arbitrage | Normative Narratives

Micheal Lewis’s new book, “Flash Boys”, (re)focuses the spotlight on the controversial practice of high-frequency trading (HFT) (original article):

Already, officials at the Federal Bureau of Investigation’s New York office are investigating whether such firms traded ahead of other players in the market, in what may amount to insider trading or other fraud, according to an agency spokesman. Regulators in Washington and in New York State have opened their own inquiries.

The worries are hardly new. Over the past five years or so, high-speed computers have increasingly taken over Wall Street, and trading has migrated from raucous trading floors in Lower Manhattan to far-flung electronic platforms.

Critics argue that Mr. Lewis broke no new ground (link inserted, not part of article). And a number of executives at the firms mentioned in the book said that Mr. Lewis did not double-check the facts.

High-frequency trading is almost impossible to avoid today. By some estimates, it accounts for half of all shares traded in the United States. Supporters argue that it has made the markets more efficient by creating a cadre of traders willing to buy or sell at any time.

Others are more skeptical. The New York attorney general, Eric T. Schneiderman, has put high-frequency trading on his list of top priorities. He seized the moment on Monday to discuss his yearlong investigation into the practice.

“Look, the problem here is — and I’m a fan of the markets, but I think Michael is right,” Mr. Schneiderman told Bloomberg Television. “We’ve lost a lot of credibility. A lot of investors do not have confidence in the markets and it’s up to those of us who believe in them, who enforce the law and regulate them, to restore that confidence.”

Mr. Narang, the [IEX] high-frequency trading executive, said he hoped the attention surrounding the book would quickly die down. He said that while he had turned down requests to appear on TV, he couldn’t help speaking out against the book.

“There’s no unfair advantage to using your brain, last time I checked, in a capitalist society,” he said.

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Before I dive into this subject, what exactly is “high frequency trading“?

A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2009, it is estimated more than 50% of exchange volume comes from high-frequency trading orders.

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I again refer to a favorite source of mine, Keynes General Theory of Employment Interest and Money (Ch 12, Part V, #4):

“But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.”

Now, take the “professional investor and speculator” out of the equation and replace them with a computer algorithm. Remove many of the financial sector regulations put in place after the Great Depression. Change the hypothetical thee month time horizon to fractions of a second.

In Keynes day, at least there was some work going into speculation (besides creating and refining an algorithm). If traditional investment is speculative, as Keynes suggests, we need a new word for high frequency trading.

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The indisputable role the financial sector played in the financial crisis has shaken confidence in the financial system. Furthermore, the deregulation of commodities markets and subsequent commoditization of traditionally non-financial assets (food, fuel, housing, etc.) has left the “real economy” much more susceptible to fluctuations in financial markets / high frequency trading.

Therefore, it is not surprising that high frequency trading has garnered the attention of regulators. As New York attorney general Eric Schneiderman correctly states, it is the job of these regulators to restore confidence in a system that many see as a potentially destabilizing tool for the rich. There are undeniably positive aspects of financial services, but these positive aspects have been largely overshadowed by speculative and predatory practices.

We cannot wind back the clock on technology to stop high frequency trading. We can, however, curb the arbitrage / rent-seeking potential of high frequency trading with financial transaction taxation (FTT), reducing its prevalence. A FTT would raise tax revenues while also restoring confidence in financial markets (potentially without any negative impact on overall economic growth).

In a recent Economix blog, Bruce Bartlett explores the role “financialization” has played in American (and global) economic stagnation:

“Economists are still searching for answers to the slow growth of the United States economy. Some are now focusing on the issue of “financialization,” the growth of the financial sector as a share of gross domestic product.”

“According to a new article in the Journal of Economic Perspectives by the Harvard Business School professors Robin Greenwood and David Scharfstein, financial services rose as a share of G.D.P. to 8.3 percent in 2006 from 2.8 percent in 1950 and 4.9 percent in 1980. The following table is taken from their article.”

Data from the National Income and Product Accounts (1947-2009) and the National Economic Accounts (1929-47) are used to compute added value as a percentage of gross domestic product in the United States.

They cite research by Thomas Philippon of New York University and Ariell Reshef of the University of Virginia that compensation in the financial services industry was comparable to that in other industries until 1980. But since then, it has increased sharply and those working in financial services now make 70 percent more on average.”

“While all economists agree that the financial sector contributes significantly to economic growth, some now question whether that is still the case. According to Stephen G. Cecchetti and Enisse Kharroubi of the Bank for International Settlements, the impact of finance on economic growth is very positive in the early stages of development. But beyond a certain point it becomes negative, because the financial sector competes with other sectors for scarce resources.”

“Ozgur Orhangazi of Roosevelt University has found that investment in the real sector of the economy falls when financialization rises. Moreover, rising fees paid by nonfinancial corporations to financial markets have reduced internal funds available for investment, shortened their planning horizon and increased uncertainty.”

“Adair Turner, formerly Britain’s top financial regulator, has said, “There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability.”

He suggests, rather, that the financial sector’s gains have been more in the form of economic rents — basically something for nothing — than the return to greater economic value.

Another way that the financial sector leeches growth from other sectors is by attracting a rising share of the nation’s “best and brightest” workers, depriving other sectors like manufacturing of their skills.”

“The rising share of income going to financial assets also contributes to labor’s falling share. As illustrated in the following chart from the Federal Reserve Bank of St. Louis, that share has fallen 12 percentage points since its recent peak in early 2001 and even more from its historical level from the 1950s through the 1970s.

Labor Share of Nonfarm Business Sector

Bureau of Labor Statistics, Department of Labor

The falling labor share results from various factors, including globalization, technology and institutional factors like declining unionization. But according to a new report from the International Labor Organization, a United Nations agency, financialization is by far the largest contributor in developed economies (see Page 52).

The report estimates that 46 percent of labor’s falling share resulted from financialization, 19 percent from globalization, 10 percent from technological change and 25 percent from institutional factors.

This phenomenon is a major cause of rising income inequality, which itself is an important reason for inadequate growth. As the entrepreneur Nick Hanauer pointed out at a Senate Banking, Housing and Urban Affairs Committee hearing on June 6, the income of the middle class is critical to economic growth because of its buying power. Mr. Hanauer believes consumption is really what drives growth; business people like him invest and create jobs to take advantage of middle-class demands for goods and services, which must be supported by good-paying jobs and rising incomes.”

“According to research by the economists Jon Bakija, Adam Cole and Bradley T. Heim, financialization is a principal driver of the rising share of income going to the ultrawealthy – the top 0.1 percent of the income distribution.”

“Among those pointing their fingers at financialization is David Stockman, former director of the Office of Management and Budget, who followed his government service with a long career in finance at Salomon Brothers and elsewhere. Writing in The New York Times, he recently said financialization was “corrosive” and had turned the economy into “a giant casino” where banks skim an oversize share of profits.

It’s not yet clear what public policies are appropriate to deal with the phenomenon of financialization. The important thing at this point is to be aware of it, which does not yet appear to be the case in Washington.”

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A complementary practice that has accompanied “financialization” is the practice of “commoditization“:

“Commoditization” has led to food price volatility and food insecurity in the developing world. It also perpetuated the housing bubble–while it is true that mortgages were always financial products, the way the mortgage backed securities grouped mortgages together turned a practice that was once a means of saving into an opportunity for people to use the equity in their homes like credit cards. When the housing bubble burst, many people found their mortgages “under water”. While there is certainly an element of personal responsibility, the scope of the housing crisis was certainly deepened due to “financialization” and “commoditization”.

Financialization attracts the best and brightest away from other non-financial fields. When all these talented people are working in a saturated market (such as more traditional investments), a natural effect will be the creation of “innovative” financial products–“commoditization”. While commoditization creates short run value by making products more liquid, in the long run it leads to price volatility and bubbles.

Financialization has led to greater income inequality (as the vast majority of capital gains go to the ultra-wealthy), and diverts resources and man-power away from non-financial industries (the “real economy) due to higher fees paid to financial services (these resources could go to, say, MORE HIRING). It has also perpetuated destabilizing, high-speed, arbitrage-seeking investment.

It is interesting that Mr. Bartlett says that it is unclear what public policies should be used to correct for this misalignment of resources. The answers are there (and Bruce himself has mentioned some in previous posts), the problem is implementation, as the proper policy responses require transparency and international cooperation and coordination (due to the global nature of capital in the digital age in order to prevent “capital flight”). Therefore, these commitments are rife with incentives to cheat (“prisoner’s dilemma”) which makes it much harder to come to binding agreements.

One appropriate response is a financial transaction tax (FTT). Such a tax would deter short-run destabilizing trades that have accompanied “financialization” and “commoditization” and direct investments into more long-run wealth creating endeavors (think venture capitalism as opposed to high-speed trading). This would also temper the price volatility effect of “commoditization”.

Another appropriate response would be to have a global standard tax rate for short-run capital gains. By setting such a rate higher than regular income taxation, resources would be diverted away the financial sector and back into the real sector (are you seeing a theme here?). Financial bubbles would be less prevalent, as people would be more likely to hold their income in safer assets / reinvest it in non-financial assets. Due to the relative ease of making short-term capital gains, and differences in national income tax rates, a global short-term capital gains tax rate of 50% seems like a good baseline to start from. Long-term capital gains should be taxed like ordinary income, not at lower preferential rates.

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“Financialization” and “commoditization” have had adverse effects on our real economy. The brightest people and an increasing share of national output have been diverted towards (generally) unproductive activities In the short run this leads to economic growth. But this growth in unsustainable; in the long run crises occur when these bubbles burst, which have adverse effects that reach far beyond the financial sector (due in part to “commoditization”).

Because public policies have allowed financial institutions to grow so powerful, the were able to become “too big to fail“, necessitating tax-payer backed bailouts.

It is a good sign that economists are scrutinizing these practices. If it can be proved that not only do these practices lead to crises, but also have adverse effects on growth, employment, consumption and equality during “good” times, then it will be much harder for politicians around the world to resist the call for greater financial industry accountability via higher taxation (despite the threats from vested interests; if global standards are established, the 0.1% are welcome to setup the Mars Stock Exchange is they so desire).