Something I Do Not Understand About the Defenders of High-Frequency Trading in the Debate Over HFT: Friday Focus: April 11, 2014

In a rational financial market, there are four and only four reasons to trade:

1. Liquidity–moving money into and out of the market because you are saving or dissaving.
2. Rebalancing–you are bearing too much of some kind of idiosyncratic risk that you are not receiving a proper reward for, and should shed.
3. Control/incentives–the trade will produce wealth by better-aligning the incentives of agents with principals.
4. Information–you have done some research, and know something about the current configuration of what asset prices should be that Ms. Market does not (yet) know.

In a “rational” financial market without noise traders in which liquidity, rebalancing, and control/incentive traders can tag their trades, it is impossible to make money via (4). Counterparties to (4) will ask the American question: If this is a good trade for you, how can it be a good trade for me? The answer: it cannot be. And so the economy underestimates in fundamental information, and markets will be inefficient–prices will be away from fundamentals, and so bad real economic decisions will be made based on prices that are not in fact the appropriate Lagrangian-multiplier shadow values–because of free riding on the information contained in informed order flow and visible market prices.

Now comes Streetwise Professor:

Streetwise Professor: Who is the Predator, and Who Is the Prey?: “The debate over Lewis’s Flash Boys…

…is generating more informed commentary than the book itself…. One of the criticisms of HFT is that it engages in various strategies to attempt to ferret out institutional order flows…. To the extent that market makers-be they humans or machines-can get signals about the informativeness of order flow… they can adjust their quotes accordingly and mitigate adverse selection problems…. Ultimately, then, the driver of this dynamic is the informed traders. They may well be the true predators…. The prey attempt to take measures to protect themselves, and ironically are often condemned for it….

The welfare impacts of all this are unknown, and likely unknowable…. It is impossible to know how the social benefits of private information about securities values relate to the private benefits…. I cannot see any way of evaluating the welfare effects of… informed trading. The social benefits… are impossible to quantify… difficult even to identify…. It is therefore at least strongly arguable that the development of trading technologies that reduce the returns to informed trading are a good thing…. I don’t know and I am pretty sure nobody knows or even can know the answers…. Strongly moralistic treatments of HFT or any other financial market technology or structure that affects the returns to informed trading is theology, not economics/finance. Agnosticism is a defensible position. Certitude is not.

That seems to me to not compute. I would have expected Streetwise Professor to argue:

1. Neither I nor anybody else can know whether HFT is good or bad.
2. By the principle of insufficient reason, the expected social benefit of HFT is zero.
3. Computers, programmers, electricity, and sales representatives are scarce, and have a positive social product in other industries.
4. Other industries than HFT add to social welfare.
5. It would be social welfare-improving in expectation to ban HFT and force the computers, programmers, electricity, and sales representatives to go do something useful–at least until they can come up with evidence that leads us to presume that HFT adds to social welfare.

They have not done so yet. Streetwise Professor will not say: “HFT is beneficial”. The most he will say is: “Noobuuudeeenoose”.

How then does he escape the conclusion?

Particularly since I cannot figure out what HFT brings to the market. Additional investors, even uninformed investors, bring risk-bearing capacity. Additional informed traders bring information. Additional HFTs bring… what, exactly? And what is the mechanism by which people who consume resources but do not add factors of production are people we want to invite into the market?…

Perhaps it’s just me. But the argument that our problem is that we have too many informed traders in the market does not seem to me to scan…