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.