Krugman's take on high frequency trading
nytimes.com
nytimes.com
(b) What does it even mean to question whether "one thirtieth of a second faster" merits profits? As Krugman well knows, the markets aren't inherently frictionless; when you trade, you trade across a spread between bid and ask prices, a spread representing a premium to your trade that is taken out of the market by middlemen. HFT cuts the spread and hurts those middlemen, but also reduces friction in the market.
Krugman's argument seems to reduce to the notion that the only people who should profit in a trade are principal buyers and sellers; people with a long-term strategy or outlook on an instrument who are trading for a reason. But HFT or not, a huge swath of the market consists of entities that exist solely to connect buyers to sellers and to facilitate price discovery, and it's naive (or disingenuous) to suggest otherwise, or to pretend that markets would work effectively in their absence.
But yeh basically the counter argument is liquidity. There's nothing stopping an exchange restricting speed of trades, the reason most of the major ones don't is companies don't want to be listed on a non-liquid exchange.
If HFT damaged the companies being traded than the companies could move to exchanges that didn't allow it.
I think the big losses are from the all of the wasted resources being put into making trades faster and faster. It seems to me that if merely swapping one set of machines out from a data center near the exchange and moving a few miles away is going to drastically change how that it performs, something is wrong.
From my personal experience, a brilliant friend of mine left his job at some Silicon Valley startup where he was definitely creating value for society to work at an HFT shop. After a few months of working there, he calls me and we talk about some C++/algorithms stuff (I think he is much, much smarter than me, I just happened to have written a lot more C++ than he has) about how he needs to make his code run microseconds faster so that it can make more trades.
I am all in favor of people who change the world for the better being rewarded immensely. I have no love for the iphone, but since many, many people do, I am sure Steve Jobs is worth his billions. But for people getting rich doing HFT, the only return for society I see are some nebulous claims about liquidity. Can the societal gains be quantified in some manner? If every transaction on the exchange had an added latency of a microsecond, how would things change? What if it was a millisecond? What about a second? How much worse off would the world be?
I worked in Silicon Valley for 12 years. Many of the projects I worked on had negative financial value - they never made any money. So essentially I was just wasting some rich person's money. The projects that were successful in terms of users and "eyeballs" often had negative social value. The whole point was to induce users to spend more and more time on our sites. Finally, some of the things going on right now in startup-land are quite frankly, creepy. The last project I did in Silicon Valley involved working with all these vendors who essentially are building up dossiers of every human who uses the internet and shopping it around as "market data." When I realized I was basically contributing to a surveillance state, I quit and moved to Manhattan, where at least I'm only fucking around with rich people's money, instead of fucking around with people's lives.
But you could also see it as "pushing the limit", similar to people trying to see who runs 100m the fastest, or Formula 1, or Kasparov-beating chess machines. Of course, in and of themselves, these look like silly activities and a total waste of dollars and energy given the poverty in the world. It strikes me, though, that these boundary pushing activities are somehow useful to the rest of us, in some weird and non-obvious way sometimes. Also, given that technologies have a habit of moving down the exclusivity scale, perhaps this persistent boundary pushing in HFT is contributing to general liquidity (speed of execution, lack of price impact, etc.) in a trickle-down way
Liquidity also isn't a nebulous concept. Look at over-the-counter fixed income trading markets, where prices are governed by ratings agencies and salesmanship as much as real price discovery, for a telling case study.
One way to look at the current situation --- probably idealistically --- is that HFT are to broker/dealers what ITA and Kayak are to travel agencies. That what liquidity is supposed to mean, right?
Shrinking times also have the advantage of improving price precision, when your talking about price moves over a very small period of time we can often be talking about very small price moves (say one-thousandth of a cent) which helps everyone. When before something may have been worth 213.314 you may have only been able to sell at 213.31, which for large deals can have a significant impact in high-volume markets, but with higher precision prices are more accurate.
That said, it's greatly unfair, IMO, that markets are allowed to provide information to select people (for an additional fee of course) that is not provided to the general public. These are supposed to be publicly traded stocks - by providing information to some that others don't receive until some delay (whether it's milliseconds to minutes), then there is nonpublic trading capitalizing on information not yet delivered to the public - this walks the fine line of insider trading, to me.
A lot of these concerns seem to be predicated on the notion of the markets as interactions between simple buyers and sellers, and since so few people really understand how the markets --- even in old open-outcry markets --- work, I wonder how much of this controversy is really a side effect of more people hearing about the fundamental structure of the market.
On another note, it should be pointed out that flash orders were created by EXCHANGES, not by demand from traders. The exchanges didn't want to have to route orders to other exchanges because of NBBO, so they offered this to traders hoping that someone would come fill the order at NBBO.
First the financial industry plunged us into economic crisis, then it was bailed out at taxpayer expense.
[M]any financial-industry high-fliers made fortunes through activities that were worthless if not destructive from a social point of view.
[H]igh-frequency trading probably degrades the stock market’s function, because it’s a kind of tax on investors who lack access to those superfast computers. . .
[A] bill setting rules for pay packages...a step in the right direction... is opposed by the Obama administration, which still seems to operate on the principle that what’s good for Wall Street is good for America.
[W]e’ve become a society in which the big bucks go to bad actors, a society that lavishly rewards those who make us poorer.
If you're a principal buyer or seller of an instrument, because you have a trading objective (capitalizing on an impending market shift, accumulating exposure to a business or industry you believe in, diversifying your portfolio, or simply a speculator), HFTs are (a) at worst simply replacing a middleman that was taking a chunk out of every one of your trades, and (b) at best helping you by refining competition for access to that spread and thus amping up liquidity and making it easier for you to buy or sell.
There certainly do appear to be problems with HFT in particular and large-volume algo trading in general; for instance, it appears to drastically amplify volatility and create crazy swings. But that's not the argument Krugman is making. He's saying it's inherently unfair. Bullshit. It's unfair in the same sense that UUNet was unfair to bulletin board systems.
But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”
It’s hard to imagine a better illustration than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses, for example by helping companies with good ideas raise money. But it’s hard to see how traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve that social function.
However, HFT is rather a group of market making strategies that operate at high speeds. They'd still work at lower speeds (above a certain threshold). But they 'make it worth it' for businesses, so to speak, because of the volume that can be generated, because high speeds means more trades.
Most people doing HFT are taking very small spreads. Fractions of pennies. But because they can do HFT a lot, this grows a lot. In fact, many HFT equity traders make money via rebates. Which means if anything they are only providing a service to the market (it's someone else coming across and crossing them for a trade).
So HFT is a mixed bag, as others have said. There are predatory strategies that probably do more harm than good -- accelerate crashes, etc.
But all HFT is -- is some slow strategy in the background + an ability to make markets a lot. By making markets a lot -- liquidity is provided. Whether the slow strategy in the background is good or bad -- again, is a totally different thing.
So insider trading + HFT (as Hirshleifer maybe is getting at), which we would include in the HFT category because of the latter component, is bad. But providing a certain risk assessment that other people think is overvalued or undervalued + HFT is not necessarily bad.
Where it gets tricky is that HFT infrastructure usually requires the same foresight that 'knowing more than other people' requires. And so it seems like people are being taken advantage of. But judged purely objectively, HFT is just a measure of speed. I.e., it's just magnitude. The direction is totally up to the market participant (many of whom, it's true -- are ruthless and even amoral).
But people may not appreciate the importance of liquidity (which is what HFT mostly provides). Liquidity -- which of course gets its name from this 'smoothing out' of markets -- i.e., making things more readily accesible based on a wide variety of demands, etc. -- that is the basis for any type of economy or convenience. It's a deep problem that we always probably want to improve.
Should some farmer in Africa who has some idea for taking some plant and using it to treat some ailment be given funding from a bank? In a highly liquid world -- yeah, there's an ATM machine in the middle of nowhere and he enters his information and gets a loan. I.e., this is an extreme example, but this 'convenience' is huge for innovation and making all of life, for lack of a better word, more elegant.
On the other hand, the risks of people who provide liquidity with much higher insights into the market than other people -- is like with any misaligned information relationship. Any type of manipulation is very bad -- and very tempting when you're one of the large market participants. So that should always be safeguarded against.
But yeah, I suppose it's like anything. You want things fast but safe.
ETA. I read the question (parent comment) a little more thoroughly. So I should probably answer -- why does 1/30th of a second make a difference? It rarely does. But nobody makes money solely with speed, right? What we mean by someone makes money by being faster by a couple of milliseconds -- is that there is some well-known strategy out there, and some market participants, with really fast connections, can get into that strategy faster than everyone else. But clearly, in regards to sub-second market entry, these strategies are fairly rare (e.g., trading announcements or IPOs or pairs trading, etc.).
High frequency trading means entering AND exiting quickly (i.e., you have to have some other strategy -- usually a hedge -- that you're doing to get rid of the risk of entering one side of the trade). Being sure about the direction somehow, that's of course the trick. But what HFT traders are counting on is -- for lack of a better way to put it -- dumb commercial paper. On average, they want to have a strategy that eeks out a little bit of a profit. Then, add in all the individual investors and mutual funds, etc., that have a mixed bag of clarity into the market, and extract some of the inefficiency out of it without assuming much risk.
But just because they've figured a way to extract rewards out of the misalignment of interests in the markets -- doesn't mean what they're doing is wrong. It's just annoying to speculators. Because it seems like they are being constantly reminded that the markets are unforgiving unless you have a very clear idea about what type of risk/reward profile you're willing to present.
The best way to fix the financial markets is education and other efficiencies. Anyway, that's just my two cents. I could go into the problems with GS and bailed out bulge-bracket firms -- but suffice it to say, the systemic problems are mostly based on conflations (e.g., conflating a commercial bank and proprietary trading).
An angel investment allocates resources. A VC round allocates resources. And yes, an IPO does allocate resources. But trading stocks is just a way for mutual fund managers to charge a fee.
Once, owning stock had to do with dividends. But that's back in the day. Now, the only way to reliably make money in the stock market is to spend other people's money and charge them for the honor.
If I'm investing in a company, I should have an asymmetric informational advantage or an ability to direct management. Public companies, by definition, don't make this possible (unless you have significant voting power).
One doesn't really need to engage your argument about whether equities are truly about allocating resources to observe that electronic markets do play a pivotal role in resource allocation. How do you think anyone knows what wheat, iron, or bulk block cheddar costs?
Your other points are well taken, but I do think Krugman is largely referring to equities, and I sort of parrot part of the argument made by Mark Cuban in the following link without sharing how I got to that line of thinking:
http://blogmaverick.com/2008/09/08/talking-stocks-and-money/
Sure, products could still be moved without all the market's actors. But they'd move at inferior prices, jackpotting some producers and bankrupting others by sheer chance with little opportunity for smart producers to mitigate (or even profit from) risks.
Even pure speculators serve a purpose in the market; if nobody wants to hedge a risk or lock in a price by dealing with them, they can't succeed; if people do want to do that, the speculator is providing a service to them.
This, by the way, isn't any great insight on my part; it's the first chapter in any book that explains futures and options.
For such a clever & informed group, finance types like to quantify their positive contributions and qualitatively dismiss their negative contributions ("there are -some-inefficiencies when...")
We lose a lot of peak potential value when we depress high finance's ability to leverage and exploit markets, but we also shave off the deepest parts of the trough we inevitably fall into when the "markets" swing back the other way.
History suggests we shouldn't consider the boom-bust cycle as part of our inevitable march forward; sometimes, you bust big enough and you reach your day of reckoning. Why is it a given that this cycle needs to be so dramatic?
Maybe Robin Hanson (on the very technical side) or Robert Shiller (on the very academic side) might be better sources.
You can, by the way, get a pretty good intro to high-level market concepts (particularly, what concerns motivate them) by listening to the free lecture courseware from Shiller's markets class. And I have to chime in to every discussion about how markets work to promote "Trading & Exchanges" by Harris, which is just an awesome, awesome book, and which you can get on Kindle as well.
coco the monkey
Although I do actually like Paul Krugman's writings, and although I do have an opinion about the financial industry, whoever crowned Krugman "social evaluator" of the world? I mean, who is to say Krugman writing stuff on the internet, winning a fake Nobel for a (basically fake) discipline, and scribbling formulas on blackboards is constructive from a social point of view? I know people who would dispute that. In fact, let's not even go into this question for we might find out ugly things about our societies. If I were to put my own "social evaluator" hat on, I'd throw half the stuff I see on TV commercials out. [EDIT: In fact, I might throw the TV and all the associated junk itself out.] Economist Krugman may not like the result on the employment rate when we really introduce this sort of criterion into capitalism. I mean, seriously, who in our society really makes truly valuable or "constructive" stuff, from a social point of view. Isn't a huge chunk of our population involved in making consumer junk and industrial waste? How is a marketer who tickles the basest instincts of people to make them buy stuff they don't need by working harder at jobs they hate any better than a guy who spends his day doing HFT?
Over-processing Muda!