There's really two sets of opinions on high frequency trading these days. To some it's the very devil himself and must therefore be strongly regulated if not out and out banned. To others, like myself, it's just the latest form of arbitrage and it will soon enough settle down into being just a normal feature of the markets. With, as it does so, a reduction in costs to all market traders as the increased liquidity reduces the spread. There's an interesting paper just been published which leads to the thought that that "soon enough" is almost here already. For reasons that Adam Smith would have happily pointed out himself.
Here's a report on the paper:
High-frequency traders treat the latest economic reports like predators stalking their prey, pouncing in tiny fractions of a second to buy or sell according to whether it was good news or bad.
For all the preparation and high technology, a new academic paper suggests they’re not minting money.
Emory University researchers examined how much the fastest firms earn with two key financial products in the moments after major U.S. economic data comes out. In aggregate, algorithmic traders made about $24,000 per event with the SPDR S&P 500 ETF Trust and $75,000 with E-mini S&P 500 futures contracts, the academics found.
Note that that's not per trader, or even per trade, on such information releases. That's the total profits accruing to all HFT activity over those information releases. From the paper itself we also get this:
Our findings are consistent with increasing competition over time among high speed market participants. In particular, aggregate profits for the S&P500 ETF fall from $43,000 per event in 2011, to $22,000 in 2012, and further to $5,600 in 2013. The corresponding profits in the E-mini futures are $172,000, $78,000 and $22,500.
Note again, that's "aggregate" profits. That's everyone lumped together.
And it's that fall in those aggregate profits that Adam Smith would have recognised. Indeed he explained exactly how it happened. Start with the basic observation that capitalists are greedy. They like to make profits and the larger the profits the happier they are. Assume also that they are observant: they look around the world to see who is making profits doing what. So, if they see someone making above normal profits they'll investigate. What is it that they're doing which is making those lovely profits? Further, if they can work out what it is then they'll go and do some of that themselves.
So, what happens is that as people work out new ways to make profits then other people come into the same market and do much the same thing. This is great for us, even if not so great for the people who found out this new method originally. For the profits, as more people enter the market, get competed away. Capital has moved from other activities to this new one and in the process the competition has reduced those above normal profits. The end stage will be when profits in this new thing are the same rate as they are everywhere else in the economy. At which point all the capitalists are off looking for the next new big thing.
Us consumers meanwhile get to enjoy the benefits of whatever is produced by that new method. It's pretty obvious when we talk about the iPhone what that is: the competition has meant that we can now get perfectly acceptable landfill Android for $30 a pop. With HFT it's a little more obscure but still knowable. More traders trading means more liquidity. They're actually the same phrase. And it's a standard of markets that the more liquidity there is the lower the spreads are. That is, the difference between what you can buy at and sell at compresses the more people are trading more things in that market. So, more HFT in the stock market leads to a smaller gap between the bid and ask, the spread. This means that when we go and buy stock to put into our 401 (k) we're leaving less money with Wall Street for the joy of being able to purchase stock. We're made better off by that HFT as a result.
Which brings us to the possibility of regulation of HFT. Obviously, if we consumers are benefiting then there's no grounds there. But there could be if HFT is exploiting some unfairness, extracting some rent. The usual signal for that is that the HFT companies are making excess (ie, above normal) profits. But as we can see profits are being very swiftly competed away. So, there's no maintainable rent being collected, consumers are better off: don't regulate HFT.
