Financial Transaction Tax Would Be Damaging

An editorial in today’s New York Times calls for a financial transactions tax – a tenths of a percent charge on the market value of every trade of a stock, bond, or derivative. My Working Papers column two years ago described the pitfalls of such a tax.  While tax rates in the range of tenths of a percent sound small they would have large effects on stock values.  Bid-ask spreads are now 1 cent for large cap stocks. A 0.10 percent tax would add 5 cents to the spread for a $50 stock.

The alleged purpose of such a tax is to reduce the arms race among High Frequency Traders who exploit differences in the timing of bids and offers across exchanges at the level of thousandths of a second to engage in price arbitrage.  In the Fall 2015 issue I review a paper that demonstrates that this arms race is the result of stock exchanges’ use of “continuous-limit-order-book” design (that is, orders are taken continuously and placed when the asset reaches the order’s stipulated price). The authors use actual trading data to show that the prices of two securities that track the S&P 500 are perfectly correlated at the level of hour and minute, but at the 10 and 1 millisecond level, the correlation breaks down to provide for mechanical arbitrage opportunities even in a perfectly symmetrical information environment.  In a “frequent batch” auction design (where trades are executed, by auction, at stipulated times that can be as little as a fraction of a second apart), the advantage of incremental speed improvements disappears. In order to end the arbitrage “arms race,” the authors propose that exchanges switch to batch auctions conducted every tenth of a second.  No need for a tax.