The Plus Side of High Frequency Trading for the Economy

Jared Dillian |

As I write this, I am watching the Mets play the Dodgers and not watching the Democratic debate. I can catch the highlights on Twitter. I am half expecting someone to propose a tax rate of over 100%.

Something I’m sure will be suggested at some point is a financial transactions tax, a tiny tax placed on every single financial transaction: stocks, bonds, and derivatives.

For example, if General Electric (GE) were $20 per share and you bought 1,000 shares, that would be $20,000 worth of stock. If there were a financial transactions tax of 5 basis points, you would pay $10 in tax on that trade. The commission is probably around $10 if you use a discount broker, so it would double your transaction costs.

$10 doesn’t seem like a lot.

A financial transactions tax (otherwise known as an FTT or a Tobin tax) is so attractive to left-leaning politicians because they look at this giant pot of money, the trillions of dollars of annual trading activity, and if you take a tiny percentage of that, 1 basis point or 5 basis points, you can raise a lot of money to… well, certainly not to pay down the deficit; nobody wants to do that.

Some people also view this as a way to “punish” the banks, though in practice, it doesn’t really work out that way, which we will discuss later.

The Good Old Days

Back in 2006, I used to make locked markets in trades as large as 1,000,000 shares of the SPDR S&P 500 ETF (SPY). I would give customers a choice of whether they wanted to buy or sell 1,000,000 SPY (at the time, about $125,000,000) at the same price, essentially letting them trade for free. I could do that because my cost to hedge, either in futures or in the basket of stock or even the ETF, was minimal.

We were awash in liquidity.

Most of that liquidity has disappeared. The Volcker Rule has made it outright illegal to trade proprietarily, and Basel III capital rules make it prohibitively expensive to carry positions, so nobody is incentivized to make markets in anything.

Liquidity is terrible. I hear this from my institutional subscribers all the time. You, the retail investor, probably don’t notice a difference, because it costs you the same to trade 100 shares of GE now as it did 10 years ago: about a penny.

But if you are trying to move 500,000 shares of GE, good luck. And we are talking about GE here, not 1-800-Flowers.com.

People love, love, love to blame high frequency trading for this. Michael Lewis wrote a book about it. It sold pretty well. The criticism is that the algorithms provide liquidity when you don’t need it and consume liquidity when you do. That may be true, but sometimes I wonder why all the HFT guys don’t all go on strike one day, not turning on the computers, and see what happens then. I think they will be sorely missed.

The banks used to provide liquidity, 10 years ago, but not anymore. Nonbank liquidity providers (smaller dealers, hedge funds) are starting to spring up, slowly, making the market more fragmented than ever. It is a mess.

What It Means

The definition of liquidity is the ability to sell something at a price you think is reasonable, in a time frame you think is reasonable. Again, most people never experience this first-hand because since decimalization 13 years ago, stocks are still a penny wide and commissions are less than 10 bucks.

It wasn’t always that way, though. You used to have to pay an eighth, a quarter, a half, or even a whole point to trade a stock, plus a $75 commission.

Back then, people traded a lot less.

But don’t we want people to trade less? Isn’t all this day trading and computer trading socially useless?

It’s not for me to decide what’s socially useful or not. But the combined effect of day traders and computer traders and speculators participating in the markets every day is that it makes the market liquid for what you might call a “real” investor, like a mutual fund or a pension fund.

If you pass an FTT, liquidity will evaporate. The day traders and the computer traders and the speculators will just disappear.

Holding periods will stretch out, for sure, by necessity. But you won’t like it.

If you still can’t really get your head around what this means, imagine you are trying to sell your house. You expect it to take a month or two, and you think you will get $250,000. But imagine that HUD and/or the Treasury passes a patchwork of regulations that vastly increases the administrative burden on banks and real estate brokers, and it will take you two years to sell your house, and you will get only $225,000 for it.

That’s a lack of liquidity.

Deadweight Loss

This translates directly into economic losses. The more efficient the economy is, the lower transactions costs are, the more quickly the economy can grow. I can’t think of a more effective economy killer than a financial transactions tax.

But screw Wall Street, right?

Like I said before, it doesn’t work that way. If mutual fund A buys 500,000 shares of GE from bank B, the $5,000 tax doesn’t get paid by the bank or the mutual fund. It is passed along to the fund shareholders—retail investors. The reduced execution quality is directly reflected in the performance of the fund. Fun!

We sure punished Wall Street.

A large portion of the population—very large—see no connection to the socially “useless” trading that goes on and their ability to do simple things like take out a loan or a mortgage or invest in a mutual fund. That trading is slowly disappearing. When it disappears completely, they will be unhappy with the results.

But who will they blame?

Funny.

Jared Dillian
Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
GE General Electric Co 31.34 -0.05 -0.16 21,401,028
FLWS 1-800 FLOWERS.COM Inc. 10.70 -0.10 -0.93 123,979

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