Streetwise Professor

April 12, 2014

Yes, Brad, It’s Just You (And Others Who Oversimplify and Ignore Salient Facts)

Filed under: Derivatives,Economics,Exchanges,HFT,Politics,Regulation,Uncategorized — The Professor @ 2:48 pm

Brad DeLong takes issue with my Predator/Prey HFT post. He criticizes me for not taking a stand on HFT, and for not concluding that HFT should be banned because it is a parasitic. Color me unpersuaded. De Long’s analysis is seriously incomplete, and some of his conclusions are incorrect.

At root, this is a dispute about the social benefits of informed trading. De Long takes the view that there is too little informed trading:

In a “rational” financial market without noise traders in which liquidity, rebalancing, and control/incentive traders can tag their trades, it is impossible to make money via (4). Counterparties to (4) will ask the American question: If this is a good trade for you, how can it be a good trade for me? The answer: it cannot be. And so the economy underestimates in fundamental information, and markets will be inefficient–prices will be away from fundamentals, and so bad real economic decisions will be made based on prices that are not in fact the appropriate Lagrangian-multiplier shadow values–because of free riding on the information contained in informed order flow and visible market prices. [Note to Brad: I quote completely, without extensive ellipses. Pixels are free.]

Free riding on the information in prices leading to underinvestment in information is indeed a potential problem. And I am quite familiar with this issue, thank you very much. I used similar logic in my ’94 JLE paper on self-regulation by exchanges to argue that exchanges may exert too little effort to deter manipulation because they didn’t internalize the benefits of reducing the price distortions caused by corners. My ’92 JLS paper applied this reasoning to an evaluation of exchange rules regarding the disclosure of information about the quantity and quality of grain in store. It’s a legitimate argument.

But it’s not the only argument relating to the incentives to collect information, and the social benefits and costs and private benefits and costs of trading on that information. My post focused on something that De Long ignores altogether, and certainly did not respond to: the possibility that privately informed trading can be rent seeking activity that dissipates resources.

This is not a new idea either. Jack Hirshleifer wrote a famous paper about it over 40 years ago. Hirsleifer emphasizes that trading on information has distributive effects, and that people have an incentive to invest real resources in order to distribute wealth in their direction. The term rent seeking wasn’t even coined then (Ann Kreuger first used it in 1974) but that is exactly what Hirshleifer described.

The example I have in my post is related to such rent seeking behavior. Collecting information that allows a superior forecast of corporate earnings shortly before an announcement can permit profitable trading, but (as in one of Hirshleifer’s examples) does not affect decisions on any margin. The cost of collecting this information is therefore a social waste.

De Long says that the idea that there is too little informed trading “does not seem to me to scan.” If it doesn’t it is because he has ignored important strands of the literature dating back to the early-1970s.

Both the free riding effects and the rent seeking effects of informed trading certainly exist in the real world. Too little of some information is collected, and too much of other types is collected. And that was basically my point: due to the nature of information, true costs and benefits aren’t internalized, and as a result, evaluating the welfare effects of informed trading and things that affect the amount of informed trading is impossible.

One of the things that affects the incentives to engage in informed trading is market microstructure, and in particular the strategies followed by market makers and how those strategies depend on technology, market rules, and regulation. Since many HFT are engaging in market making, HFT affects the incentives surrounding informed trading. My post focused on how HFT reduced adverse selection costs-losses to informed traders-by ferreting out informed order flow. This reduces the losses to informed traders, which is the same as saying it reduces the gains to informed traders. Thus there is less informed trading of all varieties: good, bad, and ugly.

Again the effects of this are equivocal, precisely because the effects of informed trading are equivocal. To the extent that rent seeking informed trading is reduced, any reduction in adverse selection cost is an unmitigated gain. However, even if collection of some decision improving information is eliminated, reducing adverse selection costs has some offsetting benefits. De Long even mentions the sources of the benefits, but doesn’t trace through the logic to the appropriate conclusion.

Specifically, De Long notes that by trading people can improve the allocation of risk and mitigate agency costs. These trades are not undertaken to profit on information, and they are generally welfare-enhancing. By creating adverse selection, informed trading-even trading that improves price informativeness in ways that leads to better real investment decisions-raises the cost of these welfare-improving risk shifting trades. Just as adverse selection in insurance markets leads to under provision of insurance (relative to the first best), adverse selection in equity or derivatives markets leads to a sub optimally small amount of hedging, diversification, etc.

So again, things are complicated. Reducing adverse selection costs through more efficient market making may involve a trade-off between improved risk sharing and better decisions involving investment, etc., because prices are more informative. Contrary to De Long, who denies the existence of such a trade off.

And this was the entire point of my post. That evaluating the welfare effects of market making innovations that mitigate adverse selection is extremely difficult. This shouldn’t be news to a good economist: it has long been known that asymmetric information bedevils welfare analysis in myriad ways.

De Long can reach his anti-HFT conclusion only by concluding that the net social benefits of privately informed trading are positive, and by ignoring the fact that any kind of privately informed trading serves as a tax on beneficial risk sharing transactions. To play turnabout (which is fair!): there is “insufficient proof” for the first proposition. And he is flatly wrong to ignore the second consideration. Indeed, it is rather shocking that he does so.*

Although De Long concludes an HFT ban would be welfare-improving, his arguments are not logically limited to HFT alone. They basically apply to any market making activity. Market makers employ real resources to do things to mitigate adverse selection costs. This reduces the amount of informed trading. In De Long’s world, this is an unmitigated bad.

So, if he is logical De Long should also want to ban all exchanges in which intermediaries make markets. He should also want to ban OTC market making. Locals were bad. Specialists were bad. Dealers were bad. Off with their heads!

Which raises the question: why has every set of institutions for trading financial instruments that has existed everywhere and always had specialized intermediaries who make markets? The burden of proof would seem to be on De Long to demonstrate that such a ubiquitous practice has been able to survive despite its allegedly obvious inefficiencies.

This relates to a point I’ve made time and again. HFT is NOT unique. It is just the manifestation, in a particular technological environment, of economic forces that have expressed/manifested themselves in different ways under different technologies. Everything that HFT firms do-market making, arbitrage activities, and even some predatory actions (e.g., momentum ignition)-have direct analogs in every financial trading system known to mankind. HFT market makers basically put into code what resides in the grey matter of locals on the floor. Arbitrage is arbitrage. Gunning the stops is gunning the stops, regardless of whether it is done on the floor or on a computer.

One implication of this is that even if HFT is banned, it is inevitable-inevitable-that some alternative way of performing the same functions would arise. And this alternative would pose all of the same conundrums and complexities and ambiguities as HFT.

In sum, Brad De Long reaches strong conclusions because he vastly oversimplifies. He ignores that some informed trading is rent seeking, and that there can be a trade-off between more informative prices (and higher adverse selection costs) and risk sharing.

The complexities and trade-offs are exactly why debates over speculation and market structure have been so fierce, and so protracted. There are no easy answers. This isn’t like a debate over tariffs, where answers are much more clean-cut. Welfare analyses are always devilish hard when there is asymmetric information.

Although a free-market guy, I acknowledge such difficulties, even though that means that implies that I know the outcome is not first best. Brad De Long, not a free market guy, well, not so much. So yes, Brad, it is just you-and other people who oversimplify and ignore salient considerations that are present in any set of mechanisms for trading financial instruments, regardless of the technology.

* De Long incorrectly asserts that informed trading cannot occur in the absence of “noise trading,” where from the context De Long defines noise traders as randomizing idiots: “In a ‘rational’ financial market without noise traders in which liquidity, rebalancing, and control/incentive traders can tag their trades, it is impossible to make money via [informed trading].” Noise trading (e.g., in a Kyle model) is a modeling artifice that treats “liquidity, rebalancing and control/incentive” trades-trades that are not information-driven-in a reduced form fashion. ┬áRandomizing idiots don’t trade on information. But neither do rational portfolio diversifiers subject to endowment shocks.

It is possible-and has been done many, many times-to produce a structural model with, say, rebalancing traders subject to random endowment shocks who trade even though they lose systematically to informed traders. (De Long qualifies his statement by referring to traders who can “tag their trades.” No idea what this means. Regardless, completely rational individuals who benefit from trading because it improves their risk exposure (e.g., by permitting diversification) will trade even though they are subject to adverse selection.) They will trade less, however, which is the crucial point, and which is a cost of informed trading, regardless of whether that informed trading improves other decisions, or is purely rent-seeking.


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  1. Interesting post. I had thought “rent-seeking” referred to use of political means to obtain privileges, and was at first confused by your use of the term. I see that it could mean any attempts to redistribute profits to oneself that do not increase efficiency. That would include activity with negative externalities and no offsetting social benefits.

    Comment by emerich — April 12, 2014 @ 6:31 pm

  2. @emerich-Yes. Use of political means to obtain a benefit is one example of rent seeking, but not the only form of rent seeking. Basically, it means expending real resources to redistribute wealth.

    Glad you liked the post.

    The ProfessorComment by The Professor — April 12, 2014 @ 6:42 pm

  3. I am not a professional economist and therefore unsure of much of the nomenclature used. but, it seems to me there is a difference between “informed decisions” made from research and decisions made by frontrunning orders. if you are using algorithms to analyze the publicly available data that is one thing, but ” peeking at my cards” and then adjusting the bet is another thing entirely. that the exchanges allow this without dis losing it is outrageous. in the days of specialists we all know they were taking their 1/8 the but at least the bids and asks were real. today you place an order and they price moves away from you before it executes. I believe that undermines trust in the system and leads to a market with fewer participants. without trust our financial system will end up like third world countries, I.e. an inefficient mess.

    Comment by berourke — April 13, 2014 @ 9:23 am

  4. SWP, your several posts on high frequency trading for some reason made some things pop into my head.

    1) diamonds – I pity every schmuck who buys a diamond ring for some girl, and then for one reason of another, has to sell it to someone, typically to a dealer or a “market-maker” who is obviously not going to give him back his purchase price.

    2) there has always been a steady drumbeat of publicity about the “integrity of the markets” and “investing for the long term.” Hence the Securities Act and the Securities Exchange Act, among others, right? And who was brought in to fix things? The “wolf of Wall Street,” if I’m not mistaken, last name beginning with K.

    Then after pink sheets, and penny stocks, and boiler rooms, and NASDAQ kicking the exchanges in the butt, after day traders – here comes HFT, boiling down to 350 millisecond time intervals.

    And supposedly this is front-running ahead of individual investors, who gamble or compete or trade against professionals through mutual and other funds.

    To make a lame point – not much investing for the long term in this, is there?

    3) Ray Dirks and the Equity Funding Scandal

    As you no doubt know, Ray Dirks was the analyst who discovered that Equity Funding, with its reinsurance scheme, was a fraud. He alerted his own clients before going pubic with the info. The SEC spent years trying to nail him for having developed his own information, and then releasing it to his own clients before releasing it to publicly.

    Not quite the same as developing algorithms and computers which merely look for pricing information, regardless of any “fundamentals.”

    But it popped into my head, nevertheless, based on all the posts and all the comments in your posts.

    4) I wonder if this HFT stuff is the same as “blowing up the customer,” to use Lewis’ term, even if he and others claim it is front-running?

    Comment by elmer — April 13, 2014 @ 10:55 am

  5. @berourke: What do you mean by “peeking” at the cards? Automated traders, including market makers, can only use publicly available information, including publicly available trade and quote information, in deciding whether and how to revise their quotes. Are you referring to exchange feeds of data to colocation centers that are offered on the same terms to any market participant and where the terms are completely transparent? If so, I am curious as to what you suggest would as a better alternative. As for quotes not being real, are you suggesting that market makers never update their quotes in response to new information?

    Comment by Scooter — April 13, 2014 @ 2:27 pm

  6. Michael Lewis alledges that, at a minimum, hft traders can see orders before they hit some of the exchanges, that is what is meant by “peeking at the cards.” it may be only milliseconds, but it is enough for their computer algorithms to front run other’s orders.

    Comment by berourke — April 13, 2014 @ 4:25 pm

  7. @berouke: HFT cannot see an order before it hits an exchange order book. The speed advantage is that they see order book information faster due to colo and private data feeds, which are faster than the SIP. Re front running, again this is a term with a specific legal meaning that is being thrown about loosely and which does not apply to HFT. And the point of my posts is that if market makers can mitigate adverse selection costs by seeing and reacting to information faster, this can actually benefit non-predatory, non-informed traders (liquidity demanders).

    The ProfessorComment by The Professor — April 13, 2014 @ 4:35 pm

  8. @berouke: I agree with The Professor. I am afraid that you have been given some serious misinformation. HFT algorithms simply do not have the ability to see orders before these orders are displayed in the exchange order book. I also agree with The Professor that the term “front running” does not apply to an HFT updating their quotes in response to public information about displayed quotes and recent transactions.

    Comment by Scooter — April 13, 2014 @ 4:50 pm

  9. I agree with the ideas in this post, but I don’t think the discussion needs to be this contentious…

    Comment by Noah — April 13, 2014 @ 9:51 pm

  10. I think you need to read Michael Lewis’s interview, he contends that HFTs do indeed front run orders, your contention that they don’t is based on what? the HFTs own assertions, your certainty that the SEC is busy policing, that the markets don’t allow fudging in return for the enormous sums collected for “co-location”?

    Comment by berourke — April 15, 2014 @ 1:14 pm

  11. @berourke: I am perfectly aware of Lewis’s contention. It is just that, not Gospel or Revealed Truth. My criticism is that he uses a term with a specific legal and regulatory meaning to refer to another form of conduct which bears some similarities, but which has crucial differences. Most notably, the term “front running” as used properly implies that there is an agency/contractual/fiduciary duty involved. Generally speaking, front running occurs when a broker trades in front of his customer.

    What Lewis calls “front running” is a form of order anticipation, facilitated by a technological advantage that HFT firms spend money to obtain. HFTs act on public information on order flow to trade profitably. They act faster because they buy better data feeds, and invest in hardware and software to process that data more rapidly. The key point is that even though they have an information advantage, they do not obtain this advantage by violating any relationship with those whose orders they observe and use to condition their trading. They are in no contractual, agency, or fiduciary relationship with those whose orders they anticipate.

    Order anticipation is as old as markets, and has never been illegal. The technology has changed, but the phenomenon has not.

    There is a legitimate question as to whether rules (most notably, those that could regulate access to and use of public order book information) should be changed to make it more difficult for HFT to anticipate orders.

    The whole point of my Predator/Prey post is that the economics of this are not as black and white as Lewis suggests. Informed orders are predatory, and HFT anticipating informed orders can improve market liquidity: by detecting informed trades, they reduce their vulnerability to being “picked off,” which allows them to quote tighter markets. The potential downside is-as I discuss in that post and my reply to DeLong-is that anticipating informed orders reduces the incentives to collect information. But as I discussed in detail, it is virtually impossible to know whether this is a good or bad thing because collection of information for trading purposes can be a form of rent seeking.

    Lewis’s problem is that he has a simplistic, moralistic view of the markets and how they work. His lack of understanding allows him to be a True Believer.

    I am more agnostic, because I understand trade-offs that Lewis doesn’t even know exist-or at least which he betrays no understanding of.

    If you want to shout Amen! in Lewis’s church, be my guest. I am just trying to make you aware that his is a creed based on ignorance of some very basic aspects of the economics of the trading of financial instruments.

    I know moral certitude is comforting. I am just telling you that it is a false sense of security (no pun intended).

    The ProfessorComment by The Professor — April 15, 2014 @ 3:16 pm

  12. @berouke: Let’s try to zero in on what the issue is here. I doubt that the issue can be with individual retail orders in US equity markets, such as those orders placed through a retail brokerage like Schwab. There orders, unless specifically directed, never reach an exchange for execution. Here is a good disclosure, from Schwab, on its order routing practices and where non-directed orders go.

    Unless the retail customer directs his order to an exchange, it will be executed at the prevailing NBBO or better in a broker network (i.e., a dark pool). Even if it were possible, no rational trader will step in front of a retail order because as a pool, these orders contain no useful information about the future direction of prices, either short-term or long-term. These orders do not cause prices to move, so there is no predictable price rise to buy in front of, or predictable price fall to sell in front of. I would argue that those HFTs performing a market making function have improved the quality of trade executions for individual retail customers by narrowing the bid-ask spread, which is the relevant cost consideration for retail order flow. The narrowing of the spread occurs from the risk-management attributes of spread, that allows HFT market makers to quickly revise quotes in response to new information about market conditions. Informationless retail orders are not part of the set of useful information for an HFT, hence there is no “peeking” at the retail cards even if it was possible.

    For institutional orders that reach an exchange, these orders are not known to an HFT until they arrive at the exchange order book and are publicly displayed. Likely what you refer to as “peeking” is data on quotes and transactions that are received by servers residing at a colocation (proximity hosting) facility near an exchange’s matching engine. Access to these facilities are not exclusive to HFTs. Brokers use colocation on behalf of their customers. These customers include buy-side institutions but could also include retail customers placing directed orders. Buy-side institutions executing their own orders may also use these facilities. They are not exclusive to HFTs, and are available on the same menu of terms to anyone. To refine the discussion, I think it would be helpful for you to articulate what you mean by “peeking.” Is it colocation that you find objectionable? If so, we can have a productive discussion about that.

    Related to your previously expressed concerns about quotes being real, you may find the data in the link below about actual time in force of quotes, and the interaction of high-speed orders, to be helpful in understanding the issue.

    Comment by Scooter — April 15, 2014 @ 4:05 pm

  13. I still maintain that short-bid HFT is fraud — making a bid knowing you will withdraw it in milliseconds before it can be accepted. This is not an option with any value because it cannot be accepted by many, if any market players. It just draw out acceptances and suckers them with cancels. Pure noise.
    If an arbitrary quote lifetime is to be avoided, then at the very least, the exchange should return a new (randomized) quote number to be used for a cancel, after posting. That way cancels cannot be pipelined, and there is some chance the quote would get hit by anyone with the same or shorter latency.

    Comment by Robert in Houston — April 17, 2014 @ 8:36 pm

  14. what a bunch of conjecture you are stating, you say Michael Lewis is just conjecture, I think history shows that the SEC and the exchanges have no claim on being legitimate endorsers of fairness in the markets. you claim there is no proof they are front running and then define front running as requiring a fiduciary relationship, well how about the exchanges fiduciary responsibility not to reveal customers orders to other traders before placing my order, show all the spreadsheets and economics nomenclature you wish, there is no way that a reasonable person will agree that showing my order to my competitor is reasonable. I often direct my orders but still find the issue of offers moving away from my orders. paying to get faster info is one thing, paying to get info before it is public is something else, do you really think the HFT guys and they exchanges are really playing straight? really, with all the money at stake and the gov’t’ asleep? Bernie Madoff wasn’t caught, he turned himself in. how many crooks are still out there that have even less concscience than he did? how has it taken this many years for this discussion to even take place? you are playing with matches here, the public is losing all confidence sin the markets and you may will destroy them, what happens when only the crooks are left trading. there is a very old saying, ” the bad drives out the good.” we are close to there.

    Comment by berourke — April 20, 2014 @ 6:08 pm

  15. berourke, I’m not sure what your view of “fair” is. Do you expect your order to get executed without anyone ever looking at it? The stock market is a real market, in the true sense of the word, with buyers and sellers negotiating price and quantity in a public (as far as the exchanges go) setting. It is NOT your local supermarket with posted prices for every stock.

    Comment by nivedita — April 21, 2014 @ 5:52 pm

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