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.

Here is a good survey of some of the debates, plus Paul Krugman mentions the topic in his column today.  Here's my earlier post but I'd like to add or reiterate a few points:

1. On one hand, critics wish to charge that there is little or no advantage to having prices move more quickly to reflect new information.  On the other hand, some of these same critics charge that short-run volatility of prices — assuming this is in fact the result of HFT (and that is not proven) — creates social costs.  That's not quite a contradiction but it is an odd mix of views about the relevance of the short run.

2. I haven't seen a good estimate, or for that matter a bad estimate, of the social loss involved from investing resources in HFT.  Even if the practice has no gain, I suspect the loss is small.  It's the symbolic nature of the issue which excites people — bailed-out elites doing fancy things with powerful computers in a non-egalitarian manner — rather than the belief that it is a policy priority.  Even if you think HFT is bad, on an actual list of bad policies or practices in our world, would it be in the top million?  Mostly it's a canvas on which to paint complaints about the continuing political and economic power of finance, but we shouldn't let that skew our judgment of the practice itself.

3. There is no argument to date, and probably no argument period, that HFT can lead to financial insolvency or collapse on a major scale.  The cost, if there is one, is that the associated trading strategies bring a temporary collapse of asset prices for some period of time (how long?) or perhaps greater ongoing price volatility, or uncertainty about order execution, in the short run.

When I read that HFT may give markets "a new, currently unknown set of emergent properties" I think buying opportunity.

4. Research by Hans Stoll indicated that program trading was not in fact an instrumental culprit behind Black Monday in 1987, yet media coverage of HFT seems to be indicating that it was.  Many of the HFT debates echo themes from the earlier program trading debates from the late 1980s but in fact program trading did not turn out to be a major problem.  We have been down this path before and it turned out there was much less there than the critics thought at the time.

5. The more I read these debates, the more nervous I get about the idea of a financial products safety commission.  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.  We should still follow the rule of regulating practices shown to be harmful or likely to be harmful.