




Information Asymmetries





Power of the Market

Won't markets take care of this by themselves? Remember that there will be brutal competition to get the trades to run faster, hit more stocks and spin more money out of consumers. Even though more players can get into this, that just means there will be more players ripping off the information of other players. The issue isn't that this is concentrated among a few big market players (though that is an issue) but that it is happening to our investments.

In fact, a worrisome trend is traders who are looking to attack HFT with side moves. There is an influential white paper by Themis Trading called Toxic Equity Trading Order Flow On Wall Street. Themis calls them program traders, and their job is to push prices in such a way that it causes a cascade of computers to start going into motion. Now what is happening? There is no actual change in the fundamentals of the stock in question, but prices are moving dramatically. This hurts the ability to learn real information in the feedback mechanism in prices, which gets us back to the question of what we want prices to do in a market.

Momentum Effects

In the UChicago efficient financial markets theory, markets are efficient because, if prices diverge from fundamental values, smart arbitrageurs will always jump in to bring prices back into line. But what if it is more profitable to drive prices further away from fundamental value? This is likely in theory, and for a variety of reasons we believe there are limits to what arbitrage is capable of accomplishing in bringing prices back into line anyway. HFT, instead of bring prices to a fundamental value, brings them to the edge of what a person is willing to pay. This influences other computers, and other traders, who react accordingly. I've spoken to a few quants, and I agree with their assessment that HFT can exacerbate momentum effects. I'm willing to be convinced otherwise, but on the first approximation instead of converging prices to a fundamental value, it seems likely that these computers are actually driving them away, and away in such a way where much of cutting-edge finance theory thinks there is a big weak spot in how financial markets work to correct bad prices.

Hasn't It Always Been This Way?

It is very reasonable to ask "Isn't this same as it ever was, plus computers?" This is very similar to what specialists used to be able to do with the similar "the look" (peeking at someone's information) before the NYSE cracked down on them. In those cases though, "the look" was approximations, not the highly organized front-running of limit prices down to the penny. And the specialists were legally required to provide liquidity in specific ways. They were providing a public good, liquidity in financial markets, and were perhaps getting rewarded too well for it. The HFT in this case don't have the requirements; they can pull their liquidity from the market at any time, and they'll pull it at exactly the moment we need it the most.

So as the debate unfolds, remember to ask yourself, (1) whose information is being exploited by whom and how, (2) does this make financial markets stronger and more efficient - say by providing liquidity - during a downturn when markets need them the most, and (3) what is this doing to the price mechanism - is it helping prices converge to fundamental values or driving them further away? The evidence currently looks like HFT is doing bad things on all three accounts.