Negative sentiments against the financial markets and its participants are not new; “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done,” John Maynard Keynes wrote in 1936 in his General Theory. Even among practitioners, there is a common (mis)understanding, that certain aspects of trading, as such the race towards lower latency, is a waste of human capital that could instead go towards other causes. While it is certainly possible for markets to encroach on society in a manner detrimental to general welfare, it is important that we place the debate within the right context. A lot of the points made in this and subsequent posts come from the textbooks Trading & Exchanges and Regulated Exchanges by Larry Harris.
Preliminary Definitions
Liquidity—the ease with which a security can be bought or sold in large volumes without materially affecting its price—is supplied by sell-side agents (brokers and dealers) and consumed by buy-side agents (for example, hedge funds and asset managers). These trades occur either on formal exchanges or off-exchange directly between counterparties.
Dealers act as principals, trading on their own account, while brokers act as agents on behalf of clients; although many firms perform both roles as broker-dealers, regulation prohibits them from acting as principal and agent in the same transaction.
The market operates within a multi-tiered regulatory framework: legislators enact financial-market laws; Self-Regulatory Organizations (SROs)—such as FINRA, exchanges, and clearinghouses—establish and enforce industry rules; and regulators like the U.S. Securities and Exchange Commission oversee SROs and market participants, ensuring compliance and issuing guidance.
In the short term, trading is a zero-sum game in expected value—every dollar one participant gains is a dollar another loses—though it need not be zero-sum in expected utility once you account for differing risk preferences and hedging benefits. Over the long run, however, well-regulated financial markets become positive-sum: by aggregating diverse information and facilitating the efficient allocation of capital, they promote economic growth through a robust price-discovery process.
Many market participants trade for utilitarian purposes:
- Investors and borrowers use markets to solve intertemporal allocation problems—young savers buy equities to boost future consumption, retirees liquidate holdings to fund living expenses, and corporations issue debt or equity to finance projects whose returns exceed their cost of capital.
- Asset exchangers simply swap one form of purchasing power for another—an exporter might sell dollars to obtain euros for overseas operations, for example.
- Hedgers mitigate their business risks by taking offsetting positions—oil producers sell futures to lock in prices while airlines buy them, and producers and processors of wheat enter complementary futures contracts to stabilize margins.
- Regulatory arbitrageurs structure transactions to exploit tax or regulatory disparities, such as realizing short-term capital losses to offset income while retaining long-term, tax-favored gains.
- Finally, not all trading is driven by economic necessity. Gamblers trade for the thrill, fully aware they lack a statistical edge, while futile traders mistakenly believe they possess one—whether due to flawed analysis or trading strategies that the market has already arbitraged away. Both groups contribute to overall liquidity, even if they do not generate lasting value for themselves.
On the other hand, profit‐driven traders—also known as signal traders—enter the market because they expect to earn short‐term profits from their activities. Among them, market makers (or dealers) earn the bid–ask spread by continuously quoting two‐sided prices and facilitating liquidity for all other participants. To do so profitably, they manage their inventory risk—widening spreads or adjusting quotes whenever bids are “hit” too frequently or offers are “lifted” too often.
Other profit‐driven participants speculate on anticipated price changes. Informed traders use news‐driven signals to update their positions immediately after new information arrives, while value traders seek to exploit discrepancies between a security’s market price and its underlying fundamentals.
Algorithmic, quantitative, and statistical‐arbitrage (stat‐arb) traders programmatically identify and correct mispricings created by less informed market behavior, and pure arbitrageurs ensure that equivalent assets across venues or related instruments trade at consistent prices. Together, these signal traders accelerate price discovery and help markets converge toward their true economic value.
Market Formation
Because trading is zero-sum in the short term, a market composed solely of profit-driven participants would collapse: those who lose money would quickly exit, and the survivors—fearing adverse selection—would refuse to trade or post quotes unless they believed their counterparty knew less.
In practice, markets endure only because of utilitarian participants whose transactions reflect real economic needs—allocating capital across time, hedging business exposures, or exchanging currencies for operational purposes. It might therefore seem natural to design market structure and regulation primarily for these utilitarian traders, since their activity underpins the market’s broader social utility. Yet markets also impose externalities: what benefits one group can impose hidden costs on another, a tension we will examine in later sections.
Utilitarian traders generate order flow that is relatively insensitive to short-term price fluctuations—individuals dollar-cost averaging into retirement accounts, companies issuing shares to fund long-term projects, or producers and consumers hedging real exposures. This uninformed flow introduces “noise” into prices, creating the very deviations from fair value that profit-driven traders exploit. Market makers earn the bid–ask spread on these price-insensitive orders—so-called “good flow”—by matching trades over time and bearing inventory risk. Their quoting behavior inevitably pushes prices away from intrinsic value, which then attracts information-based speculators—traders armed with costly research or arbitrage strategies—whose “toxic flow” corrects those mispricings.
A healthy market thus depends on the symbiosis of utilitarian and profit-driven participants: the former supply the essential economic rationale and baseline liquidity, while the latter provide continuous price discovery and risk intermediation. Without noise traders, spreads would vanish and informed speculation would wither; without market makers and speculators, transaction costs for real-economy actors would become prohibitive. This dynamic balance underlies long-term market resilience and highlights why regulation must carefully calibrate incentives across all types of participants.
Fisher Black describes the dynamic between noise traders and information traders beautifully in Noise, and I now summarize his points.
- The more noise trading occurs, the more liquid markets become—frequent trades provide more price observations. As noise trading increases, trading on information becomes more profitable, since greater price noise creates wider mispricings. However, this doesn’t necessarily make prices more efficient: more information traders enter the market, take larger positions, and spend more on research, yet a market can be highly liquid and still exhibit persistent inefficiencies.
- Information traders can’t take positions large enough to eliminate all noise because their informational edge doesn’t guarantee profit. Larger positions entail greater risk and thus remain size-limited. In practice they can’t be certain they’re trading on true signals rather than random fluctuations—what seems like information today may simply be noise. Even after adjusting returns for market exposure and other factors, realized performance is a noisy estimate of expected returns, making it hard to prove an edge ex post or to distinguish informed from noisy flow.
- Moreover, the noise that uninformed traders introduce into prices is cumulative, causing prices to drift farther from fundamental values over time. Information traders counteract these deviations through research and aggressive trading as mispricings deepen, which in turn attracts still more informed participants. Their collective activity can even precipitate corporate events—mergers, leveraged buyouts, restructurings—as they push prices back toward true value. If that reversion becomes visible, momentum traders may accelerate it. In equilibrium, the farther prices stray from fundamentals, the faster (though never instantaneous) the correction back.
Market Externalities of Informative Prices
In his landmark 1945 essay The Use of Knowledge in Society, Friedrich Hayek writes:
“We must look at the price system as such a mechanism for communicating information if we want to understand its real function—a function which, of course, it fulfils less perfectly as prices grow more rigid. The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned.”
The informational role of prices is therefore vital to the health of an economy. Production and allocation decisions hinge on price signals: in primary markets, they ensure that only the most promising projects receive capital; in secondary markets, they help allocate existing capital to the managers best able to steward it. Many shareholder incentives—stock grants, options, and so on—only function properly when secondary-market prices reliably reflect intrinsic value. Misallocations and distortions arising from noisy or inefficient price signals can be substantial.
For example, if AI-related stocks (or companies that merely tout “AI” in their earnings calls) become artificially inflated through noise trading, too much capital flows into that sector at the expense of other valuable pursuits: fundamental physics research, drug development, justice enforcement, entertainment, consumer-goods manufacturing, housing construction, software development—even prudent risk-management strategies. In the short term, land, labor, and capital are effectively zero-sum: each dollar or hour devoted to one activity reduces what’s available for another. Noisy prices therefore lead to a suboptimal allocation of resources over the long run.
Fundamental Trade-Offs
By now, it should be clear that the design of financial-market structure involves balancing the interests of many different types of market participants. In this post, we highlight the role played by three distinct groups.
- While noise traders introduce inefficiencies, they also supply the trading volume and liquidity necessary for markets to exist. Their participation—though potentially detrimental to price accuracy—is crucial for market formation and continuity. Moreover, utilitarian noise traders derive real utility from their activities, whether hedging business risks, reallocating capital over time, or simply dollar-cost averaging.
- Information traders, by acting on private insights or productively analyzing public data, help incorporate knowledge into prices. This aligns with Hayek’s view that the price system harnesses widely dispersed information. Information traders thus provide a positive externality by making prices more informative, benefiting society at large through improved resource allocation.
- Market makers facilitate trading by continuously posting buy and sell quotes. They enable both noise traders and information traders to execute their orders, connecting market participants across time and space—essentially serving as the lubricant that keeps the market mechanism running smoothly.
In designing market structure and regulation, there are fundamental trade-offs in balancing the needs and impacts of these three groups. Noise traders must be accommodated to ensure market viability, but their activity can reduce price efficiency. Information traders enhance price accuracy—and with it social welfare—but may widen bid–ask spreads (raising trading costs for everyone) and could even be deterred from trading if prices become “too efficient.” Liquidity providers and exchanges are required to serve both groups, yet they need to profit from spreads and fees, aligning their interests with maximizing the product of trading volume and per-trade costs.
Hayek’s insight about decentralized knowledge remains central: through the price mechanism, markets aggregate the diverse information and actions of all participants. Thus, market design faces a broad tension between creating conditions that allow markets to exist and function (which may require some inefficiency) and maximizing the informational and allocative efficiency that makes markets socially beneficial. Policies that limit informed trading can boost liquidity (for example, restrictions on insider trading). As Fisher Black aptly observed, “Noise makes financial markets possible, but also makes them imperfect.”
Disclaimer
The information provided on TheLogbook (the "Substack") is strictly for informational and educational purposes only and should not be considered as investment or financial advice. The author is not a licensed financial advisor or tax professional and is not offering any professional services through this Substack. Investing in financial markets involves substantial risk, including possible loss of principal. Past performance is not indicative of future results. The author makes no representations or warranties about the completeness, accuracy, reliability, suitability, or availability of the information provided.
This Substack may contain links to external websites not affiliated with the author, and the accuracy of information on these sites is not guaranteed. Nothing contained in this Substack constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. Always seek the advice of a qualified financial advisor before making any investment decisions.
