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Financial Transaction Tax: Oversimplifying Complex Market Issues

| FinReg

By Kenneth J. Burke

Originally published on TABB Forum

In a recent editorial, the New York Times editorial board claims high-frequency trading hurts ordinary investors and market stability, adding that, ‘A well-designed financial transaction tax … would be a progressive way to raise substantial revenue without damaging the markets.’ But an FTT is too simplistic a proposal to deal with the markets’ much more complex issues.

A recent New York Times editorial by the paper’s editorial board, “The Need for a Tax on Financial Trading” (Jan. 28, 2016), brings to mind the old adage variously (but probably inaccurately) attributed to Abraham Lincoln and/or Mark Twain that, “It’s better to remain silent and be thought a fool than to speak and remove all doubt.”

In the piece, the editors state that, “A financial transaction tax — a per-trade charge on the buying and selling of stocks, bonds and derivatives — is an idea whose time has finally come.” They speak of the “windfall profits” high-frequency traders earn “on small and fleeting differences in prices at the expense of ordinary investors and market stability.” The presupposition that high-frequency trading creates a windfall is absurd – if just showing up availed one of the opportunity to trade profitably, the volumes would be vastly higher than they are.

For better or worse, the current market structure is a function of the post-Reg NMS environment, and the profitable participation of all market intermediaries is a function of the combination of what real investors are willing to pay for liquidity and the capital that speculators can afford to put at risk to achieve trying profits. Neither is unlimited.

As to its effect on ordinary investors, the editors must not be familiar with what has happened to the cost of trading stocks for the “ordinary investor” over the past 20 years – it’s just never been cheaper. The market stability question belies the fact that the SEC has implicitly made the tradeoff between volatility and low costs by allowing tick sizes to shrink and making it impossible for market making activities to profitably commit capital – nothing that an incremental tax would address.

The editors go on to assert that the effect of such a tax on trade volumes “is debatable,” mentioning one calculation of the tax that, at 10bps, would yield $66 billion with but a 7% decrease in volume – ignoring the fact that the preponderance of today’s volume likely is based upon profit margins less than that. Further, “The tax could bring $76 billion a year if it was set at 0.3 percent, but above that rate would probably decrease.” Is there any HFT activity that could be sustained with such a tax?

Finally, the editors go on to infer that institutional (“pension funds”) allocations to hedge funds are for speculative purposes and that they are de facto bad because some large funds (e.g., CALPERS) have recently begun to reduce allocations because they have begun to question the after-fee returns. This conflating of hedge funds, speculators and (by inference) HFTs is simply mindless.

As an aside, the Brookings Tax Policy Center study that the editors must have read to inspire the editorial suffers from much of the same myopic view of the realities of the current market structure and starts with the implication that the Great Recession could have been avoided by a transaction tax that would have discouraged “excessive risk-taking.” Why would they have read further?