High frequency trading, markets, exchanges

Three thoughtful posts from Martha, Daniel, and Yuval comment on the NYT article about Goldman Sachs’ high-speed trading unit. The rather critical article suggests that high-speed trading is the latest way to exploit innovation at the expense of everyone else, to the tune of $21 Billion in 2008.

This issue is not new as such, as speed of electronic trading (in the form of co-location, or having your servers physically located nearer to an exchange to eliminate tiny latency times in execution) has been an issue for years. See the industry magazine here (from March of this year) and here (from 2007) [both are pdfs].

I have three things to add:

1) Liquidity is bullshit. This has always been the case, but the use of volume and ‘continuity of price’ as a proxy for liquidity is increasingly ignorant. There is a historical trajectory here – the shift from locals making money off of institutions (who provided liquidity) to institutions making money off of locals (who provide liquidity), but the cat-and-mouse nature of high frequency trading means that a terrific amount of traffic in quotes with little value added for price discovery. The metaphors of financial markets being ‘deep’, ‘liquid’, whatever, are inadequate to the task of capturing what is the value of a working market. I don’t think there are replacements yet.

2) Markets are sausage, and exchanges, regulators, and large financial services firms are the sausage-makers. This is definitional, and important. The HFT article peeks at the varied ways that exchanges provide incentives for some players over others. To wit, a large all-or-nothing order at the CME/CBOT doesn’t have to go into the normal queue of orders. Ok, so the people trading 1000 lots can just screw first-in-first-out. The NYSE privileges high-frequency-traders by incentiving them to ‘make markets’ (liquidity providers, right!). Regulators privilege bulls over bears by making it harder to sell short than to buy long.

All of this is true, and yet whatever ugly, improbable, unfair (or too fair) set of practices, rules, and activities that comes out of this process is, by definition, a market. A market is whatever exchanges, the SEC/CFTC/Fed, and financial firms say it is. It is a Durkheimian ‘social fact.’ That is, it is factual but not ‘real’ in the sense of pre-social.

3) Insiders win. All of the technological and financial innovation that might theoretically make markets more accessible, more democratized, more ‘fair’, simply do not. In absence of a real idea of what a market should be, and an acknowledgment that whatever the current sausage-making apparatus spits out defines what a market is, we in fact have an edifice that benefits insiders by design.

That electronic trading consolidates power rather than democratizes it is not a new thing to point out, but I wish there was a bit more attention paid to this dynamic.

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