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July 30, 2009

Cost/Benefit of High-Frequency Trading

On Marginal Revolution, Tyler Cowen discusses high-frequency trading and gets to the nub of the issue:

The philosophical question is why it might possibly be beneficial to have market prices adjust within five seconds rather than within fifteen. One second rather than five? 0.25 rather than one?

Of course, it's an economic question, not just philosophy. A commenter named "a student of economics" argues persuasively that there is in fact no benefit at these short time scales:

The social benefit is the net present value of having "accurate" prices a few fractions of a second earlier. This benefit is a function of the discount rate, which is customarily expressed in annual terms, and the value of the changes in decision-making that might result under the new, more "accurate" prices.

I submit that the social benefit is trivial.

The private benefit is in the billions, but that is almost 100% rent-seeking. It is gained almost entirely at the expense of another party who's computer or trading algorithm might be fractionally slower.

This is an nice example of almost pure rent-dissipation. It's a case where the invisible hand of the market does more harm than good, by directing enormous capital resources and some of our most brilliant minds toward an activity that creates essentially zero value.

We should set up the rules of the game to maximize incentives for value creation and minimize incentives for rent dissipation. That suggests banning or heavily taxing HFT.

Rather than banning or taxing, we could adopt market rules that eliminate the benefit of HFT, as in the discrete-time trading scheme (one-second call markets) advocated in my previous post.

Posted by wellman at July 30, 2009 01:54 PM

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