[pembrook]

By referring to arbitrage as “games” OP’s comment has poisoned the well for this entire chain of responses. So to get an understanding, first we need to fix.

A “game” implies non-productive or zero sum.

By definition, an arbitrage is not that. Any arbitrage is the result of an inefficiency in prices or the economy.

When someone arbitrages prices back to where they should be, they are performing a service that everyone else benefits from, and are rightly compensated for this. Now, are finance people compensated too much for correcting price discrepancies? If yes, then that’s another arbitrage opportunity!

But the question of what would be substantially different is easy. No arbitrage = no markets = top-down command economy. Check out North Korea, Cuba, USSR, the former Yugoslavia, etc. for what would be different.

[less_less]

> When someone arbitrages prices back to where they should be, they are performing a service that everyone else benefits from, and are rightly compensated for this. Now, are finance people compensated too much for correcting price discrepancies? If yes, then that’s another arbitrage opportunity!

While I agree that finance serves a useful purpose, I don't understand this bit. Suppose hypothetically that arbitrage gives some social utility, but not in proportion to the amount of money it makes for arbitrageurs, and thus not in proportion to the effort put into it. Suppose that society is overproducing finance -- that most people would be better off if the world had slightly worse pricing information, fewer financial datacenters and low-latency microwave links, less human effort devoted to banking, and more of something else that could be built with those resources and that effort.

Maybe this creates another arbitrage opportunity -- maybe in an idealized free market (where there are no barriers to entry) more people would work in finance, and their competition would reduce profits. But it seems to me that this would only worsen the overproduction problem.

Or is there something I'm missing here? Why isn't this really an "opportunity" to (carefully) increase taxes on finance, so that it won't be overproduced by as much?

[nsvd]

I don't think it's the case that finance is over produced. If it were, then the value of financial services would drop.

Rather, because the gain produced by financial instruments is proportional to the wealth someone has, the returns of finance disproportionately benefit those with large amounts of wealth. One man can only make so much plumbing or being a mechanic, but can make an arbitrary about by investing in ETFs.

In other words, if the financial sector was largely a collection of small businesses run by middle class people, no one would think it was a problem that they make money. That would be great! But in reality it's a smaller amount of companies and smaller amount of wealthy people that benefit from it.

That problem isn't unique to finance, it affects many parts of our society.

[less_less]

> I don't think it's the case that finance is over produced. If it were, then the value of financial services would drop.

I don't think this follows for all financial services. Overproduction leads to a drop in value if the market is efficient, but real-life markets are not perfectly efficient. For arbitrage in particular, the whole point is that the market isn't efficient. Arbitrage makes it more efficient after the arbitrageurs have taken their cut, but the value of that service isn't necessarily determined efficiently. (At least as far as I know: I'm not an expert.)

> Rather, because the gain produced by financial instruments is proportional to the wealth someone has, the returns of finance disproportionately benefit those with large amounts of wealth. One man can only make so much plumbing or being a mechanic, but can make an arbitrary about by investing in ETFs.

> In other words, if the financial sector was largely a collection of small businesses run by middle class people, no one would think it was a problem that they make money. That would be great! But in reality it's a smaller amount of companies and smaller amount of wealthy people that benefit from it.

> That problem isn't unique to finance, it affects many parts of our society.

... but I do almost entirely agree with this.

[berniedurfee]

I think regulatory capture needs to be considered as well.

At some point those that amass large amounts of wealth are disproportionately able to influence government regulation to ‘game’ the system itself in their favor.

It seems in the realm of finance, it’s much easier to obscure regulatory capture than in other domains, where anti-competitive practices are much easier to suss out.

[wavemode]

It's much simpler than that. The utility provided by arbitrage is that a given security is no longer under- or over-priced in one market relative to other markets. Any buyer/seller of that security will then always be buying/selling for the best available price (rather than losing out on money by not buying/selling in a different market).

The price discrepancy which was corrected by arbitrage is, itself, the compensation the arbitrageur receives. If it weren't, that inherently also means that there still exists a price discrepancy, and thus an arbitrage opportunity.

This is all separate from the question of public policy. Should taxes on income from arbitrage be increased? Perhaps they should. Though that doesn't affect the mechanics of how arbitrage works, it simply decreases the net profit of the firm doing the arbitrage.

Conceivably, you could increase the taxes/regulations/restrictions on such firms to such a degree that they are either no longer allowed to perform arbitrage at all and/or can no longer justify the cost of the high-speed equipment involved. The end result of this would be that the markets become less efficient (there would be greater price discrepancies and they would arise more frequently).

How much does that matter? Well, that's more of a philosophical question. How much does it matter to you that you're buying something for the best possible price (versus knowing it might be available cheaper elsewhere)? Depends on the person.

[norswap]

I understood it as it's an arbitrage because it enables the creation of a new system that reward arbitrageurs less (but still enough that they would perform the arbitrage).

Though this is only true in a system where you don't face tons of hurdles to deploy these new systems, which is not the case in the current financial system.

[vinay_ys]

Most of the pricing inefficiency comes from information asymmetry. It might have made sense a 100 years ago when information traveled slowly. But in today's world, it travels fast. But still there is asymmetry due to purposeful obfuscation and complex packaging.