This article from today's paper is about Thomas Peterffy, chief executive of Interactive Brokers, and one of the inventors of high frequency trading. Now he's turned against the practice which he helped invent, and says it's bad for the market. (It also hurts his business.) He blames high frequency trading for the flash crash of May 2010, when the market dropped by 1,000 (10%) points before rebounding a few minutes later.
There is an orthodoxy that practices like high frequency trading make markets more efficient through an arbitrage mechanism. As traders exploit inefficiencies to make a profit, they tend to squeeze those inefficiencies out of the market, thus making trading more efficient (cheaper) for everyone else.
But I wonder...
Transaction costs in the stock market have been dropping for decades. Technology enables huge numbers of shares to be bought and sold with very little human intervention--cheaply. Over the years this has caused the loss of lots of middle-class Wall Street jobs. But this has been the way of the world at least since the industrial revolution.
But at the same time, a small number of people have enriched themselves to an unprecedented degree by exploiting every informational and technological advantage they could find. From big trading desks at companies like Goldman Sachs whose alumni staff the Fed and the Treasury Department, to hedge funds which somehow in an "efficient market" are able to charge many times more than what the average mutual fund manager charges --because their rich clients must believe they know something or someone that no one else does-- to high frequency traders, who somehow manage to turn a profit just by trading faster than anyone else.
It seems to me that if Wall Street is fatter than ever (in absolute terms, and as a percentage of GDP), then markets must be less efficient than ever--because after all, Wall Street is just a middle man between savers and borrowers. The less money the middle man gets, the more efficient the market is, right? Is "market efficiency" just a shibboleth that those who exploit an unfair advantage utter to defend their racket?
It's not really a mystery how high frequency traders make money. They act as "market makers", taking the opposite side of the trade for all who are ready to buy or sell, as long as you're willing to accept their spread, which is a market maker's legitimate source of profit. Market makers provide a service; they are always there if you need to sell quickly to raise cash. They earn a spread in return for taking the risk that they will get stuck with a toxic inventory of plummeting stock.
But in most markets, at least traditionally, market makers are regulated, and expected to step up as buyers of last resort in times of market stress. As I read, high frequency traders are different because they stop trading and leave the market as soon as conditions get rocky. So they really are not market makers in the traditional sense. They make a market when it suits them, then step away when it doesn't. This might be OK if they were small players, but high frequency trading is now over 50% of U.S. equity volume. So they have an undue influence on the equity markets, and contribute nothing but this so-called "market efficiency" which mysteriously manages to produce more super wealthy individuals than ever before.
There are various ways to deal with this problem. Thomas Peterffy proposes putting a 1/10 second delay on all exchange orders, which would eliminate the high-frequency houses' speed advantage, and stop their orders from getting in front of legitimate regulated market makers' orders (like Interactive Brokers).
Another solution that occurs to me is to raise transaction costs by imposing a modest tax on each trade. Those off us who buy shares because we actually want to have them will hardly notice. But those who churn the market for profit will have to slow down. And the tax could be used for something good, like fighting off bank lobbyists and splitting up some of the big players, so they have less influence and pose less systemic risk.
But I think the best solution is for the SEC to simply do its job. If you are pumping thousands of trades through the market each day, then you are a de facto market maker, and need to be regulated as such. The SEC's mandate is to ensure fair and orderly markets. If certain players are making profits through activities which destabilize markets and create more risk all around, then they need to be warned, and then banned from the markets if they continue.
Another solution that occurs to me is to raise transaction costs by imposing a modest tax on each trade. Those off us who buy shares because we actually want to have them will hardly notice. But those who churn the market for profit will have to slow down. And the tax could be used for something good, like fighting off bank lobbyists and splitting up some of the big players, so they have less influence and pose less systemic risk.
But I think the best solution is for the SEC to simply do its job. If you are pumping thousands of trades through the market each day, then you are a de facto market maker, and need to be regulated as such. The SEC's mandate is to ensure fair and orderly markets. If certain players are making profits through activities which destabilize markets and create more risk all around, then they need to be warned, and then banned from the markets if they continue.
To my loyal readers, I apologize for the 17 days that have passed since my last post. After a wonderful, though truncated visit to the island of Shikoku, Japan, I am now gainfully employed which is interesting, but makes out-sized claims on my time.
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