If you read one business book this year, make it “Flash Boys” by Michael Lewis. The journalist famous for “Moneyball” and “The Big Short” takes readers inside the parasitic world of high-frequency trading that may be harming the broader economy.
Lewis’s book is as much a tale of finance as of technology. Indeed, the digital architecture of high frequency trading is right out of a sci-fi movie – the schemes rely on algorithms that seem almost artificially intelligent and the velocity of transaction signals approaches light speed. It involves everything from super-fast fiber optic cable, to microwave towers to lasers.
As Lewis recounts, all that technological wizardry is marshaled not to build tangible assets or value, but instead to create a kind of momentary information asymmetry that stock exchanges were originally created to prevent. Those exchanges were created, in part, to standardize stock transactions and provide a third-party validator of stock data (prices, data, etc.) so that buyers and sellers could conduct business on a level informational playing field. Now, though, high-frequency trading lets insiders get price and securities order information before everyone else and then use that information to extract wealth from the larger market.
The good news is that there are straightforward ways to combat some of this. Smart regulations can curtail some abuses and a financial transaction tax can at once raise public resources and disincentivize devious practices. The even better news is that the very technological revolution happening in the financial world may be making such ideas more economically viable than ever.
Before getting to that change, consider the basics of the tax proposal, which is gaining momentum and receiving support even from some financial industry professionals. The idea is that if a tiny fee is slapped on securities transactions – say, a cent – the tax will barely affect the average investor but will force high-frequency, high-volume traders to pay a lot. Consequently, those predators might see less of an upside from – or even abandon – their market rigging schemes. And if they don’t, then at least the government will generate lots of new resources to enforce laws that might protect average investors from the most egregious stuff like front running and outright market manipulation.
Of course, when this idea has gained steam before, it has been deflated by corporate groups and financial-industry-funded politicians. Rather than simply admit they oppose the levy because it might mean less cash for speculators, they typically argue in public that the tax would prompt stock exchanges to move to jurisdictions that don’t impose such a levy. In this tale, the city, state or country that creates a transaction tax won’t stop high-frequency trading – it will only be hurting itself by driving financial business to another locale.
On its face, it is a powerful argument – so powerful, in fact, that when Chicago’s municipal government recently considered a financial transaction tax, the proposal was quickly dismissed. The Illinois legislature then gave the Chicago Mercantile Exchange an $85 million tax cut when executives threatened to move the company out of state.
No doubt, fear of such flight seems logical. Essentially, tax opponents ask us to assume that in the Internet era, stock exchanges – like many other information-sector enterprises – are no longer moored to specific geographies because they can supposedly conduct business through any digital conduit.
But that’s where the aforementioned technological change has created a flaw in the old logic.
In a financial world where microseconds are now king, all conduits are not created equal and average Internet velocity may no longer be enough for the big players. That reality potentially reduces some of the industry’s geographic mobility. Why? Because while speculators themselves no longer need to physically be on specific trading room floors, they do need their computers to either be physically near those exchanges’ computers or hooked up to them through special ultra-fast conduits.
Additionally, the newly computerized exchanges need ever-more massive data centers and conduits to process the accelerating information flow. And with so many players constructing their infrastructure around the existing trading network’s overall geography, it is more difficult for one player to unilaterally move.
All of that technology requires huge capital investments by financial firms – as one financial exec told the Chicago Tribune, it “cost(s) a lot of money and cuts into our profit margins.” And here’s the thing: those expenditures are often buying immobile digital infrastructure that relies on perfectly straight lines between key locations.
Thus, until ultra-fast technology goes truly mobile (perhaps in the future with drones), it may now be prohibitively expensive and/or logistically difficult for financial firms to simply pick up and move if they don’t like a particular public policy in a given state or city. Just like, say, petroleum companies are captive to oil-rich locales, parts of the financial world are far more captive to the locales in which they’ve built their expensive digital infrastructure.
Sure, unlike an oil company that must operate where the petroleum reserves are, financial firms probably can still move if they really needed to – that is to say, while an oil company cannot magically create oil in a new place, the financial sector can with enough money build new conduits, construct new data centers, etc. And sure, if leaned on hard enough, some of them might actually choose to do just that.
But it is no longer as logistically easy or financially smart for them to do that on a whim. The cost of doing so is now much higher, meaning they probably have to tolerate the kinds of modest policies they used to be able to easily flee (or at least convincingly threaten to flee) – stuff like, say, a one cent tax that they don’t like, but can certainly live with.
This is the silver-lining of speed-driven finance. Simply put, the federal, state and local governments that host the financial industry have more leverage because they don’t have to so completely fear the industry’s threats to leave. In other words, they can now consider the macroeconomic merits of something like a financial transaction tax, without having to fear the industry’s threats of retribution.
The big question, then, is political: Will those governments consider using this new leverage? Or will they still do almost nothing to protect the average investor?