Political Entrepreneurs

The Economic Engine of Political Change

Property and Contract Rights in High Frequency Trading?

April 30th, 2014 by Edward Lopez

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.

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From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.189, ch.7)

The most successful entrepreneurs know what they do well, they know the market and the opportunities within it, and they choose those activities that create the most value. This is true in economic as well as political markets.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.178, ch.7)

[W]hen the right elements come together at the right time and place and overwhelm the status quo, it is because special people make it happen. We call them political entrepreneurs.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.176. ch.7)

While we started this book with Danny Biasone saving basketball, we end it with Norman Borlaug saving a billion lives. These stories are not that different. Both faced vested interests, which were reinforced by popular beliefs that things should be a certain way—that is, until a better idea came along.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.174, ch.6)

Because there was a general belief that homeownership was a good thing, politicians found the public with open arms.... Everybody was winning—except Alfred Marshall, whose supply and demand curves were difficult to see through the haze of excitement at the time, and except Friedrich Hayek, whose competition as a discovery procedure was befuddled... In short, once politicians started getting credit for homeownership rates, the housing market was doomed.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.166, ch.6)

Everyone responded rationally to the incentives before them. In short, the rules that guided homeownership changed over time, which in turn changed the incentives of these actors. And bad things happened.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.153, ch.6)

They understood the economics. The ideas had already won in ... the regulatory agency itself. All that remained to be overcome were some vested interests and a handful of madmen in authority.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.146, ch.6)

If the idea for auctions of spectrum use rights had been part of the public debate since at least 1959, why didn’t the relevant institutions change sooner? What interests stood in the way?

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.121, ch.5)

When an academic scribbler comes up with a new idea, it has to resonate well with widely shared beliefs, which in turn must overcome the vested interests at the table. Many forces come together to explain political change, even though it may seem like coincidence of time and place.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.120, ch.5)

It’s the rules of the political game that deserve our focus, not politicians’ personalities or party affiliations.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.119, ch.5)

In short, ideas are a type of higher-order capital in society. Like a society that is poor in capital and therefore produces little consumer value, a society that is poor in ideas and institutions will have bad incentives and therefore few of the desirable outcomes that people want.

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