High-Frequency Trading: Where’s the Benefit to Society?

Three and a half years have passed since the afternoon when the stock markets went into a trillion-dollar free fall and just as suddenly reversed course, recovering 80 percent of the loss. It all happened in less than 45 minutes.

The “Flash Crash” of May 6, 2010, was the unintended result of high-frequency trading (or HFT), in which heavy-duty computers execute sophisticated trading strategies in millionths-of-a-second time frames. HFT has been the source of many smaller crashes and other mishaps, occasionally shutting down trading venues and even putting firms out of business. Yet the practice continues to grow, while the transaction times get shorter and shorter.

A few weeks ago, the Commodity Futures Trading Commission, which has jurisdiction over almost all derivatives markets under the Dodd-Frank financial reform law, published a paper evaluating various “kill switches” that might contain the damage when the machines go haywire again.

When, not if, because, as the CFTC’s Concept Release points out, HFT trader bots now control more than 90 percent of all exchange-traded derivatives – the “financial instruments of mass destruction” that Warren Buffett warned about, five years before the 2008 crash proved him right. In other words, we have reached the point in the sci-fi movies when the machines truly take command of the nuclear arsenal.

So it is time to ask a few basic questions about HFT. Starting with: What good is it? How does society benefit when we reduce the average trade-completion time from, say, 125 milliseconds to 5 milliseconds?

By society, I do not mean a single financial institution or even the entire financial sector. The increasing speed of transactions is driven by competition among trading firms. Speed is crucial to any trader’s ability to act before other traders do. But no one has identified an advantage to the overall functioning of the markets or the wider economy when traders get sucked into an “arms race” of escalating speed and automation. In fact, even the most passionate HFT advocates would largely agree that the public ceased to benefit several developmental stages ago.

The case for this type of trading rests on the premise that it lubricates the markets by adding more “liquidity.” A liquid market, however, is characterized by plentiful and reliable offers to both buy and sell; it must be balanced, since the market crashes if everyone wants to sell at once.

No doubt, HFT increases volume by allowing transactions to be made and reversed with blinding speed. But volume and liquidity are very different. In markets dominated by HFT, new information stimulates the trading algorithms of multiple firms, which behave like herds of impala stampeding across the Serengeti, this way and that. Prices jump up and down until the pointless activity peters out. The Flash Crash was no more than an extreme example of what goes on day in and day out in today’s markets.

HFT traders often do supply executable price quotes, which superficially increase liquidity. True liquidity, however, comes when offers can be relied upon, allowing investors to predict whether the transactions they seek can be completed within their preferred price range. Because HFT traders can morph from providers to consumers of liquidity whenever the herd abruptly shifts from buy to sell, they create uncertainty rather than predictability.

Ultimately, the diminished reliability of the financial markets is a burden on businesses and governments that seek to raise capital. By inducing short-swing market volatility, HFT traders make money from each other, but also from investors. Investors pass the cost of uncertainty on to businesses and governments, burdening their productive activities. Thus, the public pays for the non-productive churning of securities and derivatives markets by HFT traders.

The goal of each trading firm is to profit from the ability to perceive and act on information more quickly and accurately than others do. But there is no rule of nature or humanity which dictates that a spiral of such advantages must translate into improved intermediation of capital between investors and those seeking investment. Indeed, HFT has made the markets less efficient, by making them more volatile. Since investors must price this added unreliability into their decisions, raising capital for productive purposes becomes costlier, and the extra cost is passed on to the rest of us as consumers and taxpayers.

In fairness to the CFTC, it was not asked to decide whether HFT actually serves any valid purpose. Yet the whole premise of its Concept Release is that such trading creates new and serious risks. Surely there should be some compensating benefit to justify those risks. The Concept Release does not attempt to identify any such benefit.

Regulators have been hesitant to slow traders down, in part because doing so might be seen as stifling innovation. But HFT is not innovation in any real sense; it is just the accumulation of computing capacity and efficient wiring into the exchanges, with software that simply encodes trading strategies that have been around for years.

Unfortunately, businesses that can afford to compete by trading at nanosecond speed also have the wherewithal to exert tremendous influence in Washington. The big financial firms will use this influence to protect HFT because it gives them advantages in the markets and the ability to extract ever more value from the real economy. There has been plenty of conversation about HFT by lawmakers and regulators. Identifying ways to manage the risks is laudable, though it is far from clear how effective such techniques will really be. In any case, Washington needs to go further, and muster the independence to put some meaningful speed bumps in place to slow the bots down to a really safe speed.

— Wallace Turbeville

Wallace Turbeville is a former vice president of Goldman Sachs, a fellow at Demos and a member of the derivatives task force of Americans for Financial Reform.

Originally published on USNews.com


The Financial Sector Has Become an Engine of Inequality

The past three decades have been a period of explosive growth for Wall Street and the financial industry. Meanwhile, a tiny slice of the population has claimed an ever-bigger share of this country’s economic rewards. The highest-earning one percent of Americans collected roughly 20 percent of total income last year; the top .01 percent not enough people to fill a football stadiumhad 5.5 percent of the income.

Could there be a connection here? Could our booming financial sector, which now generates an astonishing 30 percent of all corporate profits (more than double the figure of thirty years ago), help explain America’s rapid ascent to the highest level of economic inequality since the eve of the Great Depression, and the highest of any of the world’s rich nations? A growing number of economists and other authorities think the first trend may have more than a little something to do with the second.

The economic and political establishments long ago settled on a theory of rising inequality: technology and globalization, they told us, were carving a rift through the American labor force between those with and without the right kind of education and know-how. This idea was criticized from the start for ignoring a formidable corporate campaign to rewrite the rules of the U.S. economy at workers’ expense, and over time it has increasingly failed to account for the reality of who is getting ahead and who is falling behind.

In his 1991 book “The Work of Nations,” former (then future) Labor Secretary Robert Reich embraced a version of the “skills-gap” story. But in his recent film “Inequality for All,” Reich has more to say about discrepancies of power than of skill.

The longer this trend continues, in fact, the more it resembles the Occupy Movement’s picture of a soaring 1 percent and a lagging 99 percent. Out of every dollar of income growth between 1976 and 2007, the richest one percent of U.S. households collected 58 cents; and after taking a big hit in the financial crisis, they were soon back on track, capturing an extraordinary 95 percent of all the income gains between 2009 and 2012. To put it more plainly, since the beginning of the current economic “recovery,” the top 1 percent (who make upwards of $400,000 a year in household income) are pretty much the only ones who have recovered.

Within that small subset of Americans, executives, traders, fund managers and others associated with the financial sector loom large, comprising about a seventh of the one-percenters and accounting for about one fourth of their income gains over the past thirty-plus years. That’s not counting the many lawyers and consultants with financial sector clientele, or the growing number of executives of nonfinancial companies who seem to make most of their money these days through stock options and short-term financial plays. Together, corporate executives and financial sector employees account for well over half the post-1980 income growth of the top 1 percent and more than two-thirds of the even more remarkable gains of the top 0.1 percent.

Pinpointing the causes of an economic trend is a hard business. But there is global as well as historical evidence for a link between financial sector expansion and rising inequality. Studies of rich and relatively poor nations alike suggest that inequality goes up when societies tie their fortunes to a free-wheeling financial industry and the easy flow of global capital. There is also substantial research to suggest that much of the financial sector’s recent growth has come by extracting wealth from other areas of the economy, not by spurring innovation and opportunity for the society at large.

Several recent studies trace the industry’s pay-and-profit surge mostly to its success in the political and regulatory arenas. See, for example, this paper by Thomas Philippon and Ariell Reshef of New York University and the University of Virginia, who attribute between 30 and 50 percent of the financial sector’s recent gains to economic “rents.” That’s basically a polite way of describing the ability of many of today’s financial heavyweights to use their market clout, their inside knowledge and various explicit and implicit taxpayer subsidies to make money out of thin air.

Banking and finance were not always a road to fabulous riches in this country. As recently as the early 1980s – and throughout much of the 20th century – there was almost no pay differential between financial and non-financial professionals. Today, by contrast, financial workers make about 1.83 times as much as other white-collar workers. You’d have to go back to the Roaring Twenties, at the tail end of America’s original Gilded Age, to find another period when financial sector incomes and profits reached such conspicuous heights. That should tell us something.

In any case, these are pivotal questions for the country – and unavoidable questions for those seeking a path toward what President Obama has been calling a “middle-out” rather than a top-down economy. Broad prosperity, the president says, calls for greater public investment in education, infrastructure and other long-term needs, and for higher taxes on the wealthy to help pay for such things. That may be a worthy agenda. It has certainly proved to be a politically difficult agenda. But in a country that has let its financial sector become an engine of inequality, more will be required.

If we believe in our founding ideal of America as a land where children should start off on roughly the same footing regardless of history or ancestry, we will all have to screw up our courage and refocus on (among other challenges) the unfinished work of making sure we have a financial economy that serves the real economy, not the other way around.

— Jim Lardner

Originally published on USNews.com.