Joseph Stiglitz on high frequency trading

I’ve had the occasional disagreement with my more left-leaning students about my views on markets. Usually, they’ve gotten the wrong impression of where I stand, which is that although markets are usually a good thing, there are limits. One of the things that has always quietly concerned me has been the way that financial markets work (or sometimes, fail to work). So, when I read this piece by Joseph Stiglitz (2001 Nobel Prize winner), I was quite happy to see that we share some disquiet in this area. Overall, Stiglitz appears to be quite negative on the effects of high frequency trading.

The paper is very readable (not uncommon based on other writing by Stiglitz I have read), even for those who are not technically inclined. Some highlights:

High frequency trading… is mostly a zero sum game—or more accurately, a negative sum game because it costs real resources to win in this game...

A market economy could not operate without prices. But that does not mean that having faster price discovery, or even more price discovery necessarily leads to a Pareto improvement… it is not obvious that more trading (e.g. flash trading) will result in the markets performing price discovery better...

…there may be little or no social value in obtaining information before someone else, though the private return can be quite high… And because the private return can exceed the social return, there will be excessive investments in the speed of acquisition of information.

…if sophisticated market players can devise algorithms that extract information from the patterns of trades, it can be profitable. But their profits come at the expense of someone else. And among those at whose expense it may come can be those who have spent resources to obtain information about the real economy… But if the returns to investing in information are reduced, the market will become less informative.

…managing volatility and its consequences diverts managerial attention from other activities, that would have led to faster and more sustainable growth.

Stiglitz concludes:

While there are no easy answers, a plausible case can be made for tapping the brakes: Less active markets can not only be safer markets, they can better serve the societal functions that they are intended to serve.

In other words, when it comes to financial markets, sometimes less is more.

[HT: Bill Cochrane]