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Home Publications Blogs Beat the Press High Speed Trading and Slow-Witted Economic Policy

High Speed Trading and Slow-Witted Economic Policy

Tuesday, 01 April 2014 05:03

Michael Lewis' new book, Flash Boys, is leading to large amounts of discussion both on and off the business pages. The basic story is that a new breed of traders can use sophisticated algorithms and super fast computers to effectively front-run trades. This allows them to make large amounts of money by essentially skimming off the margins. By selling ahead of a big trade, they will push down the price that trader receives for their stock by a fraction of a percent. Similarly, by buying ahead of a big trade, they will also raise the price paid for that trade by a fraction of a percent. Since these trades are essentially a sure bet (they know that a big sell order or a big buy order is coming), the profits can be enormous.

This book is seeming to prompt outrage, although it is not clear exactly why. The basic story of high frequency trading is not new. It has been reported in most major news outlets over the last few years. It would be nice if we could move beyond the outrage to a serious discussion of the policy issues and ideally some simple and reasonable policy to address the issue. (Yes, simple should be front and center. If it's complicated we will be employing people in pointless exercises -- perhaps a good job program, but bad from the standpoint of effective policy.)

The issue here is that people are earning large amounts of money by using sophisticated computers to beat the market. This is effectively a form of insider trading. Pure insider trading, for example trading based on the CEO giving advance knowledge of better than expected profits, is illegal. The reason is that it rewards people for doing nothing productive at the expense of honest investors.

On the other hand, there are people who make large amounts of money by doing good research to get ahead of the market. For example, many analysts may carefully study weather patterns to get an estimate of the size of the wheat crop and then either buy or sell wheat based on what they have learned about the about this year's crop relative to the generally held view. In principle, we can view the rewards for this activity as being warranted since they are effectively providing information to the market with the their trades. If they recognize an abundant wheat crop will lead to lower prices, their sales of wheat will cause the price to fall before it would otherwise, thereby allowing the markets to adjust more quickly. The gains to the economy may not in all cases be equal to the private gains to these traders, but at least they are providing some service.

By contrast, the front-running high speed trader, like the inside trader, is providing no information to the market. They are causing the price of stocks to adjust milliseconds more quickly than would otherwise be the case. It is implausible that this can provide any benefit to the economy. This is simply siphoning off money at the expense of other actors in the market.

There are many complicated ways to try to address this problem, but there is one simple method that would virtually destroy the practice. A modest tax on financial transactions would make this sort of rapid trading unprofitable since it depends on extremely small margins. A bill proposed by Senator Tom Harkin and Representative Peter DeFazio would impose a 0.03 percent tax on all trades of stocks, bonds, and derivatives. This would quickly wipe out the high-frequency trading industry while having a trivial impact on normal investors. (Most research indicates that other investors will reduce their trading roughly in proportion to the increase in the cost per trade, leaving their total trading costs unchanged.)The Joint Tax Committee projected that this tax would raise roughly $400 billion over a decade.

A scaled tax that imposed a somewhat higher fee on stock trades and lower fee on short-term assets like options could be even more effective. Japan had a such tax in place in the 1980s and early 1990s. It raised more than 1 percent of GDP ($170 billion a year in the United States). Representative Keith Ellison has proposed this sort of tax for the United States.

If the political system were not so corrupt, such taxes would be near the top of the policy agenda. Even the International Monetary Fund has complained that the financial sector is under-taxed. However, because of the money and power of the industry the leadership of both political parties will run away from imposing any tax on the financial industry. In fact Treasury Secretary Jack Lew has been working to torpedo the imposition of such a tax in Europe. So look for lots of handwringing and outrage in response to Lewis' book. And look also for nothing real to be done. 

Comments (21)Add Comment
written by SteveB, April 01, 2014 7:05
I don't understand how the tax solves the problem. Wouldn't it just increase the spread between buy and sell prices, and make the exchange even less efficient?
Outrage: Random Walk of Stock Market is Not for Economic Predators
written by Last Mover, April 01, 2014 7:24

Economic predators rip off Americans on a daily basis in every way imaginable with the slow crushing grind of market power disguised behind the fraud of "free markets" and "free trade".

The outrage from victims morphs into fatigue every time and dies out as the sock puppets eventually smother it as usual and march on with the message they are paid to preach by the 1%.

On occasion however, when economic predators rip off each other as well in this case, the outrage is conveniently legitimatized. The bigger the trade to be ripped off from the seller or buyer side, the more likely it's an economic predator at work on both sides of the trade.

What an outrage. We can't have economic predators ripping each other off can we. How are they going to cooperate and carve up markets into havens of market power and run the show? Why should they be forced to compete with each other with outright fraud to skim off stock prices on one side, up against large volume trades on the other side?

Like you know, that starts to sound like how both sides treat the middle class doesn't it. Indeed, middle class America is expected to walk that random walk of gains and losses to sort out winners from losers in a "free market" rotten to the core with corruption.

But when it comes to a random walk in the stock market by economic predators to sort out winners from losers, well then there are necessary exceptions aren't there.

After all, economic predators don't lose by definition do they. They can't. They must hang together to "compete" with the middle class as losers on a "level playing field".

Suck it up America and walk that random walk like the predators do. It's the only way out of economic serfdom. You can't beat 'em and you can't join 'em, but you can hold your head up high as a proud maker instead of a commie taker.
Read More Here:
written by Robert Baillie, April 01, 2014 7:30
The NY Times plans to cover this in next Sunday's magazine section. Here is a link to the article:
New Trans-Atlantic Cable Just to Save 5.2 Milliseconds
written by Robert Baillie, April 01, 2014 7:37
One group is building a new trans-Atlantic cable just to make it easier to game the system:

written by Jeff Z, April 01, 2014 8:24

No it would not, if the tax is evenly split between buyer and seller. High speed trading depends on trader's ability act as both buyer and seller. Even if the spread remains, the imposition of the tax reduces the value of high speed trading compared to other activities.

If the spreads are truly miniscule, then a less miniscule tax like the one proposed here would slow trading - traders would have to wait a bit longer for a sufficient spread to develop for them to be able to obtain the net gain they want. The spread has to be large enough to cover the both return, and the tax the trader would pay as both buyer and seller in these transactions.

Makes me wonder
written by Anna Lee, April 01, 2014 10:30
Somehow I imagine that the same people defending or dismissing this are the ones outraged if they believe a worker got one piece of bread without working hard for it.
They're not doing what we thought
written by KJMClark, April 01, 2014 2:40
The difference is that everyone thought they were using their speed advantage to use public news and get their trades in faster than other people could. As in, I have an internet connection and get news within seconds of it being announced, but you are getting your information from newspapers and don't find out for hours or days. It's still a bit slimy, but we generally accept that it's OK to make better decisions based on better/faster information.

OTOH, the book is claiming they're front-running, which is supposed to be illegal. What they're doing is like reading my mail on the way to the post office, seeing that I'm telling my real-estate agent that I want to buy some land, buying the land for the price I would have paid, and immediately putting it back on the market for 2% more. So my real estate agent calls me back, saying he got the land for me, but I'm going to have to pay 2% more than I thought. Huh?
Anyone Actually Read the Excerpt?
written by Tom Stickler, April 01, 2014 2:56
If anyone here had actually read the excerpt, they would learn that IEX was set up to explicitly deny any speed advantage to trades made on their exchange, nor may any owner of IEX make trades on IEX.

If investors demand that the brokers for their accounts trade only through IEX, they will be assured that their trades were made as fairly as possible, and no other trader had the opportunity to influence the price of their trade.

Read and understand what drove the creation of IEX in the NYT Magazine excerpt linked above.
written by J B Tipton, April 01, 2014 6:43
I saw Bob Pisanus on CNBC telling you whiners out there not to complain about a few pennies on a thousand dollar trade. I will agree as long as you let me(as in the movies) program JP Morgan's computers to round off monthly statements by only a penny and have it deposited to my own account. Nobody would really be hurt, only a little penny. Oh, I suppose THAT would probably be illegal.
This is not unlike what some Domain Name Registrars do
written by Joe T., April 01, 2014 10:21
Some registrars have been known to put a hold on a searched domain that isn't immediately bought, in the hopes that they can solicit a possible higher priced offer from the searcher who now decides s/he's desperate for that domain, enriching the new "owner" (the registrar). If that happens, waiting a week or so and seeing the domain available again, is proof of this practice.
written by ROb, April 02, 2014 6:29
I do not think a transaction tax will do the trick. But creating a new tax bracket for short term capital gains might.

Make the tax on gains of asset held less than a week (as an example) 75% and, just as importantly, disallow the write off or netting of any losses.

The tax combined with the cost of the computers and access to the high speed lines should kill the practice
written by Squeezed Turnip, April 02, 2014 9:21
Anyone Actually Read the Excerpt?
written by Tom Stickler, April 01, 2014 2:56

Yes, yes, I did. IEX is hoping to be a solution to the problem. But then there are the vultures like Virtu, who tax big traders (pensions, mutual funds, etc.).

Also it should be noted, the practice also increases the quantity and tempo of value variation ("noise") and, correspondingly, lack of confidence in the markets.
Not Slow Witted, But It Pays To See Nothing...
written by Jesse, April 02, 2014 10:16

It is not so much that policy is slow-witted. It is that those who make that policy and act as thought leaders have been silenced in any number of ways, both voluntary and involuntary.

To paraphrase Upton Sinclair, it is hard to get a man to see something when his paycheck depends on his not seeing it.

Reform has little traction because justice has few friends when crime pays.

If the tax destroys HFT...
written by McMike, April 02, 2014 3:32
... how will it raise $400 billion?

Don't get me wrong, I'd love to see these parasites flushed out of the system.

Wouldn't a truly independent nonprofit single-portal exchange do this? By single portal, I mean no animals are more equal than others. Is this what IEX proposes to do? (IEX is of course for-profit, so the incentives are broken out the gate).

Maybe set up a date-stamp feature that assigns a universal time stamp to orders, which are then executed in sequence after a millisecond pause, regardless of transmission delays.
Front Running is illegal ...
written by John Yard, April 02, 2014 4:24
I was going to write that front running is illegal, and risks prosecution, but as I type this I realize that the US has given a 'get out of jail card' to these parasitical elites.
Skeptical of the skeptics.
written by Jesse Maurais, April 03, 2014 2:46
As someone who is finishing off a degree in mathematical statistics and actuarial science with an eye to a career in this field, I'm a little concerned and confused. I confess that I haven't read Lewis' book yet but I have seen him in a number of interviews and this is what I've gathered from his comments.

Lewis has made accusations that HFT is "insider trading" by making two points. The first is that these firms are able to rent space next to the stock exchange which allows them earlier access to the data network. This is true insofar as such space is a limited commodity. But so is the trading floor, and we don't now see access to it as an unfair advantage even though such access is limited. Information only ever travels so fast from it's point of origin and there isn't really anything like simultaneity in it's acquisition. These are facts of physics: only so many people can be located at the epicentre of information. It would be something else entirely if the information was obtained well before anyone else had access to it (even electronically) and this would be cause for serious concern, but I don't see it as defining what HFT is about. A second related matter is how you judge people who are capable of extracting the information from raw market data faster than anyone else. Is this insider trading? Two agents can have access to the same data at the same time and one may get the information out of it faster just by having superior equipment and programming. But how is it a crime to be better at doing what everyone else is doing?

I think people are drawing a sharper distinction here between what is acceptable and what is not than is really warranted. Moreover, when I compare the supposed dangerous activities of HFT with what is done all the time more conventionally, I begin to suspect that it's a distinction without a difference.

I think we should also be cautious with how we proceed with regulations in this matter. HFT may be the first phase of a paradigm shift in which trading becomes more digital, more mathematical. We won't know the full implications, good or bad, until much later. What I hear from critics sound's to me more like complaints that they are accustomed to the old ways of doing things and will no longer be able to compete. I just don't see that as a legitimate argument.
written by Squeezed Turnip, April 03, 2014 3:46
Skeptical of the skeptics.
written by Jesse Maurais, April 03, 2014 2:46
I think people are drawing a sharper distinction here between what is acceptable and what is not than is really warranted. Moreover, when I compare the supposed dangerous activities of HFT with what is done all the time more conventionally, I begin to suspect that it's a distinction without a difference.

You need to understand how trading works and how it doesn't work (e.g. front-running a fellow trader). The best overall book I know on this, which includes a detailed explanation of front-running, is this one.

Front-running is illegal, for very good reasons, which have to do with maintaining the health of dealers. A market without dealers will not function as efficiently. HFT is not the first phase of the paradigm shift, for example, the move to tracking changes in pennies was made possible by pennies.

It's not about doing ethical business in a new-fangled ways thereby crowding out Luddite traders; some/most HFT is doing unethical business in new fangled ways (I don't have that data). The crooks are faster so we should laud them? Get real. Sure HFTs can iron out inefficiencies in market pricing and valuations, but that is not what Virtu is doing. They are nicking pieces of meat off a whale that is coming in, except its so many pieces of meat that the whale loses viability. The market needs the whales, not so many parasites. Parasites have their place, sure. But they increase the costs of trades in the long run (read the book linked above).

Anyway, I hear what you're saying Jesse, I know a bit of math and stats and actuarial myself. But you clearly don't know the entire picture (what exactly goes on the trading floor in various markets), which I will chalk up to the naiveté of youth!
written by liberal, April 04, 2014 10:34
Jesse Maurais wrote,
What I hear from critics sound's to me more like complaints that they are accustomed to the old ways of doing things and will no longer be able to compete. I just don't see that as a legitimate argument.

LOL. That's the same kind of argument people were making in the late 1990s when they argued that the derivatives market should remain deregulated.
written by chmoore, April 04, 2014 12:12
RE "If the political system were not so corrupt, such taxes would be near the top of the policy agenda."

I would agree, based on the high number of millionaires in Congress. Their salary is in the 170K range. I'm sure the millionaire club in Congress don't personally own high speed trading computers, but it's likely they have special access to those who do.
A quick explanation can be found on (the new) Wonkblog
written by Mike, April 04, 2014 4:52
Max Ehrenfreund interviews a really (really, really) smart, old trading data guy who gives a great, short-but-detailed description of HFT as it's being executed, a little bit of detail on why IEX won't really work, and some info on why it is illegal. Here's the link


Great points regarding the right policy and why
written by Viewer II, April 05, 2014 7:59
Doing the good research to inform investors helps not only investors but everyone else. Most countries can have the upper hand toward prosperity for all if they utilize sound monetary and fiscal policy. Smart trade between countries should be beneficial to all parties concerned.
Latest GM scandal speaks to the problems we see with a lot of corporations. Corporations too often take short-term profits rather than soundly investing in the long-term. If you want a good infrastructure for growth in this or any country it has to start with common sense.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.