High-frequency trading

A few MR readers ask about high-frequency trading.  Senators are calling it unfair because some traders have access to more powerful computers,and better quants, than do others.  The traders with the most powerful aids get there first and make more money.  Here is a typical critique.  Felix Salmon is also skeptical.

I do not worry about high-frequency trading.  Telegraphs and telephones also brought their own, earlier versions of high-frequency trading.  As did stock index futures.  There are second-best arguments relating to hockey helmets and the like but that is the case with most forms of progress and greater economic speed.  You don't have to think that the current profits measure the current social value of high-frequency trading to argue that the overall trend should be allowed.  The correct judgment of efficiency occurs at the system-wide level, not at the level of the individual trading strategy.  The short-run story is that private profits exceed social returns but in the longer run the trading activity and liquidity brings increasing social returns and better communication of information.

I'm not a believer in the strong versions of efficient markets hypotheses, so I do admit that high-frequency trading, like just about every other trading strategy, can bring short-run "whiplash" effects on market prices.  But if you don't like it, you can trade yourself at much lower frequencies, which is probably what you should be doing anyway.  At the same time high-frequency trading smooths out or shortens many other cases of price whiplash.  High-frequency trading brings more liquidity into the market.  Call it "low quality liquidity" if you wish, but it still looks like net liquidity to me. 

The complaint is that this liquidity sometimes vanishes.  Maybe high-frequency trading can scare other traders out of the market;
that charge has been leveled against every method of informed
trading.  In the short run it is sometimes true but markets respond by
upping the general requirements for quality trading and many market
participants rise to meet the new standard or else switch to longer
time horizons.

On the critical side there is lots of talk of "unfairness" and "manipulation," combined with snide references to the financial crisis.  I'd like to see a serious efficiency argument against high-frequency outlined and defended, without the polemics.  That would include a case that regulation will prove workable and catch only the "bad liquidity," while at the same time avoiding capture by envious and inferior competitors. 

If high-frequency trading is used to trick other traders into revealing their demand schedules, and then canceling orders, I can see a case for regulating that particular practice.  On that issue, here is background, from a critic, but note that these charges seem to be unverified.

The philosophical question is why it might possibly be beneficial to have market prices adjust within five seconds rather than within fifteen.  One second rather than five?  0.25 rather than one?  If you had been writing in the year 1800, what comparisons would you have chosen? 

Remember that old comic book where they had Superman race against The Flash?  The Flash won.  Someone had to, just keep that in mind.


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