The Real Problem With High Frequency Trading

This podcast did a great job explaining a lot of things: The origins of high frequency trading, the absurdity of financial regulation made from the point of view of a bygone era, and the absurdity of high frequency trading today. High frequency trading has (rightfully so) been under intense scrutiny since the near collapse of Knight Capital and the previous afternoon long flash crash.

High frequency trading is not bad as a concept. If the market reacts to data a day later, and you find a way to react in half a day, you have a more efficient market. You're essentially "oiling the gears" of the stock market.

The problem lies in the incentives: they're winner take all. If I come up with that improvement, I get all of the value from my information edge as the market adjusts to normalcy. And if someone jumps ahead of me to react in an hour rather than half a day, they get all of the value. There is absolutely no mechanism to stop this from devolving into a destructive arms race, which is obviously happening as HFT companies are now fighting over milliseconds, and going to extreme lengths to get that edge.

The marginal benefit of these increases in efficiency decline, but it's not reflected in the incentives. It's a good thing to take a process that normally takes a day and reduce it to an hour, but the efficiency gain in reducing this process by a millisecond is minuscule.

There should be more regulation to correct this error. Some firms should specialize in high frequency trading, but they should not be encouraged to fight over such trivial time differences. I'm not sure what sort of policy would best fit this problem, but it does need to come from a place where it addresses this exact issue.

This is only one of several problems that exist in our current financial system, but I believe it's a good example of how these problems should be approached. Instead of letting populist feelings guide thought around the regulation of the financial industry, policy makers should be looking for these misaligned incentives that are the true cause of wall street malfeasance.

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