If by some ghastly mistake I were put in charge of regulating the world's financial markets, my first order of business would be to find an organizing principle or slogan or whatever to direct my regulating. "Fairness" and "transparency" and "looking out for the little guy" seem to be popular slogans for the world's actually existing market regulators, but I think my slogan might be "the Grossman-Stiglitz paradox." This is the idea that if markets are efficient -- if market prices accurately reflect all the information in the world -- then there's no incentive for anyone to invest any time or money or effort into finding more information. And if no one goes looking for information, then there's no way for market prices to be accurate.
This is not, like, a huge thing to worry about in your everyday life, though it raises some potentially interesting questions about your index funds.1 But as a regulator I would seek ways for markets to be optimally inefficient -- that is, just inefficient enough to promote the information-gathering work that makes them efficient. And this might help organize my thoughts about insider trading, for instance, or about when activist investors should have to disclose their stakes in their target companies.2
How HFT has changed the allocation of the pie between various market professionals is hard to say. But there has been one unambiguous winner, the retail investors who trade for themselves. Their small orders are a perfect match for today's narrow bid-offer spread, small average-trade-size market. For the first time in history, Main Street might have it rigged against Wall Street.
This is obviously right, and it is my least favorite thing about high-frequency trading. Main Street are the bad guys! "Wall Street" manages your pension funds and retirement funds and mutual funds and exchange-traded funds and index funds and really all of your good funds, and may or may not be losing out from high frequency trading. (Asness thinks not, but "can't be 100% sure.") "Main Street" is "retail investors who trade for themselves," that is, wealthy hobbyists. The way the world is supposed to work is that dumb wealthy hobbyists are supposed to lose money to subsidize the normal people who invest sensibly in mutual funds.3 It's not supposed to work in reverse, where my retirement fund subsidizes your stupid hobby.
I say this not only out of self-interest,4 but also because of my organizing principle. Retail investors are dumb. I mean, fine, whatever, you're not, you're a special snowflake who consistently beats the market, but as a category, retail investors are dumb. That's why wholesalers compete to trade with retail orders: Those orders are small and uninformed and unlikely to beat the market, so trading with them is a good way to avoid being picked off. You don't want to sell stock to David Einhorn, because if he's buying then the stock is going higher and you're on the wrong side of the trade. But you should sell all the stock you can to David Einhorn's dentist.
Big, smart institutional investors, meanwhile, get a mixed bag from high-frequency trading. On the one hand, they can generally trade lots of shares quickly, and quoted spreads (that is, explicit trading costs) are very tight. On the other hand, their trades do seem to move markets more than they used to, because high-speed traders are good at reacting quickly to big orders.5
You can characterize this as front-running or phantom liquidity, or you can characterize it as HFT firms reacting quickly to avoid being picked off by informed investors at the wrong price, but the result is the same: Prices very quickly reflect information, specifically the information that there are big informed buyers in the market.
That's good! That's good. It's good for markets to be efficient. It's good for prices to reflect information. We want that. Oxford finance-physicist Austin Gerig has written about the efficiency benefits of high frequency trading, which quickly synchronizes prices to reflect new market information. My Bloomberg View colleague Mark Buchanan summarizes Gerig's research:
Ok, so HFT helps synchronization. So what? Using a standard model of financial markets, Gerig goes on to show that price synchronization is broadly good for the market, as it makes prices more accurate and thereby reduces transaction costs. Specifically, improved price accuracy leads to cost reduction because liquidity providers – market makers who stand ready to buy or sell at fixed prices at any moment – have more confidence that they won't be “picked off” or taken advantage of by someone out there who has better information. An important implication of this is that HFT is good for the average investor, as it makes real prices more apparent, and reduces the advantages of other investors with great information gathering and analyzing resources.
On the other hand, those other investors with great information lose out. Gerig:
When prices are synchronized, information diffuses rapidly from security to security and informed investors are made somewhat redundant. In the model, they make less profit as a result.
The question, i guess, is how much less profit. There are two competing forces:
- High-frequency trading quickly propagates information across markets, reducing the need for fundamental investors to do research and make capital allocation decisions.
- High-frequency trading drives down the rewards to fundamental investors, by making prices react instantly to their activity so that they can never make a profit by buying (selling) undervalued (overvalued) stocks.
If force 1 outweighs force 2 then markets will be more efficient: The David Einhorns of the world will make less money finding undervalued companies, but their work will have more effect on market prices and capital allocation. If force 2 outweighs force 1, then ... well, you could imagine a world where high-frequency trading is so speedy and efficient that there's no way for fundamental investors to make any money: As soon as David Einhorn even thinks about buying a stock, its price snaps up to what he'd consider a fair price, so he can't profit from buying it.
In this world, where high-frequency trading firms could instantly capture all of David Einhorn's profits, he'd just quit investing and go play poker. And so would everyone: No one would invest in investment research, because any information advantage you could obtain by research would disappear instantly the minute you tried to buy stock. The market would be left to no one but the hobbyists and the high frequency traders, neither of whom are much good at the fundamental analysis that in theory should go into allocating capital.6
The more hyperbolic critics of high-frequency trading sometimes talk as though this world already exists, but of course it doesn't. David Einhorn still makes a very nice living. But computers get faster and trading profits come down and people go on television to shout about how markets are rigged, the concern is that it might push people to under-invest in fundamental investment research.7 And that could be bad for market efficiency. If for nothing else, IEX and other venues that try to limit "predatory" high-frequency trading are good for making fundamental investors feel like there's a safe place for them -- and for encouraging them to keep doing their jobs. The efficiency of the markets may depend on it.
1 Here is a thing that I wrote that I think is mostly wrong, in that you don't need many investors -- just the marginal investors -- to be doing active work in order for the indexes to be right. Still: Interesting questions about your index funds. (Related.)
2 As a blogger I think about activist disclosure that way, though the Securities and Exchange Commission fairly clearly does not.
3 Important conflict of interest disclosure: I invest sensibly in mutual funds and judge people who trade individual stocks harshly.
4 Though also, obviously, out of self-interest; see the previous footnote.
5 I quoted Asness this morning but it's worth repeating:
Often when they try to trade large orders quickly, they find the trades more difficult to execute in a market that has gravitated toward more frequent trades in smaller sizes, and that the price moves away from them faster now.
We doubt that these old-school managers were truly better off in the pre-HFT world, but it's hard to prove either way. And if they're right, it may be only because HFTs have made the markets more efficient, eliminating some of the managers' edge.
Well, sorry, but prices responding quickly — and traders not being able to buy or sell a ton without the market moving — is what is supposed to happen in a well-functioning market. It happens to us too. It may be that in the old days these managers were able to take advantage of whomever was on the other side of their trade, and that nowadays they find it far more difficult to gain that advantage. A more efficient market shouldn't be mistaken for an unfair one.
Most HFT firms are run by scientists and engineers, and it is unlikely that they pay close attention to economic fundamentals and create a map of market structure that updates as fundamentals change.
7 Gerig himself, I should say, isn't too worried about this prospect. In an e-mail, he writes:
Of course, if the informed make less money, some of them may disappear (Grossman and Stiglitz). I don't mind that per se. Because synchronization produces "many eyes," you simply don't need to have as many informed investors out there waiting for information.
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