In defence of high frequency trading

By Tim Worstall , written on March 27, 2014

From The News Desk

Much is made of the evils of high frequency trading over in the financial markets. It's an unproductive use of capital, poses risks to the economy as in the " flash crash" or even the Great Recession -- and why should people be getting rich just trading pieces of paper? There's even a proposal for a tax to make HFT unprofitable and thus close it down.

I will admit I suspect most of the ire around HFT is motivated by the fact that it's something that's mostly done by guys, with money, in offices, and so is obviously inherently evil. But that is just an opinion.

However, there's an interesting paper that tries to look at the actual effects of high frequency trading in the round. It doesn't shy away from the idea that HFT could be dangerous but it also points out the two great things that it actually does do. The first is that it makes trading cheaper for everyone else: this does mean that everyone buying stocks for their IRA will end up with a larger (even if only slightly so) pension. And the second is that it coordinates prices across markets, something we devoutly desire to happen.

The paper is here and this is the meat of it:

In this paper, using a special dataset supplied by NASDAQ, I present evidence that HFT synchronizes security prices in financial markets. By `synchronize', I mean the following, to the extent that two securities are related to one another, HFT activity ensures that a price change in the first security coincides nearly instantaneously with a similar price change in the second security. Synchronization is a gargantuan task[21] tailor-made for HFT: it is profitable for the firms that do it and can only be done with high-speed computerized trade.
Imagine a change in the price of sugar (or, in the US, high fructose corn syrup) over on the commodity markets. This will have an effect on the value of the stock of the Coca Cola Corporation. We would thus expect people to buy or sell Coke stock on the basis of what they think the change in the sugar price will mean for the company. This is plain old arbitrage and it's been going on for a very long time. And it is the very action of people buying and selling that brings the two prices into order, one with the other, the sugar price with the Coke price.

Our mooted change in the sugar price will also affect the Pepsi share price. And of whoever makes Coco Pops, the vital jelly supplies for a PBJ, Lifesavers and anything else that uses sugar. As I say, it's long happened that people have arbitraged across markets. What makes HFT different is that it's now reached the speed and complexity to allow arbitrage across the same market. There are people watching the relationship between all of those different sugar consumers so the price of Pepsi, Coke, Lifesavers and so on now moves in near lockstep. Which is, as I say, something that we want to happen.

As Hayek pointed out the only calculating engine we've got that can make sense of the economy is that market and those prices. We're still generations away from having any information source that allows us top plan in detail. so therefore we'd rather like that necessary information about changes in relative prices to flow through as quickly as possible.

I will admit to a certain wry amusement here as well. Those who argue against HFT do tend to be the sort of people who prefer well planned things to the chaos of markets. Yet the only manner we could ever achieve of having an information system that would allow us to plan an economy would be one in which we had real time information on all of the connected relationships between prices across the economy.

In effect, the only planning machine possible would be one in which all prices, all commodities, had large amounts of high frequency trading going on in them. Or, and this is what provides the amusement, HFT is in fact baby steps on the road to our actually being able to plan the economy.

[Photo by Emmanuel Huybrechts]