What Would Bentham Make of High-Frequency Trading?

Despite apparent advantages, a utilitarian approach deems HFT unethical for hampering growth and favoring the few over the many.

Is high-frequency trading (HFT) ethical? The question raises an issue worth discussing for the sake of the integrity of financial markets. A quick utilitarian calculation, weighing the short and long-term good resulting from HFT against its negative consequences gives a useful, albeit non-definitive, answer. The supposition is that if HFT produces the greatest good for the greatest number, then the practice is ethical.

The Bright Side

Advocates deny the link between HFT and market abuse and assert that HFT strategies contribute to improved market liquidity.

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Advocates of HFT say the link between HFT and market abuse is largely non-existent. Sydney-based Capital Markets Cooperative Research Center analyzed five years of data spanning 2006 to 2011 and has concluded that there is a lack of empirical data to infer HFT is bad for market quality and integrity. Indeed, the study finds HFT is negatively correlated with end-of-day price dislocation, meaning that more HFT correlates to less market abuse. However, correlation is not causation.

Proponents further argue HFT strategies contribute to improving market liquidity. This benefit gives investors comfort knowing they can sell their investments at any time without complications. (The markets had this capability pre-HFT, anyway.) HFT also enables reduced costs for small investors, as increased liquidity and market efficiency contribute to decreased trading costs. Finally, HFT increases profitability for such traders and creates jobs for them.

The Dark Side

Yet, at times of market stress, HFT does not contribute to market liquidity, but on the contrary, increases market illiquidity at heart stopping speed. Indeed, HFT may cause new types of serious risks to the financial system. HFT contributed to volatility in the Flash Crash on May 6, 2010. The Dow Jones Industrial Average plunged to its largest intraday point loss in history, only to recover much of those losses within minutes. After almost five months of investigations, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission have concluded that the actions of HFT firms contributed to extreme volatility during the crash.

High-speed computerized traders disrupt markets. Indeed, HFT may cause new types of serious risks to the financial system.

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High-speed computerized traders disrupt markets. Human traders and industry officials, from equity to commodity trading exchanges, make this complaint. But exchanges and regulators have no quick fix for the concerns. Grain hedgers are as alarmed as other traditional buy-and-hold investors battling against the new HFTs. Traditional investors are critical of HFTs, who dart in and out of markets at lightning speed, narrowing bid-ask spreads, arguably providing liquidity but also creating dangerous and unnecessary swings in prices.The unhealthy price fluctuations are a negative consequence of HFT. This effect harms the overall market, even if it may benefit a few HFTs.

Then there is the problem of lying and dishonest dealing. Even reformed HFT insiders, such as Haim Bodek, say HFT is a form of cheating that is “predatory, disruptive to markets and actually unbeatable without regulatory change.” InvestorPlace describes HFT as high-tech cheating because it is skimming by algorithm. The practice impairs liquidity and efficiency for real, human investors. The finance news outlet wants more SEC regulation of HFTs, whose style of trading hardens the perception that Wall Street is rigged.

Another bad consequence of HFT is the techniques used to make profits, such as quote stuffing and spoofing, which aim to deceive traders at the other end of the transaction. To deceive people by withholding or falsifying information is to violate the principle of respect for human dignity. People have a right to this respect because humans are rational and autonomous. These techniques try to sway other traders into making a decision that is detrimental to them.

The level of financial development is good only up to a point, after which it becomes a drag on growth.

Does HFT add anything significant to society anyway? A former high-frequency trader, Dave Lauer, writes that after two years of working in HFT he felt like a leech, his work creating little value to the world. HFT apparently does not generate added value. A recent paper by the Bank of International Settlements concludes, “The level of financial development is good only up to a point, after which it becomes a drag on growth.” HFT is one of those recent creations of finance that likely is, in the long run, a negative factor for economic growth.

On Balance

From this back of the envelope utilitarian analysis we may infer that HFT is not ethical. Simply put in Spockian terms, the needs of the many outweigh the needs of the few. And HFT caters to the needs of the few with little heed to the needs of the many.

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