The benefit of being able to trade as quickly as possible (as an HFT) is you are able to put more shares/contracts up at each price, ie. provide more liquidity -- this is because anytime the price is going to move against you, you get hit for 100% of your standing bid or offer, and the faster you to cancel those orders are the fewer times this happens. This lets you post more liquidity on average and pull it when the price is no longer good.
Capping trading frequency would lower liquidity. Simply put, the less up-to-date your view of the market is (if orders are only matched every T milliseconds, you could have a view of the market thats up to T milliseconds behind), the more uncertainty there is in your prediction, which will result in you quoting a wider bid-ask spread or quoting smaller amounts at each price. I'd say for T very small (say, T < 5ms), it will make zero difference to liquidity or HFT profits.
I suppose its tough to answer your final question. I'd say liquidity is very useful, and tighter bid-ask spreads help price discovery and help portfolio allocation (the wider the bid-ask spread, the less likely a given portfolio will be allocated in the desired way, since you can only replicate a portfolio modulo transaction costs). Anytime a transaction tax or other regulation is implemented that targets only HFT, liquidity drops, often drastically (e.g. Swedish equity markets in 90s had a relatively high transaction tax that essentially dropped all trading volume on their exchanges to zero, and trading moved to other European exchanges trading equivalent derivatives on Swedish stocks). In addition, HFT industry profits are low -- I'd be surprised if it breaks 5 billion/yr.
Thanks for replying. I like your time averaged argument, that seems to be a good explanation of why it is useful, both to the trading entity and to the market, to be able to change orders quickly.
I think my final question about the balance between total costs and benefits is motivated by the fact that discussion about HFT and similar price-based trading always makes it sound like a lot of effort is being invested in the competition to find profit-making trades, and my wondering whether all that effort could be more productively used elsewhere.
I understand the market motivation behind doing it, which I think yours and others' explanations justify well, however, as I mentioned previously, I remain unconvinced by the allocative efficiency of markets in all situations, and these 'arms race' situations seem like good candidates for market failure (to stress, I mean failure only in terms of the societally-efficient allocation of resources, I don't doubt the local efficiency).
Your note about HFT profits obviously goes some way to addressing this by suggesting that the level of resource allocation isn't that high - I have to confess I didn't realise the profits were quite so low. I do, however, think that revenue is the more important figure, because that will capture the productive effort that we, as a society, are investing in this activity, which we can then usefully compare to the liquidity benefit we get from it.
In case you are interested, I think I have been spurred down this line of thinking by having recently read 'The Collapse of Complex Societies', by Joseph A Tainter, which I can heartily recommend if you haven't already read it. My argument is really his, just applied to the frontier of our times - finance.
And as a personal aside, if you don't mind my asking, you seem to have a good understanding of the realities of this situation, were or are you involved professionally?
Capping trading frequency would lower liquidity. Simply put, the less up-to-date your view of the market is (if orders are only matched every T milliseconds, you could have a view of the market thats up to T milliseconds behind), the more uncertainty there is in your prediction, which will result in you quoting a wider bid-ask spread or quoting smaller amounts at each price. I'd say for T very small (say, T < 5ms), it will make zero difference to liquidity or HFT profits.
I suppose its tough to answer your final question. I'd say liquidity is very useful, and tighter bid-ask spreads help price discovery and help portfolio allocation (the wider the bid-ask spread, the less likely a given portfolio will be allocated in the desired way, since you can only replicate a portfolio modulo transaction costs). Anytime a transaction tax or other regulation is implemented that targets only HFT, liquidity drops, often drastically (e.g. Swedish equity markets in 90s had a relatively high transaction tax that essentially dropped all trading volume on their exchanges to zero, and trading moved to other European exchanges trading equivalent derivatives on Swedish stocks). In addition, HFT industry profits are low -- I'd be surprised if it breaks 5 billion/yr.