Is High-Speed Trading Just a Game for Finance Elites with No Social Value?
The motivation for a transaction tax is rooted in the belief that high-speed traders profit at the expense of the “little guy” – anyone from a Robinhood investor to an advisor acting on behalf of a client. A new book provides an excellent education on high-frequency trading that can help us to evaluate that proposition.
Donald MacKenzie, a professor of sociology at the University of Edinburgh, has produced a prolific body of literature on the study of finance. His contributions are not, however, so much in what we would think of as sociology as in the study of the political economy of finance.1 By studying finance from this angle, he becomes a “fly on the wall,” observing and chronicling the history and application of developments in finance such as the option-pricing model and high-frequency trading. One significant result is that he delivers a clearer picture of these developments than you could get in any other way – even, perhaps, by being a direct participant in them. This extends to his explanations of the mathematics of modern financial theory, which are as crisp and clear and free of unnecessary complications as any I have seen (MacKenzie has an undergraduate degree in mathematics).
“An engine, not a camera”
I first became intimately familiar with MacKenzie’s work very belatedly, by reading his book “An Engine, Not a Camera” only last year, in 2020. I had heard about it and read reviews when it was published in 2006 but never read it.
I was stunned. It had an amazing number of crossovers with experiences I had had in the field, even though I have deliberately kept mostly on the periphery of the field of finance. For example, when I started reading in the book about the Chicago Board Options Exchange’s trading floor in the early 1970s when options started trading, I flashed back to an afternoon’s experience I had in 1973 or 1974 watching at the invitation of a friend at that time, Joe Doherty, who spent his days trading on that floor. I then turned the page of the book – and there was Joe Doherty, being quoted from a MacKenzie interview with him.
MacKenzie provided outstanding coverage of the October 19, 1987 stock market crash, which was in large part precipitated by the too-successful marketing of “portfolio insurance” by the firm Leland O’Brien Rubinstein. (I played a subsidiary role as a consultant on the mathematics to LOR.) For example, having contrasted “mild” randomness as that which “could be treated by standard statistical techniques” (i.e. assuming standard Brownian motion) with “wild” randomness as that which was “not susceptible to those techniques” (i.e. involving Mandelbrotian/Lévy “fat-tailed” distributions or discontinuous jumps), MacKenzie then pronounces as follows, with keen insight, on both the portfolio insurance and Long Term Capital Management disasters: “In both 1987 and 1998, practical action involving models that incorporated the assumption that randomness is ‘mild’ may thus have helped to generate ‘wild’ randomness.”
Not to over-elaborate MacKenzie’s lapidary and important inference, here is an explanation. LOR’s practice of “replicating” a put option by using stock market index futures required assuming that prices moved continuously, as in a Brownian motion model of the stock market. But it failed when prices took wildly discontinuous jumps, a result that was caused by too many market participants using portfolio insurance and other automated trading rules.
When I read the book, I decided I wanted to interview MacKenzie and write about it. But he was in the process of putting the finishing touches on a new book, on high-frequency trading (HFT), and put off an interview until after completing that.
I decided to review his new book instead.