Spread Networks recently spent $300 million to build a fiberoptic cable that will let Wall Street traders shave .003 seconds off their execution times.
What’s the social value of that cable? If you can shave .003 seconds off the time it takes to execute a trade, how much good have you done the world?
Clearly, the full value of the cable resides in its ability to get things done faster. So start with a vast overestimate: Suppose the entire economy is on hold waiting for that trade to be completed. Then, thanks to the cable, we can all get on with our lives .003 seconds sooner and produce an extra .003 seconds worth of output.
In a $15-trillion-a-year economy, that comes to about $1500.
If we assume, more realistically, that just 1/1000 of the economy is hanging fire waiting for this one trade, the social contribution of a .003-second speedup is roughly $1.50. I’m confident it’s even more realistic to replace that 1/1000 with 1/1,000,000 . That gets us down to about an eighth of a cent.
But chances are you’d be willing to pay a hell of a lot more than an eighth of a cent for that extra speed, which is why Spread Networks is willing to pour $300 million into this thing, and why, quite generally, we should expect there to be more invested in such projects than they return in social value.
Economic theory tells us that under quite general hypotheses, the private value of an activity is in synch with its social value. If growing an orange makes you a dollar richer, that’s because growing that orange makes the world a dollar richer. And that’s good, because it encourages people to grow all and only those oranges that are (socially) worth growing.
But while those general hypotheses apply to the markets for oranges, locomotives, haircuts and chocolate chip cookies, they do not apply to high frequency trading. Here’s the key difference: If I start growing oranges, I slightly diminish the value of existing orange groves — but that cost to my competitors is exactly offset by benefits to my customers. By contrast, if I build a fiberoptic cable that’s just a hair faster than your fiberoptic cable, I do not slightly diminish the value of your cable; instead, I (at least potentially) devastate it. The reason my cable can be worth more to me than it is to the world is that it effectively transfers wealth from you to me. That’s unfortunate, because the world works better when people concentrate on creating wealth, not taking it from others.
That creates at least the possibility that projects like Spread Networks’ are socially wasteful. To determine whether they are socially wasteful, we need to compare their external benefits with their external costs. (“External” here means “felt by someone other than the decisionmaker”.) We know that high frequency trading has big external costs. For it to be socially desirable, it would have to have even bigger external benefits. Over on another thread, we’ve been debating whether that’s plausible. As far as I can see, the pro-HFT arguments offered there have amounted to nothing more than a) denying the obvious external costs, with no reasons offered, b) mistaking private benefits for external benefits, and c) asserting that there are external benefits that must surely outweigh the external costs, with no reasons given.
My own position has been that the external costs are obvious, and that there might or might not be external benefits that outweigh them. That was before I did the back-of-the-envelope calculations you see at the beginning of this post. Now that I I’ve got an upper bound on the benefits, I’m pretty well convinced that the matter is settled.
There remains the question: If HFT is socially destructive (as I now think it clearly is), what should be done about it? Outlawing, directly regulating, or taxing it seems like a nightmare to me for multiple reasons, including the implausibility of effective enforcement and my general reluctance to cede power to regulators who all too often wield that power in unanticipated and obnoxious ways.
But here, perhaps, is an easy fix: What if trades were executed anywhere between 0 and 1 second after they were submitted, with the delay chosen randomly? On average, we’d slow everything down by half a second. At the same time, we’d pretty effectively destroy the value of a .003 second head start, and Spread Networks might start looking for an investment that could actually enrich the world — perhaps an orange grove.