The Problem With High Frequency Trading

by Stuart Shapiro

A chart from Nanex by way of Felix Salmon.  If you’ll click over, you’ll see the  date counts off in the lower left hand corner and the number of high frequency trades in the stock market is shown on the graph.  The growth has been explosive over the past five years and now the stock market is largely operated by computers.  Last week, this nearly led to a disaster when Knight Capital lost $440 million within hours and nearly took the market down with it. The answer is simple, a miniscule tax on each trade.

Back in 2007, I wasn’t a fan of a financial-transactions tax; today, I am. And this chart shows better than anything why my opinion has changed. The stock market is clearly more dangerous than it was in 2007, with much greater tail risk; meanwhile, in return for facing that danger, society as a whole has received precious little utility. Are spreads a tiny bit tighter than they might be otherwise? Perhaps. But that has no effect on stock-market returns for long-term or even medium-term investors.

The stock market today is a war zone, where algobots fight each other over pennies, millions of times a second. Sometimes, the casualties are merely companies like Knight, and few people have much sympathy for them. But inevitably, at some point in the future, significant losses will end up being borne by investors with no direct connection to the HFT world, which is so complex that its potential systemic repercussions are literally unknowable. The potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.

You can use the money from the tax for anything you want.  I’d prefer infrastructure or education but even paying for tax cuts elsewhere would be a net gain for society by reducing the risk of a financial crash brought on by computer programs that not even their programmers understand.

By: Stuart Shapiro

Stuart is a professor and the Director of the Public Policy
program at the Bloustein School of Planning and Public Policy at Rutgers
University. He teaches economics and cost-benefit analysis and studies
regulation in the United States at both the federal and state levels.
Prior to coming to Rutgers, Stuart worked for five years at the Office
of Management and Budget in Washington under Presidents Clinton and
George W. Bush.