Streetwise Professor

May 27, 2012

Market and Regulatory Responses to Creative Destruction: The Case of HFT

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 1:03 pm

As I’ve written before, there is good HFT and there is bad HFT.  The crucial policy choice is how to encourage the former and discourage the latter.

As I’ve also written extensively, going back to the very first days of the blog, many of the problems with electronic trading are best addressed by exchange pricing policies.  In particular, to the extent that abusive trading strategies involve distinctive patterns in orders and cancellations, exchanges can devise pricing structures that make it costly, and perhaps prohibitively so, to utilize these strategies.  Exchanges can also implement pricing strategies that encourage beneficial HFT strategies that increase market liquidity.  Although it would be stretching it to say that exchanges internalize all of the costs and benefits associated with deterring abusive and promoting constructive HFT strategies, they certainly have a far more powerful incentive to get it right, and far better information and knowledge, than does a regulator.

Exchanges around the world, and in different asset/instrument classes, are indeed responding to development.  The latest is the Oslo Bors:

Oslo Bors will issue punitive charges to traders if they send too many orders into the exchange that do not result in deals being done, as the industry seeks to crack down on the practice of “quote stuffing”.

. . . .

Bente Landsnes, chief executive of Oslo Bors, said: “A market participant does not incur any costs by inputting a disproportionately high number of orders to the order book, but this type of activity does cause indirect costs that the whole market has to bear.

“The measure we are announcing will help to reduce unnecessary order activity that does not contribute to improving market quality. This will make the market more efficient, to the benefit of all its participants.”

Oslo Bors’s action is just another example of organizational and strategic innovation in response to a technological shock.  With many exchanges introducing such strategies, they will learn from each other’s experiences, and use this knowledge to refine their strategies.

The demands for regulatory actions against HFT will no doubt continue despite the actions of exchanges to price utilization of their systems in ways that promotes liquidity and deters abuse.  This is because, as is almost inevitably the case with regulation, many of the demands for intervention are self-interested efforts to hamper more efficient competitors.  HFT has undercut many traditional liquidity suppliers, and made their skills obsolete.  As surely as day follows night, and as reliably as the sun will rise in the east tomorrow, this process of creative destruction is leading those on the destroyed end of the process to importune governments to hamstring those on the creative end.

And spare me the nostalgia for the old floor days.  There was a lot of corner cutting-and worse-on the floor, and many abusive HFT strategies have clear parallels in abusive strategies that were used by floor traders.

In a very ironic twist, this debate brings to mind two conversations, held more than ten years apart, with a legendary trader.  In the circa 2000 conversation, he welcomed the advent of electronic trading because he believed that electronic trading leveled the playing field.  He said he was tired of “getting raped by the floor.”  In the circa 2011 conversation, he lamented the rise of HFT, because he couldn’t make money in the new electronic age.

That’s creative destruction at work.  Yes, the innovations are not always-in fact, never-entirely beneficial.  But remember that these innovations destroy incumbents, and are especially effective at doing so when they result in substantial efficiency gains. Thus, the innovations that reduce costs most often generate the greatest hostility-and hence the most insistent demands for regulation by those the innovation displaces.

Since the innovations often do have some negative consequences or uses, those crying for regulatory intervention often have examples to bolster their case. But as the actions of Oslo Bors and other exchanges illustrate, market participants have an incentive to devise means that mitigate and perhaps eliminate the negative effects of the innovation.  Market participants also have legal recourse to attack others.  The proper scope for prescriptive regulation is limited to those effects that market and legal responses to the innovation cannot address.  And even then, it is imperative to be circumspect about regulatory responses, given the susceptibility of regulators and legislators to self-interested efforts to hamper competition and more efficient competitors.

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  1. […] – There is good and bad HFT. […]

    Pingback by FT Alphaville » Further reading — May 28, 2012 @ 1:10 am

  2. […] Regulating high frequency trading would be a logical response at this point.  (Streetwise Professor) […]

    Pingback by Monday links: building domain experience | Abnormal Returns — May 28, 2012 @ 5:27 am

  3. Thank you, sir, for stating the obvious but, to these eyes, previously unwritten truth about the behavior of displaced incumbents. I’m worn out by the statements of the buggy whip makers that cars are dangerous and scare the horses and should be banned. I am equally concerned about legislators who are magically able to figure out what does and doesn’t have social value. They drone on about all the gedanken experiment externalities they perceive, usually from a vantage point that does not include any understanding of the actual market ecosystem. The only thing the current market infrastructure has going for it, and it’s a big thing, is the fierce competition. As long as that’s true among participants, I’m pretty sure the residue of value will mostly flow to the average participant, Nanex cartoons notwithstanding.

    Comment by s jay — May 28, 2012 @ 8:54 am

  4. Thanks @s jay. It is rather amazing, isn’t it, that the fact that the biggest complainers are those whose oxen have been well and truly gored is seldom pointed out. And your comment about “Nanex cartoons” is spot on. Thanks again.

    The ProfessorComment by The Professor — May 28, 2012 @ 9:10 am

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