I don't consider myself an enemy of free markets. Quite the opposite. But if we are honest, really honest, a transaction tax of say .005 (half a penny per transaction), wouldn't really be a bad thing for US equity markets - or the US Treasury.
Free market vigilantes will already be reaching for their calculators, plotting how much the real life cost of imposing such a levy would be for retirees in Florida. How much U.S. competitiveness will be potentially weakened, etc.
I am not an enemy of high frequency trading (HFT) either, but it is clearly having a large influence on US equity trading. According to The Economist, trading volume on the NYSE increased 17% annually during the 1960's. From then on trading volumes increased exponentially in line with the number of new listings up until 2008. A fairly smooth upward curve. Then in 2007, the SEC introduced Reg NMS to promote "competition among individual markets and competition among individual orders." Between 2008-2011 annual turnover on the NYSE increased by 300%. A period a where:
- Turnover rates and trading volumes for traditional US money managers remained stable.
- Number of new US equity listings (IPOs) decreased.
- The NYSE saw its share of US equity trading decline. According to Tabb Group, only 27% of NYSE listed equities were traded on the NYSE in 2011. Down from 38% in 2008, and 80% in 2007.
Although there seems to be some dispute as to the actual figure, industry estimates say HFT now accounts for 40-70% of daily US equity turnover. Liquidity is now spread across a fragmented market place of exchanges, ECNs, Dark Pools and broker-dealer internal order matching. Decentralisation of liquidity has had the unintended effect of seeing it evaporate at times of high market volatility. The 'Flash Crash' of 2010 being the most extreme example. Rather than supplying liquidity at times of high volatility, "HFTs reduce their liquidity supply as day-level volatility increases," according to a report published by the FSA in the UK. HFT is complex, and a discussion of how beneficial/disruptive it is to the market place is beyond the scope of this article. But its impact on US equity markets cannot be disputed.
Really a Sales Tax
Exchanging things of value at a negotiated price is how business transactions are made. A sales tax on exchange of tangible goods is considered standard business practice. A 'sales tax' levied when a security changes hands should be treated no differently - albeit that the rate should be lower to reflect the volume of transactions. I believe a levy of .005 per transaction would be fair to all market participants, although I am sure HFTs would consider it punitive because it is based on the frequency - not the value of the transaction.
Trading frequency is directly proportional to the time frame that a security is held. It follows that the shorter the time frame the more frequent an offsetting trade will take place. The fact that these types of trades are largely speculative in nature is immaterial. Nobody's profit motive for trading in US equity markets should be censored. As long as the conduct of each actor is in compliance with SEC and exchange regulations, moral judgement should be suspended. By the same token if the introduction of a transaction tax leaves HFT's less profitable - or even unprofitable, should not be an argument for or against implementation. To the degree that a .005 levy would hurt HFT revenues is more reflective of the viability of HFT business models, than the burden of the tariff. Consistent with the transaction tax on equities would be a levy on all exchange traded derivative contracts. This would prevent equity cash market strategies being replicated in the options market to avoid the tax.
Tobin Tax is not a Transaction Tax
The UK has had a type of 'Tobin tax' on stock trades for many years. It is called stamp duty reserve tax (SDRT), and is levied at 0.5% of the value of the transaction. It is an 'entrance fee'- no additional taxes are paid to exit positions. The SDRT has been circumvented by the Contract for Difference (CFD) Market. These OTC equity derivative products were introduced in the UK in the 1990's, and have gained enormous popularity since - largely as a way to avoid paying SDRT. The US has banned CFDs. In my opinion, a value tax such as the SDRT or Tobin tax is a form of wealth tax. Instead, the US should implement a true transaction tax as it will tax the people who use the market the most - which is only fair. You can liken value taxes to a road toll where the Cadillac owner pays more than the pickup owner - simply because his vehicle is worth more. A transaction tax should be the toll you pay each time you use the 'road.' An example might help illustrate the difference:
Value Tax
Florida retiree buys 1000 x ABC @ 50 - value tax = 250 ($50,000*.05)
HFT buys 20,000 XYZ @ 2.5 - value tax = 250 ($50,000*.05)
Transaction Tax
Florida retiree buys 1000 x ABC @ 50 - transaction tax = 5 (1000*.005)
HFT buys 20,000 XYZ @ 2.5 - transaction tax = 100 (20,000*.005)
The transaction tax gives a lower rate to both parties.
It is really only practical to implement a US transaction tax in the regulated markets. Taxing OTC markets would only work if the same tariff was adopted globally. Otherwise OTC trades will simply be booked in the most tax benign jurisdictions. The likelihood of reaching a global agreement for such a tax is minimal, so it will have to start with regulated markets at national level. Tabb group estimate HFT's generated around $5billion in profits in 2011, and the industry is already well organized, with substantial lobby groups on both sides of the Atlantic. If the US waits too long entrenched interests may make it difficult to bring this into law. Introducing the transaction tax at such a low price point will make it less controversial. But it will at least it be introduced. It can always be adjusted up later.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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