The fast track to financial ruin

For the past few years, high-frequency trading, in which firms employ massive computing power to make trades within milliseconds, has been a growing profit maker on Wall Street. Computer algorithms discover miniscule pricing anomalies and then hurtle to make those trades instants before humans or slightly slower computers can catch up. High frequency traders shuttle in and out of assets incredibly fast; a day would be an unimaginably long time to hold a share. Right now, high frequency trades account for 73% of all US equity transactions, and as more firms try and get in that number is likely to go up.

There are dangers and potential for criminality in high-speed trading. Although it is not yet proved, many assume that it was involved in the incredibly rapid and otherwise inexplicable "flash crash" of May 6. That certain firms can profit by getting trading data just a tiny bit faster than their competitors certainly seems unfair, but my biggest problem with high speed trading is its fundamental uselessness for anything other than creating trading profits.

Synecdoche is my new favorite literary trope. It means using a part of something to represent the whole, and perhaps the most interesting thing about high speed trading is its utterly self-referential quality, much like the rest of the financial sector. Finance, after all, has a profound societal function, connecting savers and investors so that capital is most efficiently shifted to where it could be most useful. Venture capitalists funding Silicon Valley startups and British bond holders funding the US transcontinental railroad did more than just make money for themselves, they allowed real investment that made land and labour more productive, and thus made the entire society richer.

High-frequency trading does nothing of the sort. Flitting out of assets a millisecond faster than your competitors might make you big money, but it in no way funnels capital to where it is most needed. And that is the problem with much of the financial industry. Arbitrage, mergers and acquisition do nothing to create productive investment. Indeed, for the past generation, because of stock buybacks and increased dividend payments to shore up share prices, the US equity market has actually shifted capital away from corporate investment towards household consumption, the exact opposite of its putative function. As the financial sector has grown, growth and investment have actually shrunk.

The costs and perils of this financial crisis give us the opportunity to rethink our devotion to Wall Street and city interests. So far, proposed new regulations are specific and rule based and so relatively easy to circumvent, if you pay enough to your lawyers. Might I suggest a principle, which would eliminate much of the parasitical nature of modern finance? We should judge all financial practice not only as to its narrow legality or its profitability to early adopters, but also as to whether it has societal benefits, which would mean asking whether it stimulates productive investment. We should treat all financial innovation like we do new drugs—sceptically. Traders would howl, as would Lamborghini dealers, but the rest of us would be better off without the tax that high frequency traders, private equity mavens, and long-short arbitragers impose on the real economy.