I Know You Have More Information Than Me
Matt Levine wrote a terrific piece at Bloomberg yesterday on New York Attorney General Eric Schneiderman’s attempts to crack down on high frequency traders getting information milliseconds before the rest of the market. This happened a couple of times over the past couple of months and Schneiderman is concerned about the “dumb money” on the other sides of those trades who are being ripped off. Levine doesn’t argue against that notion, but comments that it isn’t small investors who are the ones being ripped off. It’s the other high-frequency traders who aren’t receiving the market moving data milliseconds ahead of time. Levine’s main point is that ordinary investors should never try to compete with high-frequency traders, whether or not they get the data milliseconds in advance. Instead, they should look to compete on a longer time horizon.
That’s entirely good advice and Levine is right that it’s other high-frequency traders who are hurt by the ones getting the market moving data in advance. But I want to push back on one thing he said earlier in his post:
One way you can tell it’s bunk is umm there are markets and they are not essentially equal. This is a true story: Many banks employ analysts who write detailed research reports that include recommendations on whether you should Buy or Sell a stock, and they give those research reports to their paying clients and not to anyone else. Those clients are paying for an unfair advantage!** But it’s not just banks. The Wall Street Journal employs journalists who find news and then make that news available only to paying subscribers. Bloomberg employs journalists who find news and then make that news available to anyone on the Internet, shortly after making it available only to paying Bloomberg terminal users.
The “essential equity of the markets” is bunk because the essence of the markets is inequity. You trade because you have, or think you have, better information than someone else. If everyone had the same information, and believed that they had the same information, there would be no markets.
That’s true as well. But the difference is that small-time investors know that they don’t have the same information as banks and the clients of those banks. They are aware of the information asymmetry and believe they can beat the market anyways.
But when traders gain market moving data ahead of time, investors don’t know that they are playing on a tilted playing field. They believe they all are receiving the same information as everyone else at exactly the same time. They know they are competing against high-speed supercomputers and are at a disadvantage there. They don’t know that those supercomputers have a head start on them. As Levin notes, this doesn’t really make a difference for those investors because they can’t compete with the supercomputers anyways. It’s other supercomputer that aren’t privy to advance copies of the data who are the “dumb money.”
But just because there information asymmetries, that doesn’t mean that markets are unfair, in an equitable sense of the word (not a market failure sense). As long as you know that you face an uphill battle against investors with lots more resources and lots more information than you, you’re welcome to try to beat the market anyways. It’s when you don’t know that you’re facing an uphill battle that things really become problematic.