An Example of Good Regulation

New York Times has a great article about the growing importance of electronics in the stock market. Of particular interest is high frequency trading.

They use algorithms to zip in and out of markets, often changing orders and strategies within seconds. They make a living by being the first to react to events, dashing past slower investors — a category that includes most investors — to take advantage of mispricing between stocks, for example, or differences in prices quoted across exchanges.

High-frequency traders are “the reason for the massive infrastructure,” Mr. McPartland says. “Everyone realizes you have to attract the high-speed traders.”

These trades occur mind-bogglingly fast, with speeds measuring in the milliseconds, or millionths of a second. As various trading platforms (besides the NYSE and NASDAQ, there are about two dozen smaller ones) compete for the high-frequency traders, the bill to stay in the game skyrockets.

One such project is a 428,000-square-foot data center in the western suburbs of Chicago opened by the CME Group, which owns the Chicago Mercantile Exchange. It houses the exchange’s Globex electronic futures and options trading platform and space for traders to install computers next to the exchange’s machines, a practice known as co-location — at a cost of about $25,000 a month per rack of computers.

This is a pure arms race, where value is zero sum and purely relative. At this computing level, doubling the speeds adds nothing to our wealth but costs society billions. If everyone would half their speed, we'd loss nothing (or almost nothing) as a whole AND we'd won't have to spend so much money on these damn super-super-super computers.

The SEC chairwoman, Mary L.Sharpio, has raised the idea of limiting the speeds machines can trade at and I applaud this direction. It depends on the speed that's set, of course, but the efficiency gains between 50 milliseconds and 90 milliseconds is basically zero.

Two caveats. First, it's unclear what the spillover gains from this computing technology is. Firms are expanding the limits of technology to deliver pure speed to Wall Street(s). Such computers might add little to trade efficiency but could be useful elsewhere, say medical areas, especially in the areas of genetics and nanotechnology. Getting this technology faster could save lives.

The second is the unintended consequences. These firms compete on speed: take that away (assuming there are no loopholes) and what will they compete on instead? It could encourage better customer service, but it could also encourage accounting fraud.

But in light of these two issues, I still favor a speed cap. I doubt cutting out these customers for high end computers is going to significantly reduce the investment in high speed computer technology. The second issue I'm a little bit more nervous but I suspect there's plenty of room for honest improvement to compete on.