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. Randomizing 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.