Friday, July 12, 2013

High Frequency Corn Trading

High Frequency Trading (HFT). It sounds like one of the knobs on an old cabinet-style cathode ray tube television set. It isn't. It's computer-assisted finance that yields a whole bunch of tiny returns. Instead of periodically dropping a brick into your account, it sifts dust in.

Is it euvoluntary to trade for fractions of a penny on contracts that last fractions of a second?

Let's pause for a moment to remind ourselves of the function of the finance. In a fundamental sense, finance is about information. It's a way of pooling and relaying enormous amounts of distilled market signals in the form of prices, of balancing beliefs about future states of the world and permitting folks to share what they know and what they expect. When I list an IPO, investors tell me quite bluntly whether or not they think my venture is worth a tinker's damn. When I write a pork belly future contract, I lock in the sale price and let some Chicago hot-shot bear the risk that my little piggies get swine flu before the end of the season.

When I leverage the hell out of a margin call on a Russian bond spread, it's because I have fancy models that tell me there's arbitrage in them thar hills.


Okay, so finance is obviously not euvoluntary when it introduces systematic risk that snares taxpayers in its briars, but that strikes me as an error to be laid at the feet excessive latitude in constitutional interpretation. I don't know about you guys, but I've gone over the articles and despite my best efforts cannot endeavor to lay one bent knuckle on that passage which authorizes Congress the bailout authority it has so graciously endowed itself.

Recall also one of the chief pillars of economics: nothing is free. The opportunity cost of a CBOE trader is whatever else she might have done with her life, and considering that traders tend to be smart, driven folks, that cost could be high indeed. I imagine there's some costs of capital in there too for buildings and computers and all that, so let's say that's consistent with most other industries and that it's about 1/3 of total income. Good traders earn hefty returns to their efforts, and HFT is part of this environment. Still, this doesn't tell us whether or not there's any residual value captured on the other side of the exchange. When I buy a taco from the truck, I'm better off to the tune of [my subjective value of the taco]-[whatever else I could have spent the cash equivalent on] and Carlos is better off by [the goods he can buy with the money I hand over]-[the time, effort, and materials it took to make and sell me the taco]. BATNA disparity is at least partly driven by the comparison between these two differences. If Carlos is struggling to make ends meet and I'm a high-falutin' aristocrat, the pedestrian morality cuts against me. Contrarily, if we're back in the desert, Carlos is the one with the advantage.

The point of HFT is that neither one of us captures that much excess value per trade. My taco is microscopic and I pay Carlos fractions of a cent. Enough of these trades, and I've got a thermos of taco slurry and Carlos has a pile of zinc shavings. I fear this analogy has fallen apart.

The thing I'm asking is whether or not HFT is marginally welfare-enhancing. The opportunity cost of HFT is the old-style buy-and-hold trading and maybe some brainpower bent to writing algorithms. On this margin, is the change euvoluntary? If not, which condition is violated? If it's nothing at all, then why do I hear my favorite bellwether groaning (Planet Money) from time to time? Is there something else troubling about HFT that doesn't clearly rest on pedestrian morality? Please feel free to sound off in the comments.

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Do you have suggestions on where we could find more examples of this phenomenon?