There's going to be a lot of terminology thrown around when people talk about this, and rightfully so since it is a very technical issue. But the economic ideas are simple, and I want to give you the water cooler guide to thinking through the relevant issues in the debate. When you hear discussion about this going forward, think of how the points made influence these concepts.

Information Asymmetries

As you can see from the quick eBay analogy above, being able to see someone else's information, when they can't see yours, makes for terrible markets. Beyond issues of fairness and equity, which are incredibly relevant here, this also leads to an issue of bad prices. The information reflects only part of what you believed about the stock in question; computers took advantage of your situation, but the information that others see as a result of the front-running doesn't reflect what you actually believed. You hear stories about stock prices jumping all kinds of crazy values, with crazy volume numbers and volatility, because of a few stock purchases, and these price movements reflect the HFT. Now remember that the feedback mechanism of stock prices - if you are a Hayekian - is the whole point of having a market. If trading in markets doesn't aggregate information among many diverse parties but instead turns the price mechanism into a roulette wheel played out by supercomputers ransacking your 401(k) - because believe me, your 401(k) is a great target - what's the point? Does that have any more information than the tyrant social planner?

Liquidity

The strongest claim in favor of HFT is that it is providing liquidity to the financial markets. More liquidity in markets is usually considered to be a good thing, and as such they are being rewarded for providing a service. There's a problem with this though - they have no obligation to provide liquidity. There's no formalized procedure in which they post prices with certain time limits. They, and the HFT practitioners have been very upfront about this, have no obligations when it comes to providing liquidity. And it is very likely that they won't step in when the financial markets need them the most.

So in this sense, liquidity from HFT is like having an airbag in your car that works all the time except when you are in a car accident. It isn't there when you most need it, and it encourges you to drive a bit faster, and take turns a bit sharper, because you think you are protected. So instead of being a risk management tool everyone is aware of, it is instead misinformation.

Power of the Market



Won't markets take care of this by themselves? Remember that there will be brutal competition to get the trades to run faster, hit more stocks and spin more money out of consumers. Even though more players can get into this, that just means there will be more players ripping off the information of other players. The issue isn't that this is concentrated among a few big market players (though that is an issue) but that it is happening to our investments.

