Here's a more fundamental question to ask:
What kind of behavior do you want to reward in the stock market?
If you view the stock market as a bunch of numbers that wiggle around, where "information" is conveyed by the actions of other people participating in the market (ie, what they’re buying and selling), then the HFT's play a legitimate role in spreading that information around.
If you view the market as a place to buy and sell businesses (equivalently - shares of businesses), where capital is allocated to businesses commensurate with the value they provide to society, HFT's are parasites on the effort of others.
There are participants in the market that spent an enormous amount of time, diligence and thought into deciding allocating capital to businesses according to the value they ascribe to the businesses. For these participants, the signal they send by putting out their orders is currently taken advantage of by other participants who spend enormous time, effort and money into trying to “tap into” the result of the efforts put forward by the first group and rush to another exchange to buy up that company before anyone else gets there.
So: Do we really want to reward all of the effort spent building faster machines, communication links, and algorithms to jump right in front of someone in line? Or do we want to reward those people who are actually determining which businesses have intrinsic value and which do not?
It's easy to hate Einhorn or Ackman b/c they're rich. What's important to keep in mind is that they are custodians of and act on behalf of thousands, probably even millions of other people to improve their financial situation. Pensions, endowments, sovereign wealth funds, etc make up the bulk of the funds that Einhorn, Ackman and others invest. The fact that they're rich an indication of their legitimate hard work at researching and allocating capital and enhancing the financial well-being of their clients. (Note: yes, there are always bad apples that get rich by illicit (read: insider) means, but that is an exceedingly small amount of participants and over time they usually get caught).
Warren Buffett has often said that a perfectly good stock market would be one which is open only one day a year, where participants put up orders based on the value they actually ascribe to a business. If those orders cross, then trades occur - all in one day.
Makes you wonder what would happen to society in that market. Would people would be able to find a way to channel all the frenetic activity currently employed in chasing prices and watching others’ actions into a more productive endeavor?
That was an easy point in your comment to respond to. The rest of it doesn't appear to have been based on Chris Stucchio's post at all; you could just as easily have posted it in every thread on HN about HFT. I must be missing something; what is it?
I find this to be an argument I can't dismiss easily.
I've added a link to your comment to the original post. It's important to spread this idea as well.
As a former quant trader and a current (and forevermore) value investor - there is a big difference.
There are literally hundreds of strategies that are high-frequency trading, ranging all the way from those that really perform much of a market-making and liquidity-providing function to perhaps some on the opposite end of the spectrum, where they are abusive and trying to manipulate the market, " he said.
Obviously, we need to get rid of those types of high-frequency traders, but I think the bulk of them are creating liquidity and reducing spreads for us, which has dramatically reduced costs.
No. No it fucking isn't. Furthermore, letting the bad behavior go unpunished means the 'good' behavior gets driven out: https://en.wikipedia.org/wiki/Gresham%27s_law
"Good" HFT strategies are nowadays obvious by one very salient fact: they're not very profitable. Most market making now, for instance, is simply cover - noise trading, basically - designed to disguise the real bad behavior (that the OP conveniently states is just 'very rare'... heh).
HFTs aren't dumb. They know that any regulator or prosecutor will find it very hard to dig through the trading data and discern evidence of illegal behavior from individual trades.
Vanguard's CIO (Gus Sauter) has mentioned in a CNBC interview (see http://www.cnbc.com/id/49434073) that the liquidity providing aspects of HFT tech are valuable - ie, the tools that help the real market makers fill orders on the other side. In the same breath he says the abusive practices (predatory trading) need to be reigned in.
Chris Stucchio's post seems to be defending the "predatory" side of HFT's as "spreading around" the information advantage conferred by hard work and due diligence into the workings of a company.
I'm refuting that by describing the actual effort that goes into attaining the information advantage obtained by Einhorn, Ackman, etc he describes and contrasting it with the effort involved in HFT predatory trading.
Which effort is more important and should be rewarded?
But what happens when you stop hedge fund managers (or really any informed traders) from arbitraging based on whatever research and analysis they do? Prices get out of line. And if prices get out of line or disappear, transactions either go away or are made on uneconomic terms. That's the problem with getting rid of hedge fund managers. This is why financial speculation is tolerated.
Now how does HFT affect this equation? Well, it's quite simple - they accelerate the social benefits of the actions of hedge fund managers while reducing their profits. When you're looking purely at the interaction between HFT and hedge funds, it seems like hedge funds are doing all the hard work and HFT is taking a cut for no reason. But when you realize that the product sold by these hedge fund managers to the rest of the society is better prices, HFT is bargaining with the hedge fund managers on behalf of the broader society and delivering the product quicker and cheaper.
The key to understanding this is that while the social value of hedge fund managers comes from efficient markets they help create, they themselves don't want efficient markets because they can't get paid as well in efficient markets. What HFT does is it brings about efficient prices a little quicker than they would otherwise.
Edit: The above does not preclude the possibility that HFT is harmful, but it limits the possibility largely to a world where hedge fund managers as a group are too poorly paid to be properly incentivized to do their work well. I don't think anyone's gonna go there.
Edit2: Another way to think about this is that hedge fund managers expressing outrage are trying to have it both ways - they want to get paid for their work but don't want to move prices in the process, even though price movements are their only contribution to society. And don't forget their access to liquidity comes from noise-traders who are willing to accept prices as they exist and HFT helps even the playing field between noise-traders and informed-traders, allowing the former to trade in sufficient volume to keep the spreads low.
But for the most part, it's not the buy-side complaining about HFT, because there have always been gate keepers and paying them has always been part of the game. Almost all actual complaints about HFT seem to come from people whose work is being replaced by HFT - the old school line-jumpers whose art no longer seems to translate to the brave new world.
One of the debates that seems to underlie a lot of these discussions is probably more reflective of the values of the individual than the actual issues at play. It seems like some people value justice above all else and others think that--at least in some arenas--justice is not necessary, and may be detrimental. So that the final question could be:
How do we balance fairness in the market with the need to provide liquidity?