But who can I turn to if you turn away?
- The Temptations
Everything new is old again. High frequency trading (HFT) has reached the golden years. HFT is making the transition that has characterized the arc of development of prior innovations – from the flush toilet to online dating. This once-transformative “hot new thing” is becoming a mere appliance. One implication is that the SEC should address an unpleasant reality: most of the remaining profits from electronic trading are artifacts of regulatory arbitrage, a result of poorly conceived SEC rulemaking. For example, permitting the exchanges to demand collocation fees, discussed here.
Interestingly, HFT illustrates a quirk of financial innovation. Financial innovation is often uniquely a negative-sum game, considering only its effect on the value of financial institutions. The gains from financial innovation often rearrange financial institution profits at a lower total level. Innovators gain. But competitors lose more. There is an increase in economy-wide profits, but these gains in the total are the result of resources liberated from financial use, for use in producing things we care about. Real stuff (cars, homes, Harleys, and tomatoes) producers gain twice; once as the cost of the paper-shuffling by producers of real stuff falls with financial innovation. Again as a smaller, more efficient, financial sector liberates resources available for production of real stuff.
What to make of HFT.
In retrospect, HFT wasn’t much, really. It was never the transformative creation that derivatives once were. Derivatives played a major role within banks themselves – accelerating a change in bank management pecking orders, as trading surpassed lending on the Big Banks’ bottom line. Derivatives ultimately drove the shape of the banking terrain itself, demanding ever greater financial capital; forcing the banks to combine, forming the modern behemoths that bestride global financial markets today.
HFT does not demand big capital and thus leaves room for the small and fleet-of-foot. Importantly, HFT isn’t the threat to global financial stability that OTC derivatives are. More relevant here, HFT firms illustrate the recent tendency of innovators to avoid public share issuance. With few exceptions, HFT firms are privately held.
HFT in financial regulation.
Politics is driven by public perception. HFT stands in contrast to financial derivatives in the public eye. Derivatives stoke ancient fires of Wall Street distrust in the American hinterland; HFT, in contrast, fires paranoid fear – evoking Saturday morning cartoon villains, builders of machines implementing evil plans to take over the world.
But in the corridors of Washington power, HFT never received the attention derivatives command. Derivatives, along with other wholesale over-the-counter (OTC) markets such as foreign exchange, once posed the threat of a decline in New York City’s global financial market dominance.
More than a political football, OTC posed an existential threat to the American regulatory apparatus. Why? Because London wisely opened the door to American banks and the dollar, presenting a desperately needed (during the 1970’s) alternative to the stolid, self-satisfied, mindset of American legislators and regulators of the era.
The subsequent migration of wholesale investment banking to London lit a fire under American regulators that burns today.
How HFT fits into the universe of innovation.
Ever wonder why traders write books explaining their successful trading strategies? I do. If people read such books, then adopt the proposed successful trading strategies, their use of these strategies will drive away the profits the trading strategy once produced for the author.
A successful trading strategy has three phases.
- Try the strategy. Get rich.
- Solicit investor money to leverage the strategy. Get richer.
- When the profits from the strategy peter out, write a book about it. After all, the strategy worked in the past, where the effectiveness of the strategy can be “proven” from the historical data. Buy a yacht, a personal jet, and a Caribbean island. Talk too much at cocktail parties.
Exploitation of real financial innovation within a competitive marketplace obeys Confederate General Forrest’s dictum: “Git there firstest with the mostest.” The cycle of creative destruction inevitably annihilates the value of all new financial information, trading strategies, and indeed financial innovation of all kinds. Moreover, the more successful and highly publicized is a strategy; the greater the incidence of this destructive imitation. Time is a cruel master that robs financial specialists of the fruits of their creativity.
HFT firms have reached the innovative end-game. They have been reduced to selling their strategy and implementation software to the Big Banks and the buy-side; the HFT-equivalent of writing a book.
As with derivatives before, all that remains of HFT direct profitability is regulatory arbitrage. Again, competition has driven profit from competitive-arena financial innovation.
Should financial innovators list?
An interesting nexus between two recent financial developments – the explosion of index ETF growth and the almost simultaneous end of big-time financial innovation – has raised a question in my tiny, yet admittedly Machiavellian, mind. This issue is this:
Financial observers note that the flood of investment funds into the coffers of index ETFs reduces publicly-traded corporate incentive to innovate. Since index ETF investors hold, indirectly, shares of both innovators and their competitors, an innovation has little impact on index ETF portfolio value. Innovator gains are offset by competitor losses, leaving index ETF investors indifferent to the whole process.
I find this argument unpersuasive in the case of producers of real goods and services, but perhaps decisive in the case of financial service firms. My thinking hinges on the questionable assumption implicit in this argument – that innovation is a zero-sum game. To succeed in the economic betterment of the commonweal, innovation is inevitably a positive-sum game. Indeed, setting aside negatives such as wars and political upheaval, change in economic growth owes its existence to innovation.
But, nestled within the distinction between financial services and real services lies a paradox inherent to financial innovation. Financial services are essentially a necessary evil. In order to facilitate the transfer of real goods and services from their producers to consumers, paper-shuffling financial activities are regrettably required. But no more of them than necessary.
As a result, financial innovation has a perverse effect upon values within the total financial market sector. The losses of innovators’ competitors exceed the gains of innovators. The ultimately positive results of this financial innovation go unnoticed, as the reduced cost of financial services adds profits to the real sector of the economy.
Hence the motive for financial innovators to list privately. The attraction of financial innovation to investors cannot be captured except by investing in the innovating firm directly. Moreover, the risks taken by investors in financial innovation are no longer of interest to increasingly conservative investors in the publicly traded marketplace. These risks are the province of the big shooters attracted to hedge funds and venture capital.
But there is a catch. A big-time financial innovator must put the pedal to the metal to cash in. Rapid imitation of financial innovation demands fast action. And the threat of regulatory intervention as financial regulatory agencies bicker over the new turf the innovation creates, makes a quick fait accompli desirable. Better the agencies quibble over who will regulate the innovation, rather than preventing its introduction entirely. Private financing inhibits speed, to the extent that private sources of funds are limited. But in recent years private sources of funds have grown significantly as a share of the total.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.