Failure of convergence to social optimum in high frequency trading with technological speed-up
Possible market failures in high-frequency trading are of course a hot topic recently with various widely published Flash Crashes. There has a loud call for a reign in of high frequency trading and several bodies are moving towards heavier regulation. But it is not immediately clear whether or not high-frequency trading firms are a net cost to society. For instance, it is sometimes argued that High-Frequency trading firms as simply very fast market makers. One would want a precise analytical argument for a market failure.
There are two features that make this kind of market failure work: the first is a first-mover advantage in arbitrage, the second is the possibility of high-frequency trading firms to invest in capital, technology, or labor that increases their effective trading speed.
The argument runs as follows.
Suppose we have a market without any fast traders. There are many arbitrage opportunities open for very fast traders. This inaccurate pricing inflicts a dead-weight loss D on total production P. The net production N equals P-D. Now a group of fast traders enter the market. At first they provide for arbitrage which gives more accurate pricing and net production rises to N=P.
Fast traders gain control of a part of the total production S. However there is a first-mover advantage in arbitrage so any firm will want to invest in technology, labor, capital that will speed up their ability to engage in arbitrage. This is a completely unbounded process, meaning that trading firms are incentived to trade faster and faster beyond what is beneficial to real production. There is a race to the bottom phenomenon. In the end a part A of S is invested in ‘completely useless’ technology, capital and labor. The new net production is N=P-A and the market does not achieve a locally maximal Pareto efficient outcome.
As an example suppose the real economy R consults market prices every minute. Trading firms invest in technology, labor and capital and eventually reach perfect arbitrage within one minute of any real market movement or consult (so this includes any new market information, consults by real firms etc). At this point the real economy R clearly benefits from more accurate pricing. But any one trading firm is incentivized to be faster than the competition. By investing in tech, capital, suppose trading firms can achieve perfect arbitrage within 10 microseconds of any real market movement. This clearly does not help the real economy R in achieving any higher production at all since it does not consult the market more than once every minute but there is a large attached cost.
Failure of convergence to social optimum in high frequency trading with technological speed-up
Possible market failures in high-frequency trading are of course a hot topic recently with various widely published Flash Crashes. There has a loud call for a reign in of high frequency trading and several bodies are moving towards heavier regulation. But it is not immediately clear whether or not high-frequency trading firms are a net cost to society. For instance, it is sometimes argued that High-Frequency trading firms as simply very fast market makers. One would want a precise analytical argument for a market failure.
There are two features that make this kind of market failure work: the first is a first-mover advantage in arbitrage, the second is the possibility of high-frequency trading firms to invest in capital, technology, or labor that increases their effective trading speed.
The argument runs as follows.
Suppose we have a market without any fast traders. There are many arbitrage opportunities open for very fast traders. This inaccurate pricing inflicts a dead-weight loss D on total production P. The net production N equals P-D. Now a group of fast traders enter the market. At first they provide for arbitrage which gives more accurate pricing and net production rises to N=P.
Fast traders gain control of a part of the total production S. However there is a first-mover advantage in arbitrage so any firm will want to invest in technology, labor, capital that will speed up their ability to engage in arbitrage. This is a completely unbounded process, meaning that trading firms are incentived to trade faster and faster beyond what is beneficial to real production. There is a race to the bottom phenomenon. In the end a part A of S is invested in ‘completely useless’ technology, capital and labor. The new net production is N=P-A and the market does not achieve a locally maximal Pareto efficient outcome.
As an example suppose the real economy R consults market prices every minute. Trading firms invest in technology, labor and capital and eventually reach perfect arbitrage within one minute of any real market movement or consult (so this includes any new market information, consults by real firms etc). At this point the real economy R clearly benefits from more accurate pricing. But any one trading firm is incentivized to be faster than the competition. By investing in tech, capital, suppose trading firms can achieve perfect arbitrage within 10 microseconds of any real market movement. This clearly does not help the real economy R in achieving any higher production at all since it does not consult the market more than once every minute but there is a large attached cost.