000 trades can be executed in the literal blink of an eye and relativity matters–is profitable for the traders even though it doesn’t add nearly as much to customer or social welfare. As I wrote earlier:
A small increase in speed over one’s rivals has a large effect on who wins the race but no effect on whether the race is won and only a small effect on how quickly the race is won. We get too much investment in innovations with big influences on distribution and small (or even negative) improvements in efficiency and not enough investment in innovations that improve efficiency without much influencing distribution (i.e. innovations in goods with big positive externalities).
Penny pricing (and before that 1/16th pricing) made sense when stocks were mostly traded by humans and we needed to conserve cognition but, as Stucchio points out, most trading today is done by computers and pricing in hundredths of a penny (or less) would not impose any extra effort on the computers. Pricing in 1/100ths of a penny, however, would dramatically increase price competition and reduce wasteful quality competition.
Here are previous MR posts on HFT about which Tyler and I have debated.
