

Krugman's take on high frequency trading - robrenaud
http://www.nytimes.com/2009/08/03/opinion/03krugman.html

======
tptacek
(a) Does Krugman actually _know_ that, say, GS is making record profits
principally from high-frequency trading, or is he just invoking them as a
boogeyman because they're already ill-favored by his audience and because they
are known to have invested in some high-frequency trading?

(b) What does it even mean to question whether "one thirtieth of a second
faster" merits profits? As Krugman well knows, the markets aren't inherently
frictionless; when you trade, you trade across a spread between bid and ask
prices, a spread representing a premium to your trade that is taken out of the
market by middlemen. HFT cuts the spread and hurts those middlemen, but also
reduces friction in the market.

Krugman's argument seems to reduce to the notion that the only people who
should profit in a trade are principal buyers and sellers; people with a long-
term strategy or outlook on an instrument who are trading for a reason. But
HFT or not, a huge swath of the market consists of entities that exist solely
to connect buyers to sellers and to facilitate price discovery, and it's naive
(or disingenuous) to suggest otherwise, or to pretend that markets would work
effectively in their absence.

~~~
ig1
Given he uses "one thirtieth of a second" faster I'd say he doesn't know what
he's talking about. HFT for equities is an order of magnitude faster than
that, at that speed you're just executing a normal algo trade.

But yeh basically the counter argument is liquidity. There's nothing stopping
an exchange restricting speed of trades, the reason most of the major ones
don't is companies don't want to be listed on a non-liquid exchange.

If HFT damaged the companies being traded than the companies could move to
exchanges that didn't allow it.

~~~
robrenaud
I don't think that the companies being traded on exchanges where HFT is
prevalent are the big losers from HFT.

I think the big losses are from the all of the wasted resources being put into
making trades faster and faster. It seems to me that if merely swapping one
set of machines out from a data center near the exchange and moving a few
miles away is going to drastically change how that it performs, something is
wrong.

From my personal experience, a brilliant friend of mine left his job at some
Silicon Valley startup where he was definitely creating value for society to
work at an HFT shop. After a few months of working there, he calls me and we
talk about some C++/algorithms stuff (I think he is much, much smarter than
me, I just happened to have written a lot more C++ than he has) about how he
needs to make his code run microseconds faster so that it can make more
trades.

I am all in favor of people who change the world for the better being rewarded
immensely. I have no love for the iphone, but since many, many people do, I am
sure Steve Jobs is worth his billions. But for people getting rich doing HFT,
the only return for society I see are some nebulous claims about liquidity.
Can the societal gains be quantified in some manner? If every transaction on
the exchange had an added latency of a microsecond, how would things change?
What if it was a millisecond? What about a second? How much worse off would
the world be?

~~~
starkfist
I don't know. People on HN talk about this dichotomy between the value
producing Silicon Valley startups, and the valueless of activities like HFT
stock trading. In my mind, in most cases, it's not so clear.

I worked in Silicon Valley for 12 years. Many of the projects I worked on had
negative financial value - they never made any money. So essentially I was
just wasting some rich person's money. The projects that were successful in
terms of users and "eyeballs" often had negative social value. The whole point
was to induce users to spend more and more time on our sites. Finally, some of
the things going on right now in startup-land are quite frankly, creepy. The
last project I did in Silicon Valley involved working with all these vendors
who essentially are building up dossiers of every human who uses the internet
and shopping it around as "market data." When I realized I was basically
contributing to a surveillance state, I quit and moved to Manhattan, where at
least I'm only fucking around with rich people's money, instead of fucking
around with people's lives.

------
thrill
Krugman is long talented in telling only a portion of a story to fit an
agenda. The basic theory of the market is sound, that it reflects the value of
a given stock at a given time. High speed/frequency trading simply drives the
market to that accurate point that much more quickly.

That said, it's greatly unfair, IMO, that markets are allowed to provide
information to select people (for an additional fee of course) that is not
provided to the general public. These are supposed to be publicly traded
stocks - by providing information to some that others don't receive until some
delay (whether it's milliseconds to minutes), then there is _nonpublic_
trading capitalizing on information not yet delivered to the public - this
walks the fine line of insider trading, to me.

~~~
vecter
Who is getting unfair information? Do you mean flash orders? Those no longer
exist (for which I'm glad also). HFT in general though doesn't take advantage
of unfair market information.

~~~
thrill
As far as I know, flash orders are still legal - just not being offered by
most exchanges due to the public heat they received for a period.

~~~
vecter
If so, then they should be disallowed. Regardless, they accounted for for a
tiny fraction of all trading volume. I doubt most HFT firms make much from
them. Saying HFT is bad because of flash trading is like saying driving cars
is bad because once in a while, someone dies from a car crash. The latter part
is a true statement, but that's 0.01% of the picture.

On another note, it should be pointed out that flash orders were created by
EXCHANGES, not by demand from traders. The exchanges didn't want to have to
route orders to other exchanges because of NBBO, so they offered this to
traders hoping that someone would come fill the order at NBBO.

------
adolph
Summary:

First the financial industry plunged us into economic crisis, then it was
bailed out at taxpayer expense.

[M]any financial-industry high-fliers made fortunes through activities that
were worthless if not destructive from a social point of view.

[H]igh-frequency trading probably degrades the stock market’s function,
because it’s a kind of tax on investors who lack access to those superfast
computers. . .

[A] bill setting rules for pay packages...a step in the right direction... is
opposed by the Obama administration, which still seems to operate on the
principle that what’s good for Wall Street is good for America.

[W]e’ve become a society in which the big bucks go to bad actors, a society
that lavishly rewards those who make us poorer.

~~~
tptacek
But, no: HFT isn't a tax on poor investors; it's a "tax" on poor _middlemen_
who would otherwise be able to profit from spreads that HFT systems are
slashing.

If you're a principal buyer or seller of an instrument, because you have a
trading objective (capitalizing on an impending market shift, accumulating
exposure to a business or industry you believe in, diversifying your
portfolio, or simply a speculator), HFTs are (a) at worst simply replacing a
middleman that was taking a chunk out of every one of your trades, and (b) at
best helping you by refining competition for access to that spread and thus
amping up liquidity and making it easier for you to buy or sell.

There certainly do appear to be problems with HFT in particular and large-
volume algo trading in general; for instance, it appears to drastically
amplify volatility and create crazy swings. _But that's not the argument
Krugman is making_. He's saying it's inherently unfair. Bullshit. It's unfair
in the same sense that UUNet was unfair to bulletin board systems.

~~~
aliston
From what I've read (which may be outdated), there was a system whereby high
frequency traders could discover buyers limit prices by executing a series of
small-volume "probe" trades at increasing dollar amounts. Then, once the limit
is found, execute the trade at the buyer's limit price. Without HTF, the trade
would be executed at a lower price. To me, that sort of asymetry seems unfair
-- it's like knowing, in advance of a negotiation, the other person's exact
willingness to pay.

~~~
tptacek
Again, you're describing a scheme that allows a firm to replace a series of
other traders and firms in the spread. The only difference is that instead of
a lot of little bites on its way to price discovery, the HFT-inhabited market
takes one big one. Meanwhile, you still sell at whatever price you wanted to
sell at, and buy at what you wanted to buy at.

------
robrenaud
I thought this snippet was particularly interesting. Do any of the HFT guys
here want to debunk this, or at least give the other side of the story?

But speculation based on information not available to the public at large is a
very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back
in 1971, such speculation often combines “private profitability” with “social
uselessness.”

It’s hard to imagine a better illustration than high-frequency trading. The
stock market is supposed to allocate capital to its most productive uses, for
example by helping companies with good ideas raise money. But it’s hard to see
how traders who place their orders one-thirtieth of a second faster than
anyone else do anything to improve that social function.

~~~
tmsh
I think the largest fallacy is that HFT is about making money solely via high-
frequency.

However, HFT is rather a group of market making strategies that operate at
high speeds. They'd still work at lower speeds (above a certain threshold).
But they 'make it worth it' for businesses, so to speak, because of the volume
that can be generated, because high speeds means more trades.

Most people doing HFT are taking very small spreads. Fractions of pennies. But
because they can do HFT a lot, this grows a lot. In fact, many HFT equity
traders make money via rebates. Which means if anything they are only
providing a service to the market (it's someone else coming across and
crossing them for a trade).

So HFT is a mixed bag, as others have said. There are predatory strategies
that probably do more harm than good -- accelerate crashes, etc.

But all HFT is -- is some slow strategy in the background + an ability to make
markets a lot. By making markets a lot -- liquidity is provided. Whether the
slow strategy in the background is good or bad -- again, is a totally
different thing.

So insider trading + HFT (as Hirshleifer maybe is getting at), which we would
include in the HFT category because of the latter component, is bad. But
providing a certain risk assessment that other people think is overvalued or
undervalued + HFT is not necessarily bad.

Where it gets tricky is that HFT infrastructure usually requires the same
foresight that 'knowing more than other people' requires. And so it seems like
people are being taken advantage of. But judged purely objectively, HFT is
just a measure of speed. I.e., it's just magnitude. The direction is totally
up to the market participant (many of whom, it's true -- are ruthless and even
amoral).

But people may not appreciate the importance of liquidity (which is what HFT
mostly provides). Liquidity -- which of course gets its name from this
'smoothing out' of markets -- i.e., making things more readily accesible based
on a wide variety of demands, etc. -- that is the basis for any type of
economy or convenience. It's a deep problem that we always probably want to
improve.

Should some farmer in Africa who has some idea for taking some plant and using
it to treat some ailment be given funding from a bank? In a highly liquid
world -- yeah, there's an ATM machine in the middle of nowhere and he enters
his information and gets a loan. I.e., this is an extreme example, but this
'convenience' is huge for innovation and making all of life, for lack of a
better word, more elegant.

On the other hand, the risks of people who provide liquidity with much higher
insights into the market than other people -- is like with any misaligned
information relationship. Any type of manipulation is very bad -- and very
tempting when you're one of the large market participants. So that should
always be safeguarded against.

But yeah, I suppose it's like anything. You want things fast but safe.

ETA. I read the question (parent comment) a little more thoroughly. So I
should probably answer -- why does 1/30th of a second make a difference? It
rarely does. But nobody makes money solely with speed, right? What we mean by
someone makes money by being faster by a couple of milliseconds -- is that
there is some well-known strategy out there, and some market participants,
with really fast connections, can get into that strategy faster than everyone
else. But clearly, in regards to sub-second market entry, these strategies are
fairly rare (e.g., trading announcements or IPOs or pairs trading, etc.).

High _frequency_ trading means entering AND exiting quickly (i.e., you have to
have some other strategy -- usually a hedge -- that you're doing to get rid of
the risk of entering one side of the trade). Being sure about the direction
somehow, that's of course the trick. But what HFT traders are counting on is
-- for lack of a better way to put it -- dumb commercial paper. On average,
they want to have a strategy that eeks out a little bit of a profit. Then, add
in all the individual investors and mutual funds, etc., that have a mixed bag
of clarity into the market, and extract some of the inefficiency out of it
without assuming much risk.

But just because they've figured a way to extract rewards out of the
misalignment of interests in the markets -- doesn't mean what they're doing is
wrong. It's just annoying to speculators. Because it seems like they are being
constantly reminded that the markets are unforgiving unless you have a very
clear idea about what type of risk/reward profile you're willing to present.

The best way to fix the financial markets is education and other efficiencies.
Anyway, that's just my two cents. I could go into the problems with GS and
bailed out bulge-bracket firms -- but suffice it to say, the systemic problems
are mostly based on conflations (e.g., conflating a commercial bank and
proprietary trading).

------
joshklein
I think the crux of the argument is really against speculative trading as a
whole. The stock market has nothing to do with allocating resources. When you
buy/sell stocks, you have a counter party that is doing the opposite. No part
of that transaction has to do with allocating resources.

An angel investment allocates resources. A VC round allocates resources. And
yes, an IPO does allocate resources. But trading stocks is just a way for
mutual fund managers to charge a fee.

Once, owning stock had to do with dividends. But that's back in the day. Now,
the only way to reliably make money in the stock market is to spend other
people's money and charge them for the honor.

If I'm investing in a company, I should have an asymmetric informational
advantage or an ability to direct management. Public companies, by definition,
don't make this possible (unless you have significant voting power).

~~~
tptacek
Equities are a fraction of what's traded on "the markets", and a huge chunk of
"everything that is traded" is traded on electronic markets that could or are
HFT'd (fixed income being a notable counterexample, a paragon of the ideal
universe you sort of allude to, and an unmitigated debacle when it comes to
transparency and fairness).

One doesn't really need to engage your argument about whether equities are
truly about allocating resources to observe that electronic markets do play a
pivotal role in resource allocation. How do you think anyone knows what wheat,
iron, or bulk block cheddar costs?

~~~
joshklein
That's the argument I hear from trader friends, to which I respond, the people
who produce wheat/iron/cheddar and the people who consume wheat/iron/cheddar
can figure that out perfectly well in the absence of speculators and high
frequency trading.

Your other points are well taken, but I do think Krugman is largely referring
to equities, and I sort of parrot part of the argument made by Mark Cuban in
the following link without sharing how I got to that line of thinking:

<http://blogmaverick.com/2008/09/08/talking-stocks-and-money/>

~~~
tptacek
There are tens of thousands of consumers and tens of thousands of producers
for many commodities. Each of them have different cash flow demands and
different tolerances for risk. All of them operate in a world that creates
risk.

Sure, products could still be moved without all the market's actors. But
they'd move at inferior prices, jackpotting some producers and bankrupting
others by sheer chance with little opportunity for smart producers to mitigate
(or even profit from) risks.

Even pure speculators serve a purpose in the market; if nobody wants to hedge
a risk or lock in a price by dealing with them, they can't succeed; if people
do want to do that, the speculator is providing a service to them.

This, by the way, isn't any great insight on my part; it's the first chapter
in any book that explains futures and options.

~~~
joshklein
Absolutely agreed - speculators make the market more efficient. But why is it
that this is the only half of the equation included in the chapter? All the
negative impacts of speculators are left out of chapter one, the rest of the
book, and the next twenty more advanced texts?

For such a clever & informed group, finance types like to quantify their
positive contributions and qualitatively dismiss their negative contributions
("there are -some-inefficiencies when...")

We lose a lot of peak potential value when we depress high finance's ability
to leverage and exploit markets, but we also shave off the deepest parts of
the trough we inevitably fall into when the "markets" swing back the other
way.

History suggests we shouldn't consider the boom-bust cycle as part of our
inevitable march forward; sometimes, you bust big enough and you reach your
day of reckoning. Why is it a given that this cycle needs to be so dramatic?

------
jacoblyles
I would love a serious, technical discussion of high frequency trading from
Krugman. This is just a fluffy op-ed.

~~~
tptacek
Serious question: why would you expect a serious technical discussion of HFT
from Krugman? krugman : markets : hft :: djikstra : cisc architecture : cpu
cache design.

~~~
jacoblyles
"Technical" as in meaty discussion of economic effects, not "technical" as in
source code included.

~~~
tptacek
We're working from the same definition of "technical": that of market
microstructure. I'm questioning whether Krugman, who hasn't made that his
specialty, is really someone you'd want to hear expound on it.

Maybe Robin Hanson (on the very technical side) or Robert Shiller (on the very
academic side) might be better sources.

You can, by the way, get a pretty good intro to high-level market concepts
(particularly, what concerns motivate them) by listening to the free lecture
courseware from Shiller's markets class. And I have to chime in to every
discussion about how markets work to promote "Trading & Exchanges" by Harris,
which is just an awesome, awesome book, and which you can get on Kindle as
well.

------
LiteOn
the first thing I thought of was:

coco the monkey

------
HSO
"activities that were worthless if not destructive from a social point of
view."

Although I do actually like Paul Krugman's writings, and although I do have an
opinion about the financial industry, whoever crowned Krugman "social
evaluator" of the world? I mean, who is to say Krugman writing stuff on the
internet, winning a fake Nobel for a (basically fake) discipline, and
scribbling formulas on blackboards is constructive from a social point of
view? I know people who would dispute that. In fact, let's not even go into
this question for we might find out ugly things about our societies. If I were
to put my own "social evaluator" hat on, I'd throw half the stuff I see on TV
commercials out. [EDIT: In fact, I might throw the TV and all the associated
junk itself out.] Economist Krugman may not like the result on the employment
rate when we really introduce this sort of criterion into capitalism. I mean,
seriously, who in our society really makes truly valuable or "constructive"
stuff, from a social point of view. Isn't a huge chunk of our population
involved in making consumer junk and industrial waste? How is a marketer who
tickles the basest instincts of people to make them buy stuff they don't need
by working harder at jobs they hate any better than a guy who spends his day
doing HFT?

~~~
kungfooguru
A very large amount of labor is socially unnecessary. But its not simply
making 'consumer junk'. It is by making duplicate products with different
packaging, but also all the labor wasted on all forms of advertising and these
activities like HFT. What if the economy was run democratically and everyone
worked a socially necessary job 4 hours a day! Now that sounds like a better
way to go...

~~~
adolph
"making duplicate products with different packaging"

Over-processing Muda!

<http://en.wikipedia.org/wiki/Muda_(Japanese_term)>

