High-Frequency Traders are Eating Investors’ Brains. For Free!

It can be tough to articulate a cogent argument against high-frequency trading in the context of highly liquid, efficiently functioning securities markets, but I think Rajiv Sethi has done so (riffing off Michael Lewis’s typically scathing and revealing article on Goldman’s recent bad behavior).

In brief, in my words:

1. Value investors are trying to buy shares in truly productive firms, which activity indirectly, over the long term, allocates real resources to those firms. This is A Good Thing.

2. When these investors trade in any volume, those trades are broken into multiple batches. A buy order for 1,000, 10,000, or 100,000 shares rarely finds a single sell order for the same amount at the same time.

3. A micro-instant after the buy order appears, HFTers jump in front of a bunch of the value investor’s trades, pushing up the price that the value investor pays.

In Sethi’s words:

their private information is effectively extracted early in this process

Here’s his explanation at more length, emphasis mine:

Effective prediction of price movements, even over such very short horizons, is … essentially a problem of information extraction, based on rapid processing of incoming market data. The important point is that this information would have found its way into prices sooner or later in any case. By anticipating the process by a fraction of a second, the new market makers are able to generate a great deal of private value. But they are not responsible for the informational content of prices, and their profits, as well as the substantial cost of their operations, therefore must come at the expense of those investors who are actually trading on fundamental information.

It is commonly argued that high frequency trading benefits institutional and retail investors because it has resulted in a sharp decline in bid-ask spreads. But this spread is a highly imperfect measure of the value to investors of the change in regime. What matters, especially for institutional investors placing large orders based on fundamental research, is not the marginal price at which the first few shares trade but the average price over the entire transaction.

Since value investors have no choice but to place buy and sell orders that HFT algorithms can see and react to instantly, they are inevitably giving away  their private value/fundamental research for free to the HFTers. They can’t not. This cost/extraction inevitably (incentives matter) results in less fundamental research, so poorer allocation of resources.

The HFTers aren’t paying the cost of that externality.

If you’re looking for solid economic, theoretical, justification for a Financial Transactions Tax, I don’t think you’ll do much better than this one from Sethi.

Cross-posted at Asymptosis.