Bananas and oranges go by nightfall after arrival in the day by ship, and there are no other sources of bananas and oranges. For every banana a person eats, they must also eat an orange.
Ships arrive sporadically throughout the day, and a ship can only contain bananas or oranges, not some of each. Only a few ships arrive each day. An equal number of bananas an oranges are shipped each day from the sources, but some of the ships sink on the way, so that there may be a surplus or deficit of bananas or oranges (remember, to eat one banana you must eat one orange).
Spotters see the ships coming at roughly the same time, with some randomly variation, and immediately adjust the price of existing bananas or oranges based on what the incoming ship is carrying--after all it didn't sink, and the fact that it didn't gives some information on whether or not there will be a banana/orange deficit.
One day a man invents a telescope and begins seeing the arriving ships five minutes before everyone else. He provides no net-wealth to society as a whole, but with the money he makes via arbitrage he begins commanding a disproportionate share of society's wealth for his own use.
*Galileo originally used his telescope invention for exactly this (in conjunction with a wealthy family)--one of the least useful things he ever did. Would you rather someone work in HFT (scope out banana boats 5 minutes earlier than the next guy) or work in something useful like scientific research/general technological improvement (Galileo's discovering of deeper secrets of the heavens/improvement of navigation and cartography enabled by the scope)?
Is that 5 minutes of advanced information truly worthless?
Does the average wealth of society increase or decrease with the addition of the arbitraging Galileo?
I think it increases.
Inequality increases, true, and there are other dangers in inequality.
But the median wealth of everyone also increases because now people know 5 minutes earlier if they're going to eat oranges tonight. Presumably that information is worth something, and I think there is a good argument to be made that the value of that information is equivalent to the profit of all the arbitrageurs.
I believe in wealth redistribution, but this question is less about inequality and more about the utility of that advance information.
Intuitively it does seem ridiculous that 3ms of ping is worth $300,000,000. But we're dealing in a global economy with nearing 7 billion people, and 3ms * 7,000,000,000 adds up to 8 months of human life.
It would be a problem if the fiber line owner, with his wealth, gains some kind of hegemony over the world and enforces some kind of human-life-crushing totalitarianism. But the inequality argument is most sensibly solved by wealth redistribution - taxes, welfare, public healthcare, etc. Rather than outlawing arbitrage.
> Is that 5 minutes of advanced information truly worthless?
>But the median wealth of everyone also increases because now people know 5 minutes earlier if they're going to eat oranges tonight.
Since we can assign an arbitrary utility value to that knowledge while not changing the profits telescope man makes (how much is the existing stock of oranges and separately the existing stock of bananas now worth, now that telescope man sees a boat of bananas has arrived unsunk and each banana must match an orange? He can use this to revalue the two and sell or buy from/to people who only know the old valuation).
The utility you claim isn't directly related to the telescope-man profit. Certainly not equivalent as you seem to think:
>I think there is a good argument to be made that the value of that information is equivalent to the profit of all the arbitrageurs.
What makes you think there is a one-to-one correspondence? Can you make the argument, or do you just think there is a good one to be made? If you already made the argument I didn't see it, and if it involved multiplying ping delta by current world-population then I am definitely not clever enough to understand it. ;)
("go by nightfall" in my original post should have been worded "go bad by nightfall")
My point regarding pings was that tiny advantages in speed, if leveraged across enough people, become large advantages in speed, and if a single person provides a tiny bit of value to many people, then that adds up to a lot of total value produced by one person and therefore a big paycheck for that one person.
The telescope information is valuable to fruit sellers and fruit consumers alike. If Bill is very hungry today, but Joe is not, then Bill is rightly willing to pay a higher price for fruit.
Let's say that the loss of one ship raises the fruit price from $1 to $10. Bill wants to eat today and so he is saving his last $10 for when the fruit arrives.
As the ship crosses the ocean, the closer it gets to shore, the less risk there is in Bill spending his other $9. He wants to buy beer but is unwilling due to the risk of not being able to afford fruit.
To Bill, there is clear value in knowing how far along the ship has gone. The sooner he knows the better. Since knowing the ship is coming frees up his $9, this information also provides value to the brewer who will be able to sell his beer sooner. If the brewer sells his beer sooner, the brewer will be able to buy himself new shoes sooner, and so on. The 5 minutes of foreknowledge results more economic activity, and higher wealth in general. Bill gets his beer sooner, making him happier sooner. This has value. Mr. Guinness the Brewmaster gets his shoes sooner, easing his ankles sooner, and this is worth something. Every little bit of foreknowledge helps.
All arbitrage follows this same model. Whether the arbitrage profits are collected by one person or many is not relevant. There is utility in prices that accurately reflect supply and demand. The sooner prices reflect reality, the better.
If there are going to be fewer oranges available, the price should be higher to ensure an efficient distribution - a distribution to those who most value the oranges.
Galileo made prices 5 minutes more accurate, and while that is unsexy, it saved 5 minutes of inefficient trading. In aggregate, those 5 minutes end up being worth a lot.
Those minutes provide some level of utility equal to or greater than Galileo's profit. If Bill did not get at least $10 worth of utility from his oranges, he would not buy them, and Galileo would not receive Bill's money. These are voluntary transactions after all. Bill can always starve until tomorrow, or boil his shoes, or go forage for berries.
First you were arguing that the profit equaled the utility exactly. Now you are saying something different. Taking your new example, since the trading profits are roughly the same whether the advantage is 5 minutes or 20 seconds so long as the ship is seen first by telescope man, yet the probability of Bill mistakenly wasting his money on beer when he should have saved for bananas does depend on that length of time, then the utility and the profit aren't equal; and as the time advantage approaches 0, (and thus the utility you are talking about here approaches 0) the profit remains the same.
You are saying there is always some utility. Ok fine, but it gets arbitrarily close to 0. In the case of HFT there is also some cost (brain-drain for proprietary R&D, power drain for datacenters, etc.). Which outweighs which? What timescale do we have to get to? We are already well below it.
I was wrong saying profit equaled the utility exactly.
There is clearly an opportunity cost with HFTs, and I would hypothesize that at a certain point there is a better ROI in other fields for those people. There should be diminishing returns to investments in HFT, right?
This is such a theoretical argument and my conclusions are based mainly on the idea that if there is no utility people would not pay for it. It does seem ridiculous that moving 3ms faster wins you so much, but I'm just not convinced that there is definitely no utility there. Often economic utility is very hard to intuitively recognize -- often it is not recognized until people start intervening in the market and bad things start happening. If you ask computer scientists which jobs are useless, provide no utility, and should be eliminated, they would eliminate huge sections of the economy.
Your analogy is pretty good, but the part about the telescope is critically flawed. You assume that there is very little (zero?) variance in the future once the man with the telescope sees the incoming ship. In the scenario you described, that may be the case.
Unfortunately, in the stock market, there is no where near that level of certainty about the future. There is great risk to posting prices that may in fact be terribly wrong in the future. That is the risk that market makers have to grapple with and quantify when they post or take liquidity.
Suppose that every time you spotted a ship through the telescope, it would magically explode 2 minutes later. This happened roughly 50% of the time, as observed over 1 million ship sightings for the past few years. This is a lot closer to what the stock market is like. The other difference is that every serious player in the stock market also has a telescope :(
So is mine. I develop HFT trading algorithms using statistical analysis. Placing limit orders on the other side is as dangerous as anything else. Are you on the strategy side or pure development side? If you are developing strategies, then you know what you said in no way mitigates most of the risk that we talked about.
Pure development. So yeah, there's some handwaving there.
Let's say Galileo had had to climb a rickety ladder to the top of a tower at significant risk of falling and breaking his legs. Would that in any way have altered the social utility of his end product?
re: "every serious player in the stock market also has a telescope," see my comments on the Chicago fiber installation elsewhere in this thread.
Lets say it is a hypothetical telescope that has no other use than banana/orange arbitrage. If you don't think that addition makes the analogy more accurate, you haven't seen market-data parsing FFPGAs.
And don't forget this:
"By March 2009 Spread was moving dirt. Soon it had 125 construction crews working at once. [...] At 825 miles and 13.3 milliseconds, Spread's circuit shaves 100 miles and 3 milliseconds off of the previous route of lowest latency. [...] Spread won't disclose cost, but Jason Cohen, the chief operating officer of Allied Fiber, which is building a nationwide network, says laying cable through easy terrain runs $200,000 per mile. Half of Spread's route, however, is through tough virgin terrain, pushing forbes' estimate of its cost toward $300 million."
"One day a man invents a telescope .... He provides no net-wealth to society as a whole"
Financial incentive drives creation. Programable gate arrays that can keep a limit order book drive sales of the cards. If more cards are sold, they get cheaper. If they are cheaper, they are more accessible for medical imaging.
What impact on the national fiber network has the Spread line had? What has it taught us?
Sometimes the Randian suggestion doesn't meaningfully differ from the caricature of Keynes: "dump a portion of production into the ocean to help the economy."
World War II spurred development of new metal alloys, better vehicles, and thousands of other innovations. Does that make Hitler a hero? Was war the only path?
(Sorry, I had to Godwin it before this thread got too long; the more general war analogy isn't too far off though: $300-million in heavy-equipment laden fiber laying probably resulted in some injury--is it too much to ask that we both get the beneficial externalities of R&D and put in the fiber for a useful purpose in the first place?)
The company I work for (Red Hat) has made a ton of contributions to the Linux kernel to improve real time performance. The driver and money for these contributions is high-frequency traders, but the benefits accrue to all sorts of areas and kernel users.
Bananas and oranges go by nightfall after arrival in the day by ship, and there are no other sources of bananas and oranges. For every banana a person eats, they must also eat an orange.
Ships arrive sporadically throughout the day, and a ship can only contain bananas or oranges, not some of each. Only a few ships arrive each day. An equal number of bananas an oranges are shipped each day from the sources, but some of the ships sink on the way, so that there may be a surplus or deficit of bananas or oranges (remember, to eat one banana you must eat one orange).
Spotters see the ships coming at roughly the same time, with some randomly variation, and immediately adjust the price of existing bananas or oranges based on what the incoming ship is carrying--after all it didn't sink, and the fact that it didn't gives some information on whether or not there will be a banana/orange deficit.
One day a man invents a telescope and begins seeing the arriving ships five minutes before everyone else. He provides no net-wealth to society as a whole, but with the money he makes via arbitrage he begins commanding a disproportionate share of society's wealth for his own use.
*Galileo originally used his telescope invention for exactly this (in conjunction with a wealthy family)--one of the least useful things he ever did. Would you rather someone work in HFT (scope out banana boats 5 minutes earlier than the next guy) or work in something useful like scientific research/general technological improvement (Galileo's discovering of deeper secrets of the heavens/improvement of navigation and cartography enabled by the scope)?