High-Frequency Trading Actually Does More Harm Than Good

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Computerized financial trading that takes advantage of milliseconds of lag to capture profits isn’t actually good for markets, as high-frequency trading (HFT) proponents have long argued, according to wew work by University of Michigan economists. Instead, Quartz’s Simone Foxman writes, a common type of computerized HFT activity “harms the average investor” by skewing actually markets.

The study, by Elaine Wah and Michael Wellman, focuses on a specific subset of the HFT world known as “latency arbitrage.” Latency refers to the lag time for trading information to move across data networks, and arbitrage is a general term for capitalizing on differences in the price of a given thing on different markets. The line between legitimate arbitrage trading and market rigging can be thin. Recent investigations have exposed rate rigging in oil markets, currency exchanges, and inter-bank interest rates, among many others. Those schemes are designed to make arbitrage more profitable through traders manipulating prices.

What Wah and Wellman find, though, is that even the legally sound practice of arbitrage to take advantage of computer lag is not actually providing a benefit to the market. HFT defenders have argued that the trading technique makes markets more efficient, and thus improves society. The costs, Wah and Wellman write, are greater than the benefits, and HFT serves only to capture profits and skew prices for normal investors.

As the Center for American Progress argues in its new agenda for middle-class economic growth, HFT’s dominance of financial markets has “dubious social value” at best. A Demos report from early 2013 found that HFT benefits professional investors at the expense of everyone else. And it’s not just think tanks saying this. Charlie Munger, deputy to billionaire investor Warren Buffett, told CNBC in March that high-frequency traders “have all the social utility of a bunch of rats admitted to a granary.”

The narrow findings of the study support broader arguments about the damaging effects of a financial system increasingly dominated by computer algorithms, where the firm with the fastest network cables wins. That kind of market function increases the likelihood of “flash crashes,” where markets lose trillions of dollars in value in mere seconds. But more generally, with the financial sector taking up an ever greater share of our economy – and snapping up an ever greater share of our most talented young minds – it’s worth wondering just how much trading activity is contributing to growth in the “real economy” of shovels, retail pricing guns, and waitress pads.

This supports the argument for a financial transaction tax to discourage speculation and stabilize markets without dampening the real economy’s access to the credit it needs to grow.