On high frequency trading

I have complained to my coworker a few times about how I don't think high frequency trading is socially efficient. The coworker didn't really empathize as he saw the benefit of additional liquidity and I didn't really have a strong rationale behind my complaints. I have been thinking more about this issue lately and I think now I have some arguments to support my feeling.

The inefficiency is that trading firms spend millions of dollars to reduce latency at the unit of milliseconds. This is a natural consequence of the nature of high frequency trading competition, just as price competition is a natural consequence of free market. When a supplier in free market reduces the price of its products, its loss from the competition transfers directly to the consumers and in fact the perfect competition that drives the price down to the marginal cost exhausts all mutually beneficial trades to reach a Pareto optimum. On the other hand, the cost incurred from latency competition does not benefit anyone, except for very marginal increase in liquidity (the real social benefit of HFT is liquidity in terms of ask-bid spread, not in latency). In short, all those millions of dollars spent by trading firms to cut down the latency is deadweight loss to the society. And since the latency can never reach a true zero, the arms race can continue on and on. My guess is that at this very moment highly scarce human capital is spent on researching for reducing the trade latency.

I should mention that this is the same kind of social cost incurred by education signalling that I commented on last year. More precisely, it is a social cost of type of competition that has no counter party benefiting from the cost of competition. This type of competition is of course nothing but a form of Prisoner's dilemma, where the player reaps a huge benefit as long as he spends a little more than everyone else. The unique Nash equilibrium in this case would be that everyone spends as much as the benefit which is the worst social outcome.

I can't think of any way to solve this problem. Setting some minimum latency would be an obvious solution but the cost of enforcing it would well exceed the benefit. An easier rule to enforce is no high frequency trading at all. Not to say that HFT is without its benefits, but perhaps it deserves a cost-benefit analysis.

On patent

The recent court battle between Apple and Samsung has stirred the economics community a little to discuss about the efficiency of patent law. Becker and Posner both show concern that the current patent system is excessive. Becker cites Arnold Plant (1934) who advocated the elimination of patent system, agreeing that Plant erred in the right direction. Still, Becker finds patent system still necessary, writing: Although ending the patent system is a clean solution to all the problems induced by modern patenting, it clearly is not desirable given the importance of industries like the pharmaceutical industry. Since this industry spends on average hundreds of millions of dollars bringing to market a successful drug, pharmaceutical companies would not invest such large sums without the protection of patents (or without other benefits).

And today, I came across an article by Jordan Weissman that cites a working paper by Boldrin and Levine that argues for abolishing the patent system entirely: the best solution is to abolish patents entirely through strong constitutional measures and to find other legislative instruments, less open to lobbying and rent-seeking, to foster innovation whenever there is clear evidence that laissez-faire under-supplies it. The base of the bold argument is that, although well-designed patent system would indeed spur innovations, such system cannot occur with the current political structure. This part of the argument (part 3) feels rather weak at the moment, but that is not unexpected from a working paper.

The paper reminded me of an article by Steven Johnson in Wired magazine (October 2012, "Inventors' Gold"). Focusing primarily on pharmaceutical industry, Johnson argues that the government should offer lump-sum payouts instead of granting patents. The benefit of this alternative is that it eliminates the externality of patent monopoly while still providing incentive for innovation (the lump-sum payment, or the prize, would constitute the "other benefits" Becker mentions). It further solves Plant's concern that, as Becker summarizes, patents distort innovations in favor of goods and processes that can be patented and away from innovations that cannot be patented. In similar vein, Johnson argues that the current patent system does not allow innovations in some of the most needed drugs, such as those for tropical disease.

The last point, of course, is arguable and is in fact one down side of lump sum prize compared to patent. The burden of measuring the value of innovation lies on the government with the lump sum prize, while it lies on the innovators with patent system. As we know, government has less incentive to make accurate estimate. Furthermore, the cost of wrong estimation transfers from the innovator to the taxpayers with the lump sum prize, which may be socially undesirable. Still, I find the alternative of lump sum prize quite attractive over the current patent system.