High speed trading swimming

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.

Comments

It would help if you spelled out the systemic risk you are worried about. The main critique of HFT is that it lowers market liquidity but that would seem to be internalized fairly well by the regulating exchange. More generally, the exchanges performed very well during the financial crisis and the one area that exploded -- CDS -- were notable precisely for not being traded on an exchange (which is being remedied to some extent and properly so).

The main critique of HFT is that it lowers market liquidity but that would seem to be internalized fairly well by the regulating exchange.

A completely open question: how competitive are exchanges at this moment? There appear to be only a few independent ones of importance left, although those are at each others throat.

One could argue that selling space for high speed servers is a nice side benefit for exchanges of which the potential downside to other customers is too hard to measure for those customers to consider switching, especially if there are only a few alternatives that allow the same practices.

Alex -- Are you really so sure financial innovation is mostly about distribution, and not efficiency? Sure, much of the time innovations in the field are driven by market participants focused on improving their own distribution, but occasionally we get true marketwide efficiency breakthroughs, like, e.g., exchange-traded futures and options, interest rate swaps, asset securitization, and (I would argue) the over-maligned credit default swaps. My concern is that we not pursue a regulatory regime that is so focused on the control of the former that it precludes the development of the latter. I would also point out that the latter can often (usually?) arise from the former in unexpected ways.

Competitive swimming, like all sports, is an artificially constrained field which has chosen to focus on distribution and deemphasize efficiency, for entertainment purposes. Nevertheless, outside of the swimming pool, mankind has been innovating to improve the efficiency of human transport through and across bodies of water for millennia.

As a species, we can choose to set artificial limits to innovation for frivolous purposes. I do not think most of us would agree to put FINA in charge of ocean-, lake-, and river-going transport, however. Let's not beg the question of future innovation in the field of finance by doing a similar thing there.

The swim suit controversy, like the PED controversy in baseball, is not about current athletes but about past athletes who are upset their records fell. In these cases the regulation of the sport is jealousy driven.

To me what is confused about this post is that the technology tends to level the playing field. Co-location is cheap. Before co-location where your office was determined how fast you could be, and setting up an office next to the exchange is much more expensive than sticking a few servers in a rack. With co-location hundreds of firms are as close to the exchange as possible, whereas without it only a relatively few firms can have the closest office. Computers and networking equipment are also commodities so the amount you have to actually spend on that stuff just isn't that high, and if a competitor upgrades servers or gets a new switch that just doesn't tend to give that much of an advantage, unless they were way behind to begin with.

The truth is that the little guy (not retail, but small professional) can compete on a technological basis with the biggest players in the world now. Its hard for me to imagine a regulation of the technology side of the trading business that wouldn't give the bigger players an advantage while hurting the smaller players.

"The main critique of HFT is that it lowers market liquidity but that would seem to be internalized fairly well by the regulating exchange."

I don't think so. The main critiques that I have seen of HFT is that they are engaging in front-running or they are just unfair in some way. Most high frequency algorithms add liquidity. In the stock market, one of the most import aspects of high frequency trading is the "liquidity rebate" offered by many exchanges. If you read that NYT article about HFT they mentioned it there. You only get the liquidity rebate if you add liquidity (meaning that you post an order to the order book that doesn't immediately trade, and then someone else comes in and initiates a trade against your order). The exchange will give say $.002/share to the person posting the liquidity and take $.003/share from the person hitting the order and keep the difference. The tricky part of that trade is how to earn that $.002/share and not get picked off by smart speculators when the stock moves $0.50 in your face.

The only liquidity-related argument I have heard against HFT is that somehow all the volume they are doing and liquidity they are adding is "not real" and that they could take it away at any time.

Ray, this post is by Alex and is a response to previous posts by Tyler so no contradiction at all.

I guess some of the issue here is what you want the game to be about. If the game is about making money, then I don't see what the big deal is about rewarding the entrepreneur who invests wisely in capital expenditures with a bigger piece of the pie -- at least until somebody else comes along who can do it better.

But if the game is about who has trained their body the best, then I don't see why having a more expensive, high tech swimsuit really says much.

You can't regulate away risk for two reasons.

1) Even the best regulation is trading externalities for rents.

2) Regulation only makes the risk barriers to entry larger and thus encourages black market and illicit activities by increasing the reward of such activities while the risk to such activities stays about the same.

3) Inevitably capture by the regulated parties will make the regulation more rent seeking and less externality destroying.

4) HFT DOES provide efficiency, often through arbitrage and similar methods.

5) I thought you were an economist, and your blog is named the "marginal revolution,"
have you forgotten that MARGINAL changes/improvements/profits/etc is what matters?

P.S.: Environmental regs. are an example of (1) and drug laws are an example of (2)/
(3) Is what happens over time to regulatory agencies.

Does anybody else think that the simple fact that we are talking about this is sad and reprehensible?

First of all, we wouldn't be talking about this at all if that German guy hadn't beat Michael Phelps. Guess what? Athletes aren't invincible, even the best in the world. At some point, they slow down and others take their post. The very premise of this technological conundrum we are discussing rests on the idea that NOBODY could have beat Michael Phelps, and therefore it is the suit. It is complete bullshit, and Michael Phelps himself has said so.

More importantly, by halting the technological progress of swimsuit design, we are consigning ourselves to greater uncertainty as to who actually is the best swimmer out there. As it stands right now, there is a lot of variation in the actual performance effects of different swimsuits.

There is, by physics alone, a law of diminishing returns in the performance effects of swimsuit design. At some point, no technological innovation can give you an edge, because the marginal benefit of a better suit design will be so small.

I know this sounds like a dumb distinction, but it is important to understand it this way. A swimsuit can't make you swim faster in the way that a faster car engine makes a car go faster. When you are swimming, you are the engine!

As technology increases, and diminishing returns lead to very small marginal benefits in performance, we are in essence adding control to our experiment that we have designed to find the fastest swimmer.

I would also like to add this to my last comment: My argument about reducing uncertainty through technological innovation most certainly applies to financial exchanges. Those who have access to the technology first most assuredly benefit the most...but considering how fast technology diffuses to the commoners, why are we even worried about this?

Alex,
Sorry but I cannot understand your statement that "High-tech swimming suits and trading systems are primarily about distribution not efficiency" and therefore I cannot understand the rest of your post. Please can you explain what you mean by distribution in EACH of your two examples. Reading some of the comments to your post I can see that other readers have also failed to understand what you mean.

Sport is a display of prowess. The "regulators" choose conditions of contest that will call forth a display of the kinds of prowess that people most want to see. Different conditions will be specified for different contests, since people want to see different kinds of display. Anybody can hold his own contest, specifying his preferred conditions; there is no call to force a single set of conditions on every contest organizer. (Of course, an organizer will have trouble getting participation in a contest with idiosyncratic conditions.) FINA will not prevent anyone from holding a swimming race in which hi-tech suits are allowed; it will simply refuse to *sanction* such a race.

I do not see what this has to do with *government* regulation of *trading*. Trading is not done for display, and government, unlike FINA, is coercive.

E. Barandiaran, that's why I was puzzled by your question since I know you know all this! On HFT, flash trades seem to be simply theft as far as I can tell. Speed itself is pretty clearly close to zero sum. e.g. There is a lot of investment in getting trading centers micro seconds closer to exchanges - how does society benefit from this?

http://www.marginalrevolution.com/marginalrevolution/2009/06/the-singularity-is-near.html

FYI, I don't deny that some HFT can have good effects whether it's worth the investment however I don't know.

adam: I think the issue here is that in an athletic competition, the belief is that everyone should have access to the same technology. The problem is, these suits are very expensive and those swimmers without a sponsorship don't have the money to buy them.

There's also the "purity" issue, i.e. the notion that competition should be based on athletic ability along and not by whether or not you're wearing some fancy-schmancy outfits. If not for that silly modesty thing, FINA and undoubtedly many others would just as soon eliminate the issue altogether by just having all competitors go butt-naked, just like the ancient Greeks did in their Olympics.

The analogy would be better if the swimmers with high-tech suits were also aloud to jump in the pool a fraction of a second before the other swimmers.

I am new to the site and have just begun to follow the HFT postings. Something that is still unclear to me is his statement about the idea that the switch has been thrown on the burden of proof in terms of innovation. What is the current burden of proof? Hopefully someone can help clarify that statement.

High Frequecy Trading is more like an option offering high speed water than one offering high speed swimsuits. Your swinsuit is your program.

You choose HFT if it suits your chosen trading style.

I don't know much about Nascar, but Formula 1 has technical restrictions as well. Much of it is for human safety reasons, i.e., an innovation w/ increase in speed effectively isn't allowed until an innovation w/ a corresponding increase in safety is available. Arguably, a similar logic can be applied to doping in general. And much of it is for cost reasons, i.e., to lower barriers to entry & safeguard competition. In fact, this latter point is so important that the sports body changes the rules of the game every so often to avoid formation of natural monopolies.

In swimming (and other such sports), the 'equipment' is of limited use. In fact, the technological advances come more from training techniques etc. than from the swim suit itself. As long as everyone uses the same suit, it's fine. However, if you want some semblance of temporal comparisons, you need some regulation.

The problem with internalizing externalities isn't easily obvious from your comment about internalizing "systemic risk." In fact, that just sounds like a convenient cop-out, to use terminology that can mean pretty much anything.

Now, if current (and potential future) racing teams have problems with Formula 1, they are free to start their own sport. In fact, they threatened to do so recently. Similarly, if Nasdaq or NYSE regulated a certain way, market participants are free to go elsewhere... hence your comment. Answering the implicit questions re effectiveness (or lack thereof) of Formula 1 regulation vs. exchanges; and whether exchanges are capable of developing the rules of the game, or you need a more far-reaching body (SEC; FINRA etc.) is key.

The collection of computer-automated, high-speed trading technologies and techniques that are typically lumped under the heading of "high-frequency trading" (HFT) have been around for a while, but HFT has recently become heavily identified with the banking giant Goldman Sachs, which dominates some aspects of it on the New York Stock Exchange. And as Goldman draws more media and congressional scrutiny, so will HFT. To prepare you for the high-frequency trading media onslaught, we'll take a look at HFT and at a stock market that really isn't what you thought it was.

If you look under the hood of the markets in 2009, you'll find that the trading floor has been replaced by electronic networks; the frantic, hand-signaling traders have been replaced by computer systems; and all of moves in the trader's dance—a thousand little tricks and techniques (some legal, some questionable, and some outright illegal) for taking regular advantage of speed, location, and information to generate profits—are executed hundreds of times per second, billions of times per day. And the whole enterprise is mainly powered by the same hardware from Intel, AMD, and NVIDIA, that Ars readers use for gaming.

________________________________

Storage Shed Plans
Shed Plans
Shed Building Plans

Swimming is an interesting sport and I think that more and more people will understand that with time. Now you even have quick set pools. Imagine if we had that in the 1970s. It would have been a blast.

Comments for this post are closed