High-frequency traders would be feeling rather paranoid in the wake of Michael Lewis’ highly-publicised attack on their sector in his new book, Flash Boys. After a speech by Nobel laureate and Columbia University professor Joseph Stiglitz this week, they’d realise that it isn’t just Lewis who’s out to get them.
In what he described as a “mainly theoretical” presentation to a Federal Reserve Board conference on financial regulation in Atlanta on Tuesday, Stiglitz posed the question of whether less active markets were safer and better for the economy.
Before focusing on high-frequency trading he briefly canvassed the broader issue of capital markets liberalisation and the large and volatile capital flows that occur within the modern global economy.
“When countries do not impose capital controls, or some other form of capital account management, and allow exchange rates to vary freely, this can give rise to high levels of exchange rate volatility,” he said.
“The consequence can be high levels of economic volatility, imposing great costs on workers and firms throughout the economy.
“The very existence of this volatility affects the structure of the economy and overall economic performance,” he said.
“It is thus no wonder that capital market liberalisation, leading to excessive cross-border flows, can lead to higher volatility but not higher growth and that economic performance can be improved by imposing restrictions on this excessively active market.”
There will be those looking at this economy, where the structural changes occurring as a result of the commodities boom and the wider impacts of China’s economic surge have been overlaid and exacerbated by the impact on the Australian dollar of the short-term volatility associated with speculative capital flows, who might well nod in agreement.
It is, however, when the speech focuses in on HFT to illustrate Stiglitz’s thinking on the implications of unfettered markets that it contributes to the growing debate about the impact of algorithmic trading and deconstructs the arguments -- that such trading aids price discovery and enhances liquidity -- that HFT traders use to defend their activity.
Stiglitz is sceptical about the social value of HFT, arguing that it is mostly a zero sum game or, “more accurately, a negative sum game because it costs real resources to win this game.”
Gains to one party, he says, come at the expense of money that would otherwise have gone to others.
On the claimed benefits of HFT for price discovery, Stiglitz makes the obvious point that faster price discovery, or even more price discovery, doesn’t necessarily produce a benefit and even if it did the costs associated with a slight improvement in information might outweigh the benefits.
Moreover, while there might be quite high private returns from obtaining information before someone else there might be little or no social value.
“The private return can increase, at least in part, from taking rents that would otherwise accrue to others. And because the private return can exceed the social return, there will be excessive investment in the speed of acquisition of information,” he said.
He argued that if sophisticated players could devise algorithms that extracted information from patterns of trade it could be profitable, but their profits would come at the expense of someone who may have spent resources to obtain information about the real economy.
The players, he said, could be thought of as “stealing the information rents” of those who invested in information, reducing the returns for that investment and leading to a less-informed market.
“Moreover, fear that the benefits of their research will be stolen through what many might call sophisticated front-running induces those engaged in fundamental research to turn away from markets to dark pools. Society loses the advantage of transparent markets and these dark pools may also be subjected to market manipulation.”
On liquidity, Stiglitz says that just because there is more trading it doesn’t necessarily mean that there is more liquidity -- if HFT generates more volatility at the point in which an investor wants to sell then it results in less liquidity “in a relevant sense” -- from the viewpoint of an informed investor rather than a trader.
Stiglitz raises the prospect of imposing a tax on high-frequency trading, arguing that less active markets could not only be safer markets but better service the societal functions they were intended to service.
The Australian Securities and Investments Commission has referred to the potential for investors to lose faith and confidence in the market, discouraging “real” buyers and turning the markets in traders’ markets rather than serving the real economy.
In the wake of the controversy ignited by Lewis’ book there was a fascinating insight into the mindset of HFT traders provided by a local trader.
“I don't see why the mums' and dads' long-term investment strategy should necessarily take precedence over someone else's short-term strategy,” the trader said to Fairfax Media.
“If HFTs are playing by the rules, then I don't see what the problem is. If you don't like the rules, take up the fight with whoever made them.
“To label one kind of participant as unethical -- because they are smarter and faster than you -- smacks of sour grapes.”
There are at least two major flaws with that thinking. Markets are there to raise long-term capital efficiently. Short-term trading is supposed to be an overlay that provides extra liquidity, price discovery and efficiency. It isn’t supposed to be the dominant source of activity -- the interests of “real” investors have to be prioritised over pure traders.
HFT traders might be faster (thanks to their ability to gain transaction speed advantages over investors by co-locating, at a cost, their “pipes” with securities exchanges) but front-running real investors doesn’t make them smarter.
There are a lot of people concerned about HFT, albeit that the issue is one that is, because of the multi-exchange structure of the US market and different market practices, of greater consequence in the US than here.
Whether it’s via taxation or by slowing down the rate at which high-frequency trading can be executed (taxation would probably be more effective in achieving the desired result) some policy reforms that reverse the shift by institutional investors away from lit markets to dark pools and reassures retail investors that the playing field isn’t tilted away from them -- that they aren’t being ripped off by parasitical activity -- is worthy of serious consideration.
The Stiglitz speech is a reminder that there is a fundamental social purpose to markets which has little to do with the intermediaries who seek to generate private profit from trading within them.
Click here to read Joseph Stiglitz' full presentation.