I've never understood how this applies to arbitrage. Without arbitrage, the parties to the transaction would capture the money lost to arbitrage, and in a modern market, the same information would be learned. If I offer to sell 1000 at $3.03 and you offer to buy at $3.04, we can split the difference. If someone else gets the information of that spread faster than we can resolve it ourselves, they don't "lubricate the capital markets" or anything. They just get our money.
Arbitrage supplies liquidity at all prices, including prices where most trades might not otherwise occur. Liquidity is required for businesses to systematically eliminate risk, therefore it is highly valued as a source of stability for most companies who deal with financial instruments.
Knight has some thoughts on systematic risk in his book Risk, Uncertainty and Profit.
Did this answer my question? I'm really open to the possibility that it's just me, but I still don't get it. I see that some kinds of arbitrage could be useful to a market.
I don't see how these microsecond-timing types of arbitrage can possibly help any market. Every last one of these trades will happen anyway. (*nitpicker's corner - of course some wouldn't happen, e.g. at the precise close of trading.)
He did answer your question. The value of arbitrage is liquidity. Liquidity is extremely valuable. Here, I'll quote Harris:
Liquidity is the ability to trade large size quickly, at low cost, when you want to trade. It is the most important characteristic of well-functioning markets.
Everyone likes liquidity. Traders like liquidity because it allows them to implement their trading strategies cheaply. Exchanges like liquidity because it attracts traders to their markets. Regulators like liquidity because liquid markets are often less volatile than illiquid ones.
Market are not magical. Just because something may be fundamentally worth X does not mean you can automatically find someone to take the other side of a trade based on that valuation.
I still don't get it. I accepted that liquidity is valuable. This specific case adds no liquidity. None. Both sides are participating in the same market, and have enough information to make the trade. They will make the trade if no one interferes. Someone else comes in as a MITM, and collects the spread. What value did they add?
