by Bradley G. Lewis, Prof. of Economics, Union College and Michael Sankowski, Traders Crucible
Global Economic Intersection Article of the Week
Two bills (H.S. 3313 and S. 1787) now before Congress would impose a small tax (0.03% of the value of the security) on most purchases of securities and transactions involving derivatives beginning January 1, 2013. There are some exceptions—e.g., no tax on the initial issuance of stock or debt securities, or on trading in debt instruments (e.g., some Treasury bills) that have fixed maturities of no more than 100 days, or to currency transactions. The attempted reach of the tax is significant: it would apply to trading within the U.S. but also to transactions done outside the U.S. if any party to the transaction is a U.S. corporation, partnership, or individual.
While raising revenue is arguably one aim, clearly a major purpose of imposing such a tax is to reduce the profitability of certain strategies that are common in high-frequency trading (HFT), which uses systems that can make trades in milliseconds. Since common strategies using these systems reportedly have profit margins of about 0.01 percent per trade, the transactions tax might eliminate the benefits of these strategies, and possibly the trades themselves.
Would this be good or bad?
To get a preliminary answer to that question, let’s focus on stocks but also acknowledge that both the proponents and opponents are focusing not just on the technical ability of HFT to execute transactions quickly but also on the way in which that speed is currently being used, with impunity.
Why the speed arms race over the last decade? Because the fastest providers can and do in fact use their advantage largely to accomplish a simple result: HTF exists to use information to “cut in front of the lines” of orders queued up for execution, so to speak: at the very least, you can get your transactions milliseconds ahead of others in line and collect what amounts to a tax on those who are slower.
It’s easiest to see this by taking a simple but powerful example: if you know several others have entered buy orders at market price, but their systems are slower to execute than yours, you can buy ahead of them, let their orders push the price up higher, and then, using your superior speed, sell what you just bought at the higher price their orders created and take a small profit. Do it regularly and the pennies add up. And while your HFT system might cost a lot to build and maintain (an estimated $1.2 – 1.6 billion per year reportedly has been spent in the last five years to improve them) extra trades cost you very little: high volume means high profits.
Opponents of the tax argue that by making these trades unprofitable, the proposed transaction tax would simply chase away trading to friendlier venues, reduce liquidity in U.S. markets, and (in some more apocalyptic views), raise the cost of capital to U.S. companies.