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High-Frequency Trading

The high-frequency trading game certainly sounds pretty shady. But I don't think it's a great candidate for fine-grained regulation. Rather, I'd like to see some high-frequency taxing. In particular, I'd like to see a financial transactions tax.

Dean Baker is probably the most aggressive advocate of this approach. But Larry Summers has promoted it in the past. And Britain actually has a version of it on the books. At base, it's simply a microtax on financial transactions. Say, one-half of one percent on stock transactions. The average investor would hardly notice it. Most investors would hardly notice it. But high-volume traders would notice it quite a bit. Baker estimates that the tax could raise more than $100 billion annually, even taking into account the resulting drop-off in high-volume trading. That's money the federal treasury desperately needs.

And it's money that's coming from something that the financial sector does not particularly need. I've not heard many analysts say that the problem with the financial market is that it's just too slow. Rather the opposite, in fact. If high-frequency trading is really worth something to these firms, they can pay the transactions tax, and the rest of us can have the guarantee that this financial innovation is actually helping the country. If it's not even worth a half of one percent, it's probably not something the market -- or the rest of us -- need all that much.

By Ezra Klein  |  July 31, 2009; 7:02 AM ET
Categories:  Financial Regulation , Solutions  
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A higher short term capital gains tax would probably have an impact as well. I'd like to see the dividend tax trend towards zero and high short term capital gains rates (although not to Warren Buffet's recommended 90% range). This would encourage longer term thinking in the stock market, which would encourage longer term thinking to managers that manage by the quarter. Dividends could again provide a steady source of income, as opposed to the current situation where there is an obsession with growth stocks.

Posted by: staticvars | July 31, 2009 8:22 AM | Report abuse

This is one of those great ideas that leaves you wondering why it hasn't been acted on yet. Another one is Robert Schiller's proposal to index top income tax rates to income inequality.

Posted by: pneogy | July 31, 2009 11:04 AM | Report abuse

Consumers are much better at deciding what they need than Government Bureaucrats.

Fine-grained regulation never works. Why would you have any confidence in unionized bureaucrats?

What about pension funds? Union's have pension funds. Do you really want to reduce the retirement accounts of union members. You know what union bosses can do right?

The economy is not a machine or a system. You cannot control it without destroying it.

Posted by: fallsmeadjc | July 31, 2009 11:18 AM | Report abuse

I had lunch with a hedge fund manager last week. He was pitching, as he always does, the next crop of bright young math and physics and computer science students to take their degrees and come and work for him, where you can make a tremendous salary by putting your genius to work predicting what a given stock will do in the next 5 minutes.

As far as I can tell, there's absolutely no social value to this activity. Even if trading made stock prices more "accurate", that accuracy is never used: nobody is going to make decisions about investment based in five-minute intervals. Yet it's incredibly profitable and so our brightest geeks are pushed to do that instead of doing something socially useful.

I've never wanted a financial transactions tax more than after that lunch.

Posted by: AaronSw | July 31, 2009 11:45 AM | Report abuse

There's always been arbitrage. It's not arbitrage per se that's the problem. The problem is the speed at which these transactions take place and the apparent frontrunning. Ordinarily I am not a big fan of transaction taxes but they may be necessary now.

Posted by: luko | July 31, 2009 12:22 PM | Report abuse

1. Wouldn't this proposal harm market liquidity? Even if we have an excess of trading volume now, this would affect the behavior of institutional investors which are the reason why we can (more) accurately price assets. Not saying that assets are priced adequately now, but can someone explain the Pollin paper as to why decreased liquidity increases market accuracy/efficiency?

2. Of course, that assumes this is about making markets function better in addition to revenue. The paper doesn't contemplate OTC financial transactions, nor "regulatory flight" (re-listing on a different exchange, launching an IPO elsewhere to encourage investment)

Posted by: dgs290 | July 31, 2009 12:53 PM | Report abuse

To those who are instinctively for taxation and critical of any type of financial intermediation, please answer the following questions:

1. Does HFT generate systemic risk? Which one? Please produce evidence.

2. Does HFT impose negative externalities on society or other participants? Which ones?

3. Do you think high-frequency traders with "unfair" advantage due to colocation or faster computers? Do you believe you are prevented from colocating your server?

3. If neither 1, 2 or 3 hold, do you think that Baker's rationale ("to reduce the number of ultra high-paying Wall Street jobs") holds? Do you think that job choice and compensation caps are justified in any profession?

Posted by: snap1 | July 31, 2009 6:13 PM | Report abuse

Well, IMO we want the best and brightest on Wall Street to do the difficult, but important and valuable job of trying to predict long term cash flows, in order to buy when low, and sell when high. The problem I have with HFT and other "risk-free" strategies that depend on small mispricings is that they usually require lots of leverage in order to yield an attractive return. Liquidity is a good thing, but only in moderation. Too much liquidity increases system volatility and instability. We want a modest transactions tax, and a tobin tax on currency trading, for the same reason we want treads on our tires, for the same reason we want reserve requirements for banks, for the same reason we'd want a small tax on email to eliminate spam. They decrease performance slightly under good conditions, in order to make performance safer and more robust under all conditions, including bad ones.

In addition, it would raise useful revenue, in a relatively painless way.

Posted by: roublen | July 31, 2009 6:58 PM | Report abuse

Also, there are some basic, value creating activities a financial system performs: channeling investment to productive areas, providing insurance, providing liquidity. Then there is some level of unproductive, zero-sum betting layered on top of that.

The two strategies for making money the top people in Wall Street seem to have preferred lately are to use high leverage ratios, and to try to wangle favorable zero-sum bets against the Wall Street equivalent of the Washington Generals (AIG, Bear Stearns). We want Wall Street to turn away from those strategies, and into the more productive, positive-sum areas of finance.

Posted by: roublen | July 31, 2009 7:20 PM | Report abuse

For more, read Richard Bookstaber's "A Demon of Our Own Design", reccomended by Krugman:

". . .To make his point, Bookstaber uses various analogies to describe how the market is a highly complex, tightly coupled system... and to explain why the combination of high complexity and tight coupling is particularly dangerous.

The counterexample Bookstaber gives of a highly complex, loosely coupled system is the US Postal Service. The USPS has countless potential points of failure and myriad moving parts, but there are no catastrophic linkages involved. A lost package does not set off a disastrous daisy chain of events in which millions of packages are lost.

In contrast, the classic example of a highly complex, tightly coupled system is a nuclear reactor. The reactor is tightly coupled because any point of failure can lead to a knock-on chain reaction; one small thing going wrong can set the entire mechanism on a path to disaster. Being a highly complex, tightly coupled system, the market is less like the postal service and more like the nuclear reactor, in that the combination of aggressive leverage, complex methodologies and heavily interlocking parts leads to significant potential for catastrophe. . ."

Posted by: roublen | August 1, 2009 7:22 PM | Report abuse

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