He writes
High frequency trading presents a lot of interesting puzzles. The Booth faculty lunchroom has hosted some interesting discussions: "what possible social use is it to have price discovery in a microsecond instead of a millisecond?" "I don’t know, but there’s a theorem that says if it’s profitable it’s socially beneficial." "Not if there are externalities" "Ok, where’s the externality?" At which point we all agree we don’t know what the heck is going on.
Tragedy of the Commons.
There is valuable unowned information in the pattern of trades and prices. This is an arms race to exploit it.
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Wednesday ~ February 29th, 2012 at 5:35 am
Leigh Caldwell
I instinctively want to disagree with John Cochrane, but on this it is hard to do.
But looking at your tragedy of the commons argument – are you suggesting that for markets to work, and for traders to have an incentive to find information to support price discovery, there must be some margin left for them by an inefficient price? I’m not sure that HFT really damages the gains from discovery; it only removes (if it works as advertised) some of the randomness in prices, which would otherwise themselves damage those incentives through uncertainty effects.
Wednesday ~ February 29th, 2012 at 6:51 am
david
Grossman and Stiglitz argued precisely that a while ago – that there must always a degree of price inefficiency to justify the costly continual revelation of private information.
Duly note the scattered reports that stock exchanges allow HFTs to play by slightly different rules from everybody else, and in particular allow them to peek at what other traders intend to do (by withdrawing trades/etc.). Stock exchanges are not perfectly Walrasian auctioneers, alas.
I’m not sure whether Smith is saying that HFTs compete traders with actual information out of the market, or whether HFT is a socially unproductive arms race (as, e.g., a race of increasingly improved advertising technology chasing finite consumers would be – i.e., that the race is zero-sum).
Wednesday ~ February 29th, 2012 at 11:17 am
Chris Stucchio
HFTs are not permitted to peek at what other traders intend to do. HFTs are allowed to place orders, cancel them (if unfilled), etc. So can you, you just can’t do it as fast.
It is true that some HFT’s play by slightly different rules. For example, if an HFT becomes a designated liquidity provider for an ETF, they are obligated to maintain a spread and permitted to create/destroy ETF shares. But that probably isn’t what you are referring to, is it?
Wednesday ~ February 29th, 2012 at 9:23 am
cig
There’s no interesting tragedy of the commons if it is an internal race, with the fastest hf traders really profiting at the expense of their slower colleagues, which keeps working until they run out of new slow mugs.
The number of instruments where you can do high freq is tiny, and so are the spreads on them, so there’s not much low freq traders can lose to high freq (outside of flash crash style events). It makes you wonder if the high freq universe as a whole is profitable at all or just a case of the best players scalping the lesser ones.
Wednesday ~ February 29th, 2012 at 9:43 am
nemi
“”what possible social use is it to have price discovery in a microsecond instead of a millisecond?” “I don’t know, but there’s a theorem that says if it’s profitable it’s socially beneficial.”"
I´m speechless. No combination of profanities would come even close to what I would like to express. Are these people fucking idiots?
Wednesday ~ February 29th, 2012 at 9:58 am
No Country For Constitutional Men
The HFTs have screwed the pooch, or if you prefer, they killed the goose that laid the golden egg. We have had at least 14 weeks of outflows of the equity markets while the markets moves higher, as nobody trusts the markets anymore. How in the Hell do I protect myself when they can drop an index a thousand points in 15 minutes? The volume says it all, as these scalpers aren’t fooling anyone. They all sit around in a circle and scalp fractions of a penny from each other all day long while investors flee the markets.
Wednesday ~ February 29th, 2012 at 9:14 pm
Matt (@MeCampbell30)
You play the fundamentals. HFT rests on the lie that markets have priced the information avaialbe to the market and all you have everything you need to know about a stock in the form of a graph.
The externality of HFTs is increased volatility.
Thursday ~ March 1st, 2012 at 10:04 am
No Country For Constitutional Men
Fundamentals and technicals no longer exist in a world where the criminals have institutionalized theft and thievery. I know this first hand as a trader, as I watch their actions on a daily basis. It’s all about the PPT and QE. Remove the 10% of GDP being borrowed by the govt. every year, and we are toast.
Wednesday ~ February 29th, 2012 at 10:02 am
No Country For Constitutional Men
nemi, I’m right there with ya, and yes, they are fucking idiots, but it’s the regulators who are the thieves for allowing it. After all, we wouldn’t want to piss someone at these firms off, as how will the regulators go to work for them when they leave the public sector? It’s always about the money.
Wednesday ~ February 29th, 2012 at 11:27 am
Lord
But is the valuable unowned information that there is no information? Vegas does quite well in spite of information.
Wednesday ~ February 29th, 2012 at 11:44 am
Max
There doesn’t need to be any social benefit to motivate the pursuit of free money. I believe the econ term is rent seeking.
Thursday ~ March 1st, 2012 at 10:10 am
No Country For Constitutional Men
Social benefit? A bunch of math geeks sitting in a circle scalping fractions of a penny from each other while investors leave the market is rather unhealthy for everyone concerned. Where are the regulators? Oh ya, they are filling out job apps with the same people they regulate. Welcome to The Wizard of Oz. Pay no mind to the blowhards behind the curtain.
Wednesday ~ February 29th, 2012 at 12:14 pm
jsalvatier
It’s intuitively plausible to me that HFT has some kind of externality. I’ve considered your explanation before, and while it superficially makes sense, there’s actually an agent who can internalize those externalities: the exchange who makes money from having people use their exchange. If there were net costs from that arms race, the exchange should try hard to fight it since it makes people want to trade less. The exchange could easily make it difficult to do high speed trading (for example, just add a delay), but they don’t do this.
Wednesday ~ February 29th, 2012 at 12:53 pm
anon
Exchanges compete with each other in terms of providing lower latencies to traders. The reason? Higher latencies means less price efficiency, which is effectively a higher spread, which means more costs and lower liquidity.
Exchanges and instruments with the higher liquidity and lower spreads attract traders of every type and these exchanges and instruments prosper. The others dwindle away. That is why you see lower and lower trading latencies.
Thursday ~ March 1st, 2012 at 11:18 am
TGGP
Reminds me of Eli Dourado on cybersecurity market failure.
Wednesday ~ February 29th, 2012 at 1:37 pm
ed
It seems to me that HFT is mostly just market making. Any profits it generates come from previous, slower market makers. Didn’t specialists on the old NYSE generate big profits as well?
I just can’t see what the source of the profits could be otherwise, if it’s not market-making.
Wednesday ~ February 29th, 2012 at 1:55 pm
Barton
“I don’t know, but there’s a theorem that says if it’s profitable it’s socially beneficial.”
When your ideas become as disconnected from reality as this, why listen to you at all? I could make a lot of money selling weaponized small pox to terrorists, but I struggle to find something socially beneficial. Ridiculous.
Wednesday ~ February 29th, 2012 at 6:16 pm
HistorySquared
The overwhelming majority of high frequency strategies post bids and offers, earn the spread and rebates – market making algorithms. They have replaced the specialists.
Others use various arbitrage strategies, such as between securities or on occasion, latency arbitrage, which is a good thing and always took place, just at a slower pace.
The last one, that people grossly overstate in size and scope, also is beneficial to moving price to a fair value despite it’s appearance – detecting order imbalances created by large institutions moving in and out, who also use their own order order splicing high frequency algorithms in a game of cat and mouse – a game that has always occurred. Here, they are rewarded for taking the market to a more efficient price quicker.
The flash crash was caused by a mutual fund seeing riots on tv and hedging a large portfolio with an order splicing algorithm in the futures market – panic – not a high frequency trading strategy. Some market making firms turned off their algorithms to cut their risk, as they should. We don’t want one to bust a clearing firm and create something systemic, which limit moves may some day. The SEC, like most governments, believe in intervention and want to force firms to buy when humans, not algorithms, are panicing.
The government solution will be to grant certain firms a monopoly to maintain a farce of a spread, say 100 x 100, 10% wide, give them an advantage to front run and abuse orders the 99% of the time there is no panic. Or they will institute a tax or fee, which will naturally drain liquidity, driving more people out of the market, and enhance liquidity. The firms will then pay a token fine when they inevitably step away on that rare event – like they did during Black Monday, which was magnitudes worse, which creates an opportunity to buy from overlevered people, enabled by central banks, who are forced to sell.
Manias and panics will continue to happen because humans and human.
They are be made worse by leverage, excess currency and/or debt in the system, whose price and quantity is manipulated by governments, which distorts the price of risk.
Thursday ~ March 1st, 2012 at 12:57 am
ed
I have no inside experience with the HF trading shops, but this all sounds very plausible to me. The prediction about policy responses also sounds depressingly plausible.
Wednesday ~ February 29th, 2012 at 8:55 pm
Airman Spry Shark
“Not if there are externalities.”
“Ok, where’s the externality?”
I would venture that it’s a stochastic, not deterministic, externality (i.e., they’re externalizing risks, not costs), and therefore not directly observable.
Thursday ~ March 1st, 2012 at 7:25 am
reason
My guess is this is the right direction to go. After all, this is the predominate theme of the last 30 years. By chasing abitrage opportunities, the HFT traders are pushing extra risks onto other players who can’t respond so fast. Exactly.
Friday ~ March 2nd, 2012 at 1:26 am
Jon
There is a simple reason why those market moves are synchronized. HFTraders pay for low latency market information. Typically you pay for a certain periodicity, ’1 sec’ is common. So prices are pushed at that ’1 sec’ interval by the data provider. There is low latency and jitter in the distribution, and then everyone responds very fast.
It is scary that a bunch of professors who don’t know how HFTing works, just assume the behavior is some stupidity.
Saturday ~ March 3rd, 2012 at 4:11 pm
gappy (@gappy3000)
“Tragedy of the Commons.
There is valuable unowned information in the pattern of trades and prices. This is an arms race to exploit it.”
I am not in HFT, but am one degree removed from price participants. I know that I don’t know much about it, and that academics know less than me. Not Cochrane, who doesn’t claim to be an expert, but rather those who publish on the subject and consider themselves experts. I can say for sure that the comparative advantage of HFT doesn’t lie “in the pattern of trades and prices.” If anything, that’s how statistical arbitrage makes money, and if you know the business, you know that Stat Arb margins have been shrinking faster than HFT’s post-2008. The purported advantage of HFT is to exploit simple market inefficiencies, for which you need very low latencies. In this exchange economy at extremely short time scales and trade amounts, there are winners and losers (mostly among market makers). To call it a “Tragedy of the Commons” implies there are externalities among participants that are not transmitted by prices. There may be issues in HFT, but externalities are not among them. And, incidentally, the claim (made by “No Country For Constitutional Men”) that reduced volume in equity markets is due to HFT scaring investors away is factually incorrect. The decrease in volume is due, if anything, by fewer high frequency participants.