Results for “high frequency trading”

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That’s a common criticism of high-frequency traders, or for that matter of the older specialist system, or of some other trading practices; many MR readers make that point in these comments.

But is that a problem with uninternalized, Pareto-relevant externalities?

Let’s say many men visit a bar for its beautiful women.  That said, if the women, on a given evening, don’t see enough desirable men, they go home.  The beautiful women run away, but the plain women stick in the other bar, across the street, no matter what.  Men choose between bars, knowing that the one bar will often be very crowded, but sometimes empty.

The negative externality from the beautiful women, if there is one at all, is on the bar with the plain women.  That bar might find it harder to achieve critical mass and get off the ground.  But the first bar is not made worse off by the possibility that beautiful women might show up or instead might “flake.”  Men internalize that knowledge when deciding whether or not to visit that bar.

In other words, potential negative externalities from HFT (or other culprit trading strategies) are on the markets where HFT is not very active.  Yet the complaints you hear are about the markets where HFT is very active, and those complaints don’t correspond to the theoretical argument which might make sense.  They are wishing for the beautiful woman who sticks around at the bar no matter what.

The high-frequency traders are like the beautiful women.  If their biggest “threat” is to stay home, we are not worse off for their existence.   If we fear their flaky departures enough, we may prefer to trade in other markets or at other time horizons, namely very long.

All this is assuming that such flaky departures occur — relative to the relevant alternatives — and that point can be debated.

I’d like to reproduce chunks of his old yet prescient post (or go here and scroll down to 22 January):

Pundits continue to link the Enron debacle to a need for increased regulation,
especially of derivatives. What most of these people…don’t appreciate is that regulation and/or accounting rules are the
most fertile breeding ground for derivatives and synthetic or packaged
securities. Regulations and accounting rule-inspired transactions
describe the bulk of the well known derivative-related blow-ups of the
last two decades. Proscriptive regulation and the derivative trade have
a symbiotic relationship.

Investors and operating companies buy derivatives for two basic
purposes: speculation and risk transfer. A derivative, (a financial
contract based on the price of another commodity, security, contract or
index) either eliminates an exposure, creates an exposure, or
substitutes exposures. That last one, substituting exposures, is
important to heavily regulated investors.

For example, insurance companies were a goldmine for derivatives
salespeople in the last two decades, only slowing down in the late
1990s. The fundamental reason for this is not because insurance
executives were stupid, but because they manage their investments in a
thicket of proscriptive regulation. Insurance companies have to respond
to their national regulatory organization (the NAIC), their home state
insurance department and the insurance departments of states in which
they sell or write business. They file enormous statutory reports every
quarter using special regulatory pricing, and calculate complex
risk-based capital reports and "IRIS" ratios regularly.

Even though the insurance industry has been heavily regulated
throughout the entire post-war era, the incidents of fraud and
financial mismanagement have been numerous and spectacular.  Remember Marty Frankel?
Mutual Benefit Life? For each of these cases that are in the news,
there are many smaller ones you don’t hear about. Some of that may be
the nature of the industry, but it doesn’t make a prima facie case for more regulation…

Insurance companies often need the yield of less creditworthy
obligations. So derivative salesmen see an opportunity to engineer
around the regulations. They package securities that substitute price
volatility for the proscribed credit risk. Then the investor can be
compensated for taking some additional risk, and the banker can be
compensated for creating the opportunity. A simple example of this is
the Collateralized Bond Obligation (CBO). A CBO is created by buying a
bunch of bonds, usually of lower credit quality, putting them in a
"special purpose vehicle" (SPV) and then issuing two or more debt
instruments from the SPV. The more senior instruments can obtain an
investment grade rating based on the "cushion" created by the junior
debt tranche. The junior bond absorbs, for example, the first 10% of
losses in the entire portfolio and only when losses exceed that amount
will the senior obligations be impaired. The junior instruments, known
as "Z-Tranches" become "toxic waste", suitable only for speculators and
trading desks with strange risks to lay off (or, in a famous 1995 case,
the Orange County California Treasurer).

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing – they decrease frequency of loss but increase the severity.
So they blow up infrequently, but when they do it’s often a big mess.
Ratings-packaged instruments are less risky than the pool of securities
they represent but often riskier and less liquid than the investment
grade securities for which they are being substituted. As a result,
they pay a yield or return premium (even net of high investment banking
fees). That premium may or may not be enough to pay for their risk. But
they pass the all-important credit rating process and are therefore
sometimes the only choice for ratings-restricted portfolios reaching
for yield.

…[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests
that regulation is often the derivative salesman’s best friend.
Complicated rules encourage complex transactions that seek to conceal
or re-shape their true nature. Regulated entities create demand for
complex derivatives that substitute proscribed risks for admitted
risks. If a new risk is identified and prohibited, the market starts
inventing instruments that get around it. There is no end to this
process. Regulators have always had this perversely symbiotic
relationship with Wall Street. And the same can be said for the
ridiculously complicated federal taxation rules and increasingly
byzantine Financial Accounting Standards, both of which have inspired
massive derivative activity as the engineers find their way around the
code maze.

Dreck, in case you don’t know, used to blog with Megan McArdle over at Asymmetric Information.  Here is what happens when you enter "Star Dreck" into YouTube.