Next year the innovative swimming suits that are causing world records to fall at rapid pace will be banned. Michael Mandel wonders if this is the beginning of the counterrevolution against technological progress and Tyler argues “essentially on innovation we’re seeing a flipping of the burden of proof and I don’t think it is possible to easily fine-tune that flipping in a way to capture good innovations and rule out bad ones.” Believe it or not, Mandel really was talking about swimsuits. Tyler, however, was talking about high speed trading but is there much difference between the two? I don’t think so.
High-tech swimming suits and trading systems are primarily about distribution not efficiency. 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).
One difference between swimsuits and trading systems is that the former are regulated by FINA, the federation that administers international competition in aquatic sports. We have some hope that a group like FINA can internalize the major externalities both because it encompasses the primary players in the market and because externalities outside of the market are likely to be small (swimming rules are unlikely to cause non-swimmers many problems.) Thus, FINAs rules on swimsuits have some claim to efficiency. Note that we see similar “anti-innovation” rules in many other sports such as car racing. NASCAR, for example, does not allow stock cars to use fuel injectors even though this innovation is now standard on production cars.
NASDAQ (and the other exchanges) are the logical equivalent to NASCAR and FINA in that they can internalize the externalities among the primary players. Thus, if the exchanges were to regulate various high-speed trading strategies I wouldn’t have any problems with that.
But would exchange regulation go far enough? Unfortunately we have learned that the exchanges don’t internalize systemic risk. Trading rules can cause non-traders many problems. As a result, I think there is a case to be made for greater regulation than the exchanges would provide. There is good reason to be skeptical about regulation in general but since this product, “financial innovation,” is primarily about distribution I’m less worried about regulation in finance than in fields where innovation is more closely tied to efficiency.