Here is the full text of my 30th Quartz column, ”How to avoid another Nasdaq meltdown: Slow down trading” now brought home to supplysideliberal.com. It was first published on August 23, 2013. Links to all my other columns can be found here.
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© August 23, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.
The last paragraph of this column is especially heartfelt.
Whatever the exact trigger that brought Nasdaq down today, it is likely that a contributing cause is the huge increase in lightning-fast high-frequency computer trading in recent years. Nathaniel Popper wrote in the New York Times in October 2012 that the profits from high-frequency-trading have started to fall because the volume of stock-trading has fallen in the wake of the Great Recession, but that
Many market experts have argued that the technical glitches that have recently hit the market have been a result of a broader trend of the market splintering into dozens of automated trading services and a lack of human oversight.
High-frequency trading has been controversial because of the idea that it takes advantage of slower human investors. Back in 2009, the New York Times’s Charles Duhigg detailed an insider account of one case of computers besting humans:
The slower traders began issuing buy orders [for Broadcom]. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds—0.03 seconds—in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.
In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing.
In terms of fairness, this seems worse than the controversial two-second advance notice subscribers could get for the University of Michigan’s Index of Consumer Sentiment. At least in that case, subscribers’ fees for the advance notice pay for the collection of scientifically valuable survey data. But what social benefit flows from letting high-frequency traders peek at market supply and demand 30 milliseconds before everyone else? It could be that giving high-frequency traders that kind of advantage entices them to provide liquidity in the market, selling to those who want to buy and buying from those who want to sell. But the magnitude of this supposed benefit is unproven. As Popper writes: “Regulators are still grappling with whether the rise of high-speed firms has been a net benefit or loss for investors.”
If letting high-frequency traders have an advantage measured in milliseconds doesn’t provide enough benefits to be worth the seeming unfairness, what can be done? One simple approach would be to have the market only clear 20 times per second, and insisting that all orders received by, say, 11:05:02.05 a.m., be treated in a totally even-handed way in that moment of market clearing (as buy and sell orders are matched). Further, it should be insisted that orders be absolutely secret from other traders until the moment of market clearing when that order is supposed to be revealed and executed. It is possible that having the market clear only 20 times per second would reduce the total amount of information processing done by the market every day, but discouraging high-frequency traders and their advantageous zero-sum game off sheer speed of execution might lead the traders to focus on more socially valuable forms of information processing.
In academic finance, concerns about high-frequency trading go under the heading of “market microstructure” issues. There are other bigger problems in finance at the macroeconomic level that I have talked about more than once. The best reason to fix unfairness—or even perceived unfairness—in market microstructure is so people aren’t distracted from noticing how those in the financial industry use low levels of equity financing (often misleadingly called capital) to shift risks onto the backs of taxpayers and rewards into their own pockets. In quantum mechanics, electrons can “tunnel” from one side of a barrier to another. Using massive borrowing to ensure later government bailouts, the financial industry has perfected an even more amazing form of tunneling: the art of tunneling money from the government so that the profits appear on their balance sheets and in their pockets long before the money disappears from the US Treasury in bailouts. By comparison with this financial quantum tunneling of money from the US taxpayer that has been a mainstay of the financial industry, high-frequency trading profits of a few billion dollars a year are small change.