Robert Levy, Chairman of the Cato Institute, responds to Burton Makiel and Aurthur Levitt’s Wall Street Journal op-ed on the most recent firestorm over high-frequency trading (HFT). Highlighting its downsides, critics have called for bans and regulations to stem or eliminate the practice. These critics allege the practice lends unfair advantage to large and inside traders relative to small and retail traders, worsens market volatility such as flash crashes, and amounts to “front-running”.
Levy’s approach is to plainly and objectively highlight the benefits of HFT — such as enhanced efficiency through narrowing of bid-ask spreads and greater liquidity — as well as its downsides. While there is no presumptive basis for government regulations or bans in light of this cost-benefit analysis, Levy argues, the issue does raise the question as to what framework the regulatory approach should follow. In particular, he points to some thorny property and contract rights issues that are in play.
The Coasean answer to the property rights question is that the initial assignment of ownership doesn’t matter: If transactions costs are low, bargaining by the various parties will direct resources toward their highest valued use. But here, transactions costs among affected investors, brokers, exchanges, and HF traders are likely to be prohibitive. Moreover, libertarians are concerned with distributive shares – i.e., who benefits and who bears the costs – not just aggregate resource allocation.
A Lockean rule would assign ownership to the originator of the information. The economically efficient rule is that ownership should vest in the party least able to avoid harm if the right were to vest elsewhere. And the libertarian rule is that the victim of any harm has the right to claim compensation. Application of those rules is unclear in this instance, and perhaps even conflicting. When that happens – i.e., when rights theory doesn’t provide clear guidance – a utilitarian analysis can inform the initial assignment of a property right. In other words, an economic cost-benefit assessment and a rights-based assessment will merge. (That also happens when we evaluate, say, speed limits or any other safety regulations.)
This is a very interesting approach, and it is one to be expected from Levy given his law & economics background. I’ll simply add three observations to continue the discussion.
1. I’m generally in agreement with the property right analysis. I would like to see how robust is the point that transaction costs are prohibitively high. For example, as a retail investor I know that my orders will not be placed instantly or even with great speed. But if I also know that placing my order puts the information about my order out there to the advantage of HF traders, and if a HF trade can be linked to the information that I supply merely by the act of placing an order, then I should at least in principle be able to contract with the exchange to receive a slice that the HFT takes.
2. One neglected aspect is how best to allocate the privilege that HFTs enjoy of proximity to exchange servers and access to dark pools. In other words, what do the HFTs pay for their advantage? And who is receiving these payments? Clearly there are capital investments (a form of private sector rent seeking). But I wonder if there are forms of licensing or other “rental” agreements in place that the exchanges use to retain some of the profits earned by HFTs. If I were on the board of an exchange, I would be asking this question every minute of every day. Clearly I lack the detailed institutional knowledge to push the point further.
3. Finally, Levy is making a fundamental point to which I’m highly sympathetic and which makes his piece relevant to this blog. On the one hand we have a worldview that says a government ban is required anytime an action is observed to have adverse consequences. As we write in Chapters 3-4 of Madmen, this is foolish thinking because it omits any analysis of the benefits that the action might be providing, while also ignoring any downsides to the way that a ban might actually be implemented and enforced. In other words, we need to do comparative analysis before leaping to government solutions. This is the overarching theme and contribution of public choice theory.
Note: For more on Ronald Coase here at PE.com, see Wayne’s “Ronald Coase and Spectrum Liberalization” and my “Ronald Coase (1910-2013): He Kept His Hands Dirty.“