Market microstructure is a thing that I don’t really understand and that seems daunting to me so I’ll pass this along as tentatively as possible, but: I thought this piece was really good.* Again, not my area, so if you disagree just get furious at me in the comments, but I thought it might be fun to talk about it as a parable of financial regulation.
The background here is that there is a thing called high-frequency trading in which (i) people, and by “people” I mean “computers,” (ii) trade, and by “trade” I really mean more like “post bids and offers” – they trade, too, but the activity that they’re optimizing is posting bids and offers, (iii) frequently, and by “frequently” I mean “in tiny fractions of a second.” There are various worries about this thing, of which the two biggest are:
(1) computers are scary and
(2) the amount of resources devoted to this activity is staggering and probably out of proportion to its social benefit.
Worry (1) is hard to address** but maybe you’ll be a bit soothed to learn that humans can be scary too? No, I mean, fat fingering is a problem and seems to be a bigger problem with virtual fingers but let’s just bracket that and talk about worry (2).
Worry (2) can be phrased in two different ways. There’s the disinterested snooty way to phrase it, appropriate for those, like me, who aren’t exactly trading stocks a thousand times a day. This runs something like “wow, a lot of people are buying a lot of computers and building a lot of fiber optic cables*** and hiring all of the engineers in the world basically so one guy can trade stocks a nanosecond faster than the other guy with computers and cables and engineers, wouldn’t it be nice if those engineers were like engineering cancer treatments or whatever?”
The other, partisan and alarmist way of phrasing it, is “these rent-seekers are seeking my rents!,” which is appropriate if you trade lots of stocks, maybe? I don’t really get this; I suspect on balance HFTs offer improved liquidity to real-money market participants, but sometimes hose them in particularly hurtful and confusing ways, with those hosings perhaps especially concentrated at the worst possible times.
Anyway though former HFT guy Chris Stucchio tells the story in the first way, as a story of rent-seeking, and he isolates the rent that is being sought in the SEC rule prohibiting stocks from trading in increments of less than a penny:
The subpenny rule essentially acts as a price floor on liquidity – it is illegal to sell liquidity at a price lower than $0.01. … As with a classical minimum wage, two parties are harmed – the purchaser (who must pay extra) and the lower priced seller (who is pushed out of the market).
Similarly, at prices higher than $0.01, it makes price movements lumpy – on a bid ask spread of $0.05, it is illegal for someone to enter the market at price $0.049 or $0.045. Thus, at any price point, speculators are forced to compete on latency rather than on price. Price competition is only possible if one market maker is willing to offer a price at least $0.01 better than another, which is often not the case.
When price competition is impossible, market makers must compete for business via other methods – in this case latency.
His proposal is then to eliminate the subpenny rule, and lists some advantages and disadvantages****:
The first benefit is that the bid ask spread is likely to narrow (probably by about half a penny), thus making it cheaper and easier for speculators to ply their trade … [which] benefits price discovery (and presumably society in general). Realistically, this is probably not a major benefit.
A more significant benefit would be diverting labor from the latency arms race to more productive purposes. When I worked in HFT, my coworkers were extremely smart people, capable of doing many valuable things. I don’t believe the best use of such people’s labor is in reducing latency to make one HFT trade faster than another. While I don’t generally like to second guess a free market, I believe in this specific case the market mechanics line up in such a way as to make the most socially optimal option not individually optimal.
Coincidentally, he is not the only person thinking about slowing down the HFT arms race – yesterday David Merkel had another suggestion:
I have my own solution to high frequency trading: revamp all markets such that there is one auction per second in the trading day. Auctions happen at the top of each second: 9:30:00.000000… 9:30:01.000000… … 16:00:00.000000. Additionally, orders still standing at the start of any second may not be cancelled for the next second.
Auctions once per second. Click, click, click, click … 23,401 auctions per day offers more than enough flexibility to buyers and sellers. No truly economic commerce would be hindered by such an arrangement.
So if you like the idea of tamping down HFT, you could either eliminate the $0.01 minimum increment, or add a 0:01 minimum increment. How do you evaluate those proposals? Here is a Tyler Cowen post from three years ago that is skeptical about regulating HFT out of existence. It is short and all of it is good but let’s focus on this:
The more I read these debates, the more nervous I get about the idea of a financial products safety commission. Essentially on innovation we’re seeing a flipping of the burden of proof and I don’t think it is possible to easily fine-tune that flipping in a way to capture good innovations and rule out bad ones.
Right? How do you know the socially optimal amount of liquidity? How do you know if an auction once per second is the right number of auctions? It strikes me as a question not particularly capable of a priori answers though, I mean, that is a lot of auctions.
Similarly, how do you know that the right price for liquidity is $0.01 or an integral multiple thereof? Again, that doesn’t seem susceptible to a priori answers but you can sort of wave at interesting empirical answers by noticing that there are fewer stock splits and higher share prices these days, and by taking this chart from this Alphaville post as some evidence that there is a natural price for liquidity and it is not an integral number of pennies:
But that’s not the point. The point is, the subpenny rule reduces price competition and adds a relatively arbitrary regulation for traders to game: because you can’t be outbid by another bidder within the same penny increment, you get free money by just getting there first. One way to compensate for that waste might be to add another arbitrary regulation: if people are inefficiently competing to get that $0.01 at 9:45:00.5, because they’re forbidden from trading for $0.009, why not forbid them from trading at 9:45:00.5 and make everyone bid fairly at 9:45:00?
It’s not obvious that that’s a bad solution. But, compared to getting rid of the subpenny rule, it’s an inelegant solution – compensating for the ill effects of one arbitrary-number-based regulation by adding another arbitrary-number-based regulation – if you could achieve the same goals by just getting rid of both of them. (Again, there are probably ill effects of getting rid of both of them that I don’t know about, so commenter fury much appreciated.)
There are definitely lots of ways to go too far***** (and incentives for doing so) in claiming that the cause of all financial problems is financial regulation. But sometimes it’s a useful place to look. There’s lots of research suggesting that our financial system is not that great at reducing the cost of financial intermediation; part of the reason for that may be that the people involved in our financial system are really really good at focusing on regulatory regimes and finding ways to profit off of them.
Sometimes we celebrate that here: the intellectual daring, rigor and artistry deployed to game complex regulations is, when viewed in a certain light, breathtaking. And – this is just a subjective impression here – I suspect that the regulators rarely bring the same artistry and dedication to the game. Which is why, when there’s a possibility of achieving regulatory goals without playing, it’s probably worth considering.
High Frequency Trading – What’s broken and how to fix it [Chris Stucchio]
Should Stocks Trade in Increments of $.0001? [MR]
Stock splits and the volume-price correlations [FTAV]
Fewer Stock Splits, Record Share Prices [BW]
* It was in Write-Offs the other day but I was re-reminded of it by this good Marginal Revolution post this morning.
** If it worries you a lot, have I got a book recommendation for you! I did not love Robert Harris’s The Fear Index but if I were to give you a plot summary – which I won’t because it would contain spoilers – you would laugh really really hard because THE HEDGE FUND COMPUTERS ARE COMING TO GET YOU.
**** An interesting possible disadvantage that he raises:
The other criticism is that it might be more difficult for traders to evaluate the markets. Instead of merely looking at the number of shares available at $10.00, a trader might need to add up the number of shares available at $10.0000, $10.0003, $10.0015 and $10.0029. In my view this will merely require minor modifications to behavior and the tools available – for example, trading programs might merely display a price of “no worse than $10.0029” which aggregates the prices between $10.0000 and $10.0029, and traders will need to look at cumulative price views rather than ladder views.
As someone who sometimes reads about stocks living in continuous time, this suggestion pleases me, though I suspect the technological fix is pricier than he lets on.
***** Start at like 3:15; it’s pretty silly.