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More haste, more waste

22 April 2015 By Edward Hadas

Bloomberg LP’s terminals went dark on Friday for a few hours. Many traders were deprived of the information and communications that the firm usually provides. Activity in some usually frenetic financial markets slowed down sharply. Contrary to the standard reaction, that’s a good thing.

The outage was met with complaints and calls for more robust systems and perhaps added redundancy, something which might benefit Bloomberg rivals, including Breakingviews parent Thomson Reuters. Though any technology could still break down, the goal of keeping everyone connected at all times makes sense – as long as trading is seen as socially and economically beneficial. The trouble is, the easy exchange of financial assets often does more harm than good.

Friday’s outage disrupted a regular sale of UK government bonds, which isn’t ideal – but that really reflected the timing of the disruption, not the need for non-stop trading.

One real benefit of liquid markets is that easy trading with low transaction costs enables investors to modify their portfolios quickly and cheaply in response to the flow of news. Such advantages are heavily advertised by the financial industry. But looked at more cynically, fast trading provides a relatively cheap way to satisfy the widespread urge to gamble.

In any case, the pluses have to be set against a heavy collection of negatives. To start, each market transaction has a cost, and the costs mount up, even in the electronic age. If there were less trading, many computers, offices, traders and market regulators could be given over to other, perhaps more socially beneficial, tasks.

Fast trading also has a pernicious socio-economic influence. Large-scale investors and investment managers are mostly rich and influential. A penchant for frequent market activity often amounts to a taste for quick capital gains and a strong desire to limit market losses. Such preferences translate into distaste for both long-term investments and big bets on potentially useful innovations.

Not all investors are like that. Warren Buffett, for instance, is much more interested in the fundamentals of a business than its stock price. But the rapid trading mindset and the idea that it’s possible to time markets successfully should be discouraged.

In some eyes, slowing down trading and transferring resources away from market activity would make markets damagingly less liquid. But it would not necessarily affect the real economy task of providing goods and services. That’s because trading, whether slow or fast, is quite different from providing new capital.

When investor A sells already issued securities of X Company or the debt of Y government to investor B, nothing changes for X or Y. It is possible that B will be more interested than A in guiding strategy or policies, but that’s less likely with more frequent trading. By contrast, financial professionals who raise new money for X and Y to deploy will always have a useful role to play.

Reduced liquidity would also counter the belief that any security should be tradeable at any given second. Investors who know that it may be difficult to unload positions are less likely to engage in leveraged strategies which rely on cashing in quickly when prices are falling so as to repay borrowings.

Such strategies can lead to huge losses when liquidity disappears – as it typically does at times of serious market stress, regardless of all the technology in play – and forced sales take place at distressed prices.

Laws and regulations could easily reduce excessive trading in financial markets. Transaction taxes offer one approach. High tax rates on short-term capital gains – even up to 100 percent on the quickest flips – would be another. Exchanges could shrink their opening hours, maybe down to a few hours a week. That would be more than enough for investors interested in fundamentals, as compared to traders focusing on market moves, to adjust to any meaningful new information affecting their holdings.

Of course, little if any of this is going to happen. The financial industry has the clout to block or dilute efforts to impose levies on transactions or curb so-called high-frequency trading.

There is also much that is more broadly appealing about fast trading. The whir of activity seems modern, technology-driven and productive, the lure of speculative profit is hard to resist, and the constant counting of gains and losses fits in with a tendency towards instant gratification.

Even for those hoping for a cultural revolution that slows trading down, there’s a grim reminder in the property market. Few assets trade more slowly than residential and commercial real estate, and the commissions, taxes and other trading costs are many times higher than for financial instruments. But this market was central to the most damaging bubble and bust of the current century.

The lesson of U.S. subprime mortgages, of the Irish and Spanish construction booms and of the current Chinese rush into property is clear. People will always fall for the promise of easy, highly leveraged profit – whether it comes in a millisecond or next year.


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