We're in the middle of one of the not uncommon populist shouting matches over the practices of Wall Street. This time it's about high frequency trading (sometimes called arbitrage trading). The real question is what is the problem with high frequency trading to which the answer has to be "nothing".
What might indeed be a problem is something associated, but which is not in fact high frequency trading, something called flash trading. What seems to be causing confusion is the way in which the two practices are assumed to be the same.
Even the New York Times manages to conflate the two:
It is the hot new thing on Wall Street, a way for a handful of traders to master the stock market, peek at investors’ orders and, critics say, even subtly manipulate share prices.
It is called high-frequency trading — and it is suddenly one of the most talked-about and mysterious forces in the markets.
That peek at other trader's order is "flash trading". There are good arguments for allowing it and other good arguments against allowing it. The most important (and for myself, conclusive) argument against it is that it allows front-running. That is, allows traders to trade in a stock fractionally before they know that someone else is going to, thus profiting from their insider's knowledge of the upcoming trade. In every other area of the markets we declare this front-running to be verboten so probably should here as well. The arguments in favor of it seem much less robust.
However, that has nothing to do with high frequency or arbitrage trading. There is confusion about the fact that both rely upon high speed computing: that's really all they have in common. The Wall Street Journal gives a reasonable definition of what this actually is:
Definitions differ, but at its most basic, high-frequency trading implies speed: Using supercomputers, firms make trades in a matter of microseconds, or one-millionth of a second. Goals vary. Some trading firms try to catch fleeting moves in everything from stocks to currencies to commodities. They hunt for "signals," such as the movement of interest rates, that indicate which way parts of the market may move in short periods. Some try to find ways to take advantage of subtle quirks in the infrastructure of trading.
Rather than this "high speed trading" moniker we'd do better to use the "arbitrage trading" one for that's what this really is, a class of arbitrage. And we're very much in favor of arbitrage.
Economists have something they call the "law of one price". We expect the price of something to be the same everywhere (OK, there are lots of caveats here, we're going to ignore transport and transaction costs, taxes, other things that we can see will change them, but the law is a general observation). For if it isn't the same everywhere then someone will buy the whatever it is in one market and sell in another thus reaping a profit. Now we're not in fact assuming that magically because people can make a profit by doing so that prices will thus converge. Someone has to be actually doing such buying and selling to make it happen. Someone has to be buying in the "cheap" market and selling in the expensive one, driving up one price and down the other until they are the same.
This whole process is called "arbitrage". It's been around for eons: Roman emperors buying cheap grain in Egypt and selling it in high priced Italy could be said to have been involved in arbitrage. A huge amount of foreign exchange trading today is arbitrage. Buying a stock on the London Stock Exchange and selling it on the NYSE to make a profit if the prices diverge is also arbitrage. (There is also time arbitrage, buying now to sell later, but that is better described as speculation. "Pure" arbitrage involves buying and selling in two different markets simultaneously.)
High speed trading is simply a subset of this arbitrage: using very high speed computers to do the buying and selling, faster than any human could hope to. In fact, so fast are these trades that the speed of light becomes something of a limiting factor. No, really: those with computers closer to the main stock exchange computers do better than those with theirs further away. The speed at which the information flows over the internet becomes a factor in determining how well it all works. That will indeed privilege the bigger players, who can afford to pay for their servers to get prime position but so what?
It's also true that high frequency trading is a very large portion of stock market trades:
The article presents a very valuable perspective on just why HFT is so critical these days, especially when cash traders go for 6 hour Starbucks breaks between 10 am and 3:30 pm: "high frequency trading firms, which represent approximately 2% of the 20,000 or so trading firms operating in the US markets today, account for 73% of all US equity trading volume.
Those numbers look a little high but certainly 40-50% of total trades could be involved. This however is nonsense:
These companies include proprietary trading desks for a small number of major investment banks, less than 100 of the most sophisticated hedge funds and hundreds of the most secretive prop shops, all of which operate with one thing in mind—capture profit opportunities by being smarter and faster than the closest competition." And as the market keeps going up day in and day out, regardless of the deteriorating economic conditions, it is just these HFT's that determine the overall market direction, usually without fundamental or technical reason. And based on a few lines of code, retail investors get suckered into a rising market that has nothing to do with green shoots or some Chinese firms buying a few hundred extra Intel servers: HFTs are merely perpetuating the same ponzi market mythology last seen in the Madoff case, but on a massively larger scale.
There is absolutely nothing about high frequency trading or any other form of arbitrage which will lead to a rising (or falling) market. The aim of, the very point of, arbitrage is to take advantage of pricing mismatches: which means both buying and selling. Such net neutral (ie, at the end of the process no one owns any more or any less of the basic security) transactions will not affect the level of the market. They'll affect turnover but not the price index. If I buy (yes, I know this cannot happen, this is an example only) one share of IBM on the NYSE for $100 and sell it immediately on the ASE for $100 1/2 then I have arbitraged between the two stock markets. I've moved the NYSE price up a fraction, the ASE price down a fraction (increased demand in one, increased supply in the other) and thus moved the financial markets a little bit closer to the law of one price. But I've not moved the markets as a whole either up or down. I've simply exploited an inefficiency in the markets and by doing so made them that little bit more efficient. That's what arbitrage is and why we like people doing it.
As to the level of trades that are the high frequency kind: well, all of the secondary markets (that is, everything except the issuance of new stock) are forms of speculation: to worry about one specific kind of it seems odd.
Flash trading, as is described here, is a different matter.
Our real problem here is that even the financial experts (the NYT, in so far as they are, Zero Hedge and others) are conflating two entirely different things, high speed and flash trading. Because they both use high speed computers so they must be the same, right? When in fact they are simply new ways to do old things with high speed computers. Flash trading is front-running and we've made that illegal if you don't use computers. So we probably should get rid of it if you do. High speed or arbitrage trading we like, for it makes markets more efficient, as do all other forms of arbitrage. So, given that it is legal without computers it should be with as well.
We're not doing ourselves any favors by conflating the two very different things. We would of course hope that the professionals, the bureaucrats, at the SEC would know the difference but:
The Securities and Exchange Commission has proposed halting high frequency and flash trading.
No, sadly not. Which tells us perhaps more than we wanted to know about the quality of regulation of the markets.
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