Michael Wellman (my Ph.D. advisor) started a blog last week, and he wrote a short piece about economic efficiencies arising from high-frequency trading, which I was pointed to by Dan Reeves' blog post on messymatters.com. Mike says:
Some have suggested that rapidity of response capability per se could open up manipulation possibilities or is otherwise destabilizing. We have also seen questions about whether diverting trade surplus toward whomever builds the biggest fastest network is an efficient use of resources, and the implications for perceptions of fairness across the trading public.
He boils the problem down to the support of continuous trading:
The root of the problem, in my view, is the system's support for continuous-time trading. In a continuous market, trades are executed instantaneously whenever there are matching orders, and introduction of an unmatched order likewise causes an instantaneous update to the information available to traders.
The solution he proposes is the use of periodic clearing in equity markets, i.e., call markets:
An alternative would be a discrete-time market mechanism (technically, a call market), where orders are received continuously but clear only at periodic intervals. The interval could be quite short--say, one second--or aggregate over longer times--five or ten seconds, or a minute. Orders accumulate over the interval, with no information about the order book available to any trading party. At the end of the period, the market clears at a uniform price, traders are notified, and the clearing price becomes public knowledge. Unmatched orders may expire or be retained at the discretion of the submitting traders.
Since my dissertation topic was "Multiattribute Call Markets" (pdf), I feel a little satisfaction is possibly steering his focus back to this alternative market design (he had done a good amount of research on call markets prior to my becoming his student). Having spent my grad school years studying call markets, I'd like to add to the discussion with a short example of how inefficiencies may arise from continuous-time trading.
Assume we have three traders, Joe Sixpack, Jenny Soccermom, and J.P. Goldman. Joe has 1 share of thinly-traded InterWeb stock that he's looking to sell, and Jenny is looking to buy one share of InterWeb. Joe is willing to sell for anything over $1, while Jenny is willing to pay as much as $20. Joe and Jenny aren't savvy traders, so they just submit their reserve prices as bids. J.P. will ultimately make an arbitrage trade, submitting a buy offer for $2 and a sell offer for $19.
With continuous-time trading, J.P. monitors the stock quotes on a microsecond time scale, sees Joe's sell offer, and snatches it up at $2 with confidence that he can re-sell it in the near future. When Jenny comes along, J.P. flips the stock to her at a price of $19. In the end, Joe and Jenny have both successfully executed trades, but had to pay close to their reserve prices to execute. J.P. has effectively sucked $18 out of the system, in return for providing "trade liquidity".
With a call market, buy and sell offers are collected over a short duration of time (e.g, 1 second). In our example, all four offers will be considered together when the market is cleared (buy from Jenny, sell from Joe, and buy/sell from J.P.). When trades are ultimately executed, Jenny trades directly with Joe, since their offers represent the strongest buy and sell offers, respectively. J.P doesn't trade, since his offers don't add value to the ultimate allocation.
In the latter scenario, the call market has effectively replaced the "liquidity value" provided by J.P., providing inherent liquidity through a time-based aggregation of trades. In a later post, Mike related this liquidity provision to a "short-lived dark pool", an idea put forth by Felix Selmon.
I would expect a lot of pushback from those trading shops that have already invested heavily in continuous trading platforms, so don't expect to see call markets deployed anytime soon without a strong grass-roots effort from the academic community.