High trade shouldn’t be a win­ner takes all

The Pak Banker - - OPINION - Tim Har­ford

IWAS re­cently told about an airstrip near a ban­knote-print­ing fa­cil­ity. Ev­ery day, planes take off, burst­ing with cash. It used to be that if you stood in a cer­tain field near the airstrip, you could catch the dol­lars as they drifted gen­tly to the ground, or scoop arm­fuls of them up from the soil. On av­er­age, $1 mil­lion (Dh3.67 mil­lion) a day flut­tered down. Word soon got around. Be­fore long, the field was packed with bill-catchers, rac­ing and shoul­der-charg­ing each other to get the cash. Peo­ple started to bring but­ter­fly nets.

The skies were thick with quad­copters dart­ing around to snatch the money at al­ti­tude. If you're won­der­ing where this field might be, don't. It ex­ists only in the imag­i­na­tion of Stan­ford econ­o­mist Mike Ostro­vsky, re­ported in Al Roth's bookWho Gets What and Why. But if the field did ex­ist, you'd have to be a hardy soul to ven­ture there. If $1 mil­lion a day was known to be at stake, the fe­ro­cious quad­copter scram­ble would es­ca­late un­til it cost al­most $1 mil­lion a day to run. If it didn't, then peo­ple would have a strong in­cen­tive to keep buy­ing drones un­til it did. Econ­o­mists call such arms races the "dis­si­pa­tion of eco­nomic rents". They're frus­trat­ing, be­cause value is be­ing frit­tered away in the com­pe­ti­tion to se­cure them. Think of the queue around the block for scarce (and ev­i­dently un­der­priced) con­cert tick­ets or the ri­ots over cheap mer­chan­dise that oc­ca­sion­ally break out dur­ing dis­count sales. or skill then the en­tire value on of­fer will be con­sumed by the race to grab it. The air­field tus­sle is par­tic­u­larly waste­ful be­cause real re­sources are be­ing de­voted to grab­bing ban­knotes that could eas­ily and cheaply be re­placed. But even if the planes were drop­ping some­thing valu­able, such as saf­fron or USB drives, the process would mean that value was wasted. Mi­crowave net­works

An­other ex­am­ple is the busi­ness of high­fre­quency trad­ing in fi­nan­cial mar­kets, in which al­go­rithms try to out­wit or out­pace each other as they scram­ble for trades in a con­test that is over in less than an eye-blink. Some traders have in­vested in mi­crowave net­works, which are faster than fi­bre op­tics, to gain edges of less than a thou­sandth of a se­cond as they re­spond in New York to news from Chicago. The par­al­lel with the money-field is clear enough - and, un­like the field, high-fre­quency traders do ex­ist. A mi­crowave link to save a few mi­crosec­onds is in much the same cat­e­gory as a faster dol­largrab­bing drone, or turn­ing up ear­lier for a bet­ter place in the queue at an Ox­ford Street store. There is a value to hav­ing a liq­uid mar­ket for fi­nan­cial as­sets, one in which you can quickly find some buy­ers to com­pete for what­ever you might be sell­ing. But high-fre­quency trad­ing adds lit­tle to mar­ket liq­uid­ity in times of cri­sis; the mi­crowave link, like the drone, adds no value to so­ci­ety as a whole. Can any­thing be done about such rent-dis­si­pat­ing be­hav­iour? One ap­proach is to tax it. We could levy a fee on stand­ing in queues, or on mi­crowave trans­mit­ters, or on stock mar­ket trans­ac­tions them­selves. If peo­ple who queue for scarce con­cert tick­ets are all taxed $5 an hour while they queue, then the lines will be shorter.

The cost of the tax should roughly be off­set by the re­duced wait­ing time, so the queu­ing crowd is no worse off; the govern­ment, on the other hand, has ac­quired rev­enue from nowhere. This is a rare free lunch. Reg­u­la­tory change Tax­ing trans­ac­tions is also a pos­si­bil­ity, al­though a more prob­lem­atic one. Much of the dif­fi­culty comes not from trans­ac­tions them­selves but from "quote stuff­ing", where high­fre­quency traders make and with­draw thou­sands of bids, prob­ing for in­for­ma­tion with­out ac­tu­ally mak­ing trans­ac­tions. And charg­ing for quote-stuff­ing might not help ei­ther.

Three Cana­dian re­searchers (Katya Mali­nova, An­dreas Park and Ryan Rior­dan) stud­ied the im­pact of a reg­u­la­tory change where traders were charged for quotes, not just trades; they found that quote vol­ume fell sharply. But the bid-ask spread, a mea­sure of mar­ket in­ef­fi­ciency, rose nearly 10 per cent. And while a trans­ac­tion tax or quote tax would dis­cour­age some forms of high-fre­quency trad­ing, it seems to me that the in­cen­tive to build mi­crowave links be­tween Chicago and New York would still ex­ist.

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