High-Frequency Stock Trading

"What Do We Know About High-Frequency Trading?" by Charles M. Jones. March 2013. SSRN #2236201.

High-frequency trading (HFT) uses automation to implement strategies that were previously performed by market specialists in exchanges. HFT has increased competition in market-making and reduced the price of capital. Bid-ask spreads have decreased over time and revenues to market-makers have decreased from 1.46 percent of traded face value in 1980 to 0.11 percent in 2006. And HFT reduces stock price volatility; when the temporary ban on short sales of financial stocks existed in 2008, the financial stocks with the biggest decline in HFT had the biggest increase in volatility.

Although most commentators recognize those benefits of HFT, they also believe that it makes financial markets more fragile. The "Flash Crash" of May 6, 2010, during which futures for the S&P 500 fell almost 10 percent in 15 minutes, is often cited as an example of the costs created by HFT.

In this paper, Columbia Business School professor Charles Jones argues that HFT behavior during the "Flash Crash" was initially stabilizing, but eventually high-frequency traders also liquidated their positions, exacerbating the downturn. He claims that even before HFT, market specialists also behaved similarly, buying initially when others were selling and thus reducing the effects of a panic, but then eventually selling themselves. He concludes that HFT does not appear to be any more destabilizing than market specialists were.

Many view HFT as an "arms race" (traders pushing technology for ever-faster trading and locating servers closer to exchanges to take advantage of millisecond differences in data transit time at the speed of light) that should be stopped by policy. Some have proposed a financial transactions tax, also called a "Tobin tax" (after its first proponent, Yale economics professor James Tobin). A Tobin tax, even a small one, would have large effects on stock values. A 0.25 percent tax would lower returns by that amount. If investors expect a 6 percent return, then a 0.25 percent tax would lower returns to 5.75 percent and stocks would have to drop in value by 4.17 percent (0.25 percent divided by 6 percent) to restore the 6 percent required return. Bid-ask spreads are now 1 cent for large cap stocks, but a 0.25 percent tax would add 12.5 cents to the spread for a $50 stock.

Jones describes the Swedish tax experience as instructive. In 1984, Sweden imposed a 1 percent transaction tax, which doubled to 2 percent two years later. Some 60 percent of Swedish stock trading volume moved from Sweden to London. Swedish stock values fell by 5.3 percent and capital gains tax receipts actually fell by more than the amount of transaction taxes collected. The tax was repealed in 1991, but Swedish stocks continued to trade in London. Sweden never regained its role in financial markets.

Patent Reform

"Predatory Patent Litigation," by Erik Hovenkamp. August 2013. SSRN #2308115.

Non-practicing entities (NPEs) are firms whose sole assets are intellectual property that they have purchased the rights to, rather than developing themselves. The firms' main activity is suing other companies for patent infringement. They have been discussed in these pages before (see "The Private and Social Costs of Patent Trolls," Winter 2011–2012, as well as last issue's "Working Papers" column). Commentators seem to agree that NPEs are opportunists that exploit and illuminate flaws in overly broad information technology patents, and that they contribute little to economic growth—and may hamper it.

One proposal to reduce this opportunism is to increase the fees to renew a patent late in its life because mischievous suits seem to occur exclusively late in patent life. Another proposal is to shift the legal fees for patent infringement suits to the courtroom losers, thus increasing the costs of frivolous suits.

Northwestern University J.D./Ph.D. student Erik Hovenkamp offers a different idea: defendant mutual defense by contract. Predatory NPEs now attack firms one at a time. Defendant firms frequently settle rather than face the prospect of a financially catastrophic judgment. Hovenkamp proposes that manufacturing firms whose success is dependent on intellectual property form mutual defense associations analogous to treaty organizations among nations. The members would agree to share defense costs and to litigate to judgment rather than settle cases out of court. This, along with the shifting of legal fees to the losers as proposed by Mark Lemley and Douglas Melamed (discussed in last issue's column), would deter NPEs from litigating low-quality patent cases.

Unemployment Insurance

"Unemployment Benefits and Unemployment in the Great Recession: The Role of Macro Effects," by Marcus Hagedorn, Fatih Karahan, Iourii Manovskii, and Kurt Mitman. October 2013. NBER #19499.

Unemployment following the Great Recession has remained unusually high. One possible reason is the extension of unemployment benefits from their usual 26-week limit to a period as long as 99 weeks. The conventional wisdom is that such extensions have positive effects on the macroeconomy because they have very little effect on labor supply and also increase aggregate demand because unemployed workers have a large marginal propensity to consume any benefits they receive.

This view has been supported by low estimates of the effect of unemployment insurance extensions on labor supply. Economists have used the cross-sectional variation across states in extension initiation and duration to estimate the effect of benefit variation on the search behavior of the subset of the unemployed who receive benefits. For example, in a fall 2011 Brookings Papers on Economic Activity article, Berkeley economics professor Jesse Rothstein compared those unemployed who are eligible for unemployment insurance with those who are not, thus isolating the search behavior of those receiving benefits. He concluded that the increased duration of benefits has a very small effect on the duration of unemployment and concludes that only a small fraction of the increased unemployment in the Great Recession can be attributed to reduced worker job search effort.

The authors of this paper argue that Rothstein's research design underestimates the total effect of unemployment insurance extensions on labor supply because it does not include the indirect effects on labor demand, i.e., the posting of vacancies by firms. The effect of benefit extensions on labor demand arises because the existence of unemployment benefits reduces labor supply, which increases the wage that would-be employers have to offer, which in turn decreases firm expected profits and reduces the posting of vacancies.

To detect this effect on vacancies, one cannot simply regress the increase in benefits on wages, in general, because the wage data would include both the effect of reduced labor supply (less searching) that would increase wages as well as the effect of reduced labor demand (fewer job creations) that would decrease wages. The authors propose instead a regression of difference in wages against difference in benefits across time, but only for those workers who stay on the job. The differences in benefits arise through estimation on contiguous counties on opposite sides of a state border. The authors conclude that a rise in unemployment of 3 percentage points is the predicted result and that "unemployment benefit extensions account for most of the persistently high unemployment after the Great Recession."

Clearinghouses

"The Dodd-Frank Act's Maginot Line: Clearinghouse Construction," by Mark J. Roe. March 2013. SSRN #2224305.

Clearinghouses have become a standard response to the failure of troubled financial institutions in 2008. Proponents argue that if the credit default swaps created by American International Group (AIG) had been cleared rather than traded over the counter, the clearinghouse would have paid the capital and collateral calls of the counterparties holding credit default swaps for debt securities backed by pools of mortgages. This would have eliminated the fire sale of such assets to raise capital and the resulting decrease in asset market value that was at the heart of the financial crisis and the bailout of AIG. This thinking has become conventional wisdom and is embodied in the Dodd-Frank Act of 2010.

Regulation was one of the first to criticize such thinking in an article by University of Houston finance professor Craig Pirrong ("The Clearinghouse Cure," Winter 2008–2009). In this paper, Harvard law professor Mark Roe agrees with this criticism and argues that Dodd-Frank and similar proposals are severely misguided. Clearinghouses would not have stopped what happened in 2008: the reevaluation of the same assets by multiple institutions at the same time and selling them to raise cash. A simultaneous common failure or reevaluation of assets across financial institutions is not something that a clearinghouse is even designed to handle. Clearinghouses cannot prevent the effects of a downward asset price spiral from spreading, nor the negative information contagion about those assets. Proponents of clearinghouses seem to forget that the government bailout of AIG was $180 billion while the capital of the clearinghouse for the Chicago Mercantile Exchange is only $7 billion. If AIG had been a member of a clearinghouse, the clearinghouse would not have had sufficient capital.

Income Inequality

"Why Has Regional Income Convergence in the U.S. Declined?" by Peter Ganong and Daniel Shoag. March 2013. SSRN #2081216.

Income inequality discussions usually focus on the changing returns to skill, the role of trade, and measurement issues involving the growing role of health care benefits. A less commonly invoked explanation involves zoning. Migration to higher-wage cities is now much more difficult than in the past and may play an important role in increasing inequality.

From 1880 to 1980, incomes across states converged at the rate of 1.8 percent per year, according to Harvard economist Daniel Shoag and doctoral student Peter Ganong. Since 1980, that convergence has stopped. In 1940, per-capita income in Connecticut was 4.37 times per-capita income in Mississippi. In 1980, that ratio had decreased dramatically to 1.76. But since then no change has occurred; the ratio is now 1.77.

The authors' explanation for this is housing supply constraints. The difference in housing prices between rich and poor states has grown relative to income differences across states. The result is that from 1980 to 2010 there has been a large reduction in low-skill migration to those states with a high share of bachelors' degrees, but no change in high-skill migration to the same states. Had migration continued after 1980 at the same rate, wage inequality would have been 10 percent smaller.

Legal Services for the Poor

"The Cost of Law: Promoting Access to Justice through the Corporate Practice of Law," by Gillian K. Hadfield. December 2012. SSRN #2183978.

The most provocative advocate for the deregulation of the provision of legal services is University of Southern California law professor Gillian Hadfield. She has argued her position twice in these pages ("Privatizing Commercial Law," Spring 2001, and "Legal Barriers to Innovation," Fall 2008).

In this new paper, she notes that ordinary people often appear in court without legal representation. The legal profession has responded to this by requesting more legal aid. But in Hadfield's view, the problem arises from the economic regulation of the provision of legal services. In particular, state regulation of the corporate practice of law prohibits, say, Walmart and Target from providing legal services in their stores. And states forbid online legal-document companies from providing legal assistance. Those prohibitions prevent the development of lower-cost methods of providing legal services.