We Can “Cure” High Frequency Trading, but is It Really a Public Policy Problem?

Michael Giberson

High frequency trading practices by some financial firms have spilled into the news. The Economist provides a summary of the issue.  Bloomberg notes the Sen. Charles Schumer has proposed to ban one such trading strategy.

Here, Tyler Cowen said he is not worred about high frequency trading (HFT).  In a follow-up, he said:

Even if you think HFT is bad, on an actual list of bad policies or practices in our world, would it be in the top million?  Mostly it’s a canvas on which to paint complaints about the continuing political and economic power of finance, but we shouldn’t let that skew our judgment of the practice itself.

I think that that is about right.

I’m not sure that there is a public policy issue involved, but stock exchanges themselves may have an interest in managing the issue. A costly communication-speed arms race among member firms may burn off any economic value attainable in the form of investment in computing and telecom systems.  Member firms that choose not to play the arms race game may adopt costly defensive trading strategies instead.

A simple way to avoid the arms race is to reconfigure the underlying market structure from a continuous double auction to a periodic call market. The double auction works by continuously collecting bids and offers, with transactions occurring anytime a new bid matches the best available offer (or new offer matches the best available bid) at the matched price.  A call market works by continuously collecting bids and offers, then at announced intervals a clearing price determined such that the quantity offered is equal to quantity bid at the price.

Personally, I can’t imagine much value from running the call market more frequently than once every 5 or 10 minutes, but my lack of an imagination isn’t really a good guide here. (This paper from 1995 proposed clearing an electronic call market three times a day.)  In any case the call mechanism is quite adaptable, and the technology clearly exists to run frequent calls. If high frequency price discovery offers some value to the market, the call could be run every minute, every second or half-second, or even every hundredth of a second.

There are interesting market design issues involved.  But, like Cowen suggested, high frequency trading practices probably does not raise any significant public policy issues.