It’s frustrating to know that there’s a simple solution to a serious problem but no one seems willing to do the obvious.
Tax maven Lee Sheppard in an article at Forbes describes how transaction taxes could very quickly put a brake on numerous undesirable activities: high frequency trading, the explosion in derivatives, and overuse of repo financing. You might collectively think of these things as “junk liquidity” or “junk trading”.
HFT has proven to be singularly destructive. Despite the claims of it defenders, it does not increase market liquidity; it merely increases trading volumes without improving ease of execution. 60% of US stock market trading volume comes from HFT. HFT has undermined how markets operate. Institutional investors have diverted some of their trades to “dark pools” to escape the pred Retail traders have become increasingly distrustful of equity markets, thanks to HFT-related debacles like the flash crash and Kraft’s first trading day at NASDAQ, when its initial trades had to be cancelled. CFTC commissioner Bart Chilton pointed out some other casualties of “cheetah trading” in a speech on Tuesday (hat tip Michael Crimmins):
A few weeks ago, the Tokyo Stock Exchange closed due to technology problems. We’ve seen a few contracts shut down for different periods in Chicago and New York last month. We’ve seen market volatility increase wildly: natural gas plummeting eight percent in 15 seconds last year. One day silver plunged 12 percent in about as many minutes. One energy trader lost $1 million in one second—in a second! We saw crude tumble $3 in a minute last month. We continually see sharp rises and falls in precious metals. Knight Capital Group, in August, lost $440 million based on software trading mistakes—throwing it to the threshold of bankruptcy. There are numerous other instances and it’s a safe bet that there will be still others.
Sheppard points out that HFT is front running and the SEC should have barred it; a transaction tax is thus a way to compensate for SEC enforcement failures:
HFT is computer-generated front running. It ought to be illegal, but the SEC is too timid to kill it. Yes, front running is already illegal, and yes, the SEC has slapped a few wrists about preferential access to order data. But the tiny fines show that the SEC cannot be trusted to put the interests of investors ahead of those of traders and exchanges..
HFT computers, parked right next to the exchanges’ order-matching computers, pay the exchanges to receive order feed ahead of it being transmitted to network computers for the consolidated national best bid and offer. Called co-location, this placement permits HFT algorithms to reconstruct the national best bid and offer before it is publicly disseminated…Moreover, the exchanges have created special types of orders at the behest of HFT traders, such as “hide not slide” orders that are not displayed to other market participants.
And please, get over the idea that these trades make the markets work better:
All U.S. exchanges pay for order flow.
The exchanges pay rebates for posted quotes and charge a smaller amount for orders filled—the maker-taker rebate system. The exchange usually keeps the spread—unless both sides of the trade are the same trader. So HFT algorithms hunt for rebates when prices are stable, buying and selling the shares at the same price and pocketing the spread on the rebate.
Gee, isn’t that a guaranteed profit from the rebate when a share is holding its price? Yes, absolutely. The maker-taker rebate guarantees riskless profits for HFT. The exchanges’ euphemism for this practice is “guaranteed economics,” according to Scott Patterson of The Wall Street Journal, author of Dark Pools: High Speed Traders, A.I. Bandits, and the Threat to the Global Financial System. European policymakers are considering eliminating the maker-taker rebate.
HFT is notorious for disappearing orders—toxic quotes. Bombarding the system with toxic quotes is how the algorithms drive up prices. “They add volume, not liquidity,” said Arnuk, who originally became interested in HFT when he noticed quotes vanishing.
The primary objective of a transaction tax is like a vice tax: its primary objective is to discourage activity, not make money, although a transaction tax would generate a decent level of revenues at low cost. It’s no where near as radical as the banksters would have you believe: the United Kingdom, Hong Kong, Singapore, and (gasp) the US have forms of transaction taxes.
A new transaction tax of one basis point on securities transactions would pretty much end the HFT business, since the average trade generates less profit than that, while having a trivial impact on retail investors (a $2000 trade would face a $0.20 charge). A bill before Congress (Harkin-DeFazio, S. 1787) is revenue rather than behavior oriented, and calls for a three basis point charge, and claims it would raise $350 billion in 10 years. That seems high, since it also appears to assume that the junk trading would remain in place. But even if this number is overestimated, it’s a nice chunk of change, particularly given that transaction taxes are easy to collect.
Harkin-DeFazio would also tax derivatives transactions, not on their notional amount but the net payment. Anyone who has had any contact with the derivatives business knows that they are used overwhelmingly for speculation, accounting gaming, or regulatory arbitrage. The real tell is the insanity that is uncritically taken up on some of the more OTC markets oriented financial outlets, that of the “scarcity of good collateral”. The demand for collateral is due to the need to secure derivatives positions. When the value of side bets is so large you can’t find enough good assets to secure your positions systemically, there is something seriously wrong with this picture. Sheppard recognizes the connection between derivatives and repo financing, which is something that Harkin-DeFazio missed, and she argues the tax should include repo as well:
Repos should be taxed under a FTT [financial transactions tax] to discourage the use of this fragile form of finance. Repos are collateralized loans that are formally documented as purchase and resale contracts (hence the name).
The big banks turned themselves into publicly traded hedge funds, heavily reliant on short-term finance and leveraged to 30:1 or higher (they are at roughly 14:1 now). A lot of that leverage came through repo finance. A New York Fed research paper described repo finance as a linchpin of the frightening codependency of the regulated banking sector and the equally large unregulated, shadow banking sector, composed mainly of hedge funds and money market funds.
But borrowing against securities holdings is a longstanding market practice! Rehypothecation contributed to the meltdown. The big banks ran their repos through London, which has no limits on rehypothecation. (SEC Regulation T limits rehypothecation to 140 percent of broker/dealer loan balances.) The IMF found a lot of churning, concluding that $1 trillion of hedge fund collateral was used for $4 trillion of borrowing by big banks.
Sheppard seems unduly worried that imposing the tax might lower securities prices. First, the level of taxes is trivial for that dying breed, investors; it’s quick trigger traders that will feel the pinch. This will have a marginal impact on transaction costs for most investors. I grew up in a world where transaction costs across the board were vastly higher and despite enthusiast claims to the contrary, lowering transaction costs does not seem to have been a price booster (I’ve seen pretty dramatic examples to the contrary, where bidders on NYC apartments are insensitive to flip fees, 2% to 3% charges imposed by the co-op when they sell). Second, if she believes her own argument about the detrimental effects of HFT, getting rid of junk trading would reduce market volatility, making investments more attractive. That would likely more than offset any negative impact of miniscule increases in transaction costs.
Of course, there are more draconian remedies being bandied about. Consider Bart Chilton’s suggestion:
I’m calling for significantly increased penalties for cheetah trading that results in harm to our markets. And here’s how I propose doing it: we need to re-think what the term “per violation” means. Let me explain.
Under our statute, we can fine a miscreant $140,000 per violation—and that used to be sufficient. That dollar figure made sense in yesterday’s world of human-to-human trading. But it doesn’t work in these markets, in this incredibly fast-pace, instantaneous-almost-incomprehensible world of cheetah trading. So, my idea is that we revolutionize how we determine what “per violation” means. In the past we’ve looked at, say, each day that someone breaks the law, and for each single day, make that one violation. That’s not good enough anymore.
Today I’m suggesting that we look, not at each day of trading as being one violation, but instead look at each second. That’s right: each second. So, for every second that a cheetah trader is engaged in conduct that violates our law, we could fine them the statutory maximum of $140,000—and that could add up to sufficiently high penalties so that they actually mean something. Hey, this type of unfathomably fast trading can reap millions for the guys betting with their algorithms, and at the same time it can wreak havoc on our market players and legitimate trading of investors and consumers—we need to have a fitting consequence for rule violators, a whack that actually has some teeth.
I’m calling today for this new type of calculation, because if we don’t do something like this, our fines can be essentially meaningless—just a slap on the wrist, cost-of-doing-business. It’s this simple: if you’re making millions in seconds, then you should be liable for fines for bad conduct, counted in seconds. I know this is a revolutionary way of thinking about money penalties, but I believe it’s a necessary step to take in order to both deter illegal conduct and assess sufficient penalties to bad actors in our markets.
There are many ways to skin this cat, um, cheetah, and it’s high time we set about to do it.