Monday, September 02, 2013

Italy (sort of) taxes high frequency trading

Italy has today put into effect a tax on high frequency trading (HFT). Aside from raising some desperately-needed revenue, it may help make the financial markets a little less unstable. For as firms develop ever faster computer-based share trading systems, we risk something like the financial version of a "Terminator"-style Skynet catastrophe - except that the machines are merely following the rules shoved into them. "Garbage in, garbage out", as a college friend repeatedly told me 40 years ago. It can certainly be terminal for some:

"In 2003, a US trading firm became insolvent in 16 seconds when an employee inadvertently turned an algorithm [automatic trading program] on. It took the company 47 minutes to realise it had gone bust," said Andrew Haldane of the Bank of England in a speech given in Beijing two years ago (pdf). He also noted that for a brief moment during the "Flash Crash" of 6 May 2010, "Accenture shares traded at 1 cent, and Sotheby’s at $99,999.99. [...] The Flash Crash was a near miss. It taught us something important, if uncomfortable, about our state of knowledge of modern financial markets. Not just that it was imperfect, but that these imperfections may magnify, sending systemic shockwaves. [...] Flash Crashes, like car crashes, may be more severe the greater the velocity."

Zero Hedge had been advocating a "Tobin Tax" on HFT before the Flash Crash happened (Keynes had mooted the same in 1936!) to put what Haldane calls "grit in the wheels." A few months after the crash, financial expert Martin Hutchinson also called for it, and he repeated the call a year later, with a proposed refinement that would see one rate for shares, a smaller one for bonds and a higher one on derivatives.

Mike "Mish" Shedlock, writing in January, disliked the idea altogether, citing the experience of Sweden and claiming that such a tax would merely drive trade away from exchanges where it was introduced. But that may not be so simple: big trading firms pay big money to site their own computers right next to the exchange (it's known as "co-location") and given the incredible speed of cyber-trading, this huddling up confers a microtime gunslinger's advantage that may make the tax worth paying - after all, the co-location rent is a tax they're already more than happy to fork out.

"Mish" also objects that the tax will reduce liquidity and make the market more volatile - but Hutchinson counters: "In periods of turbulence, the liquidity that HFT supplies is quickly withdrawn, as the institutions operating the trading systems shut them off for fear of large and destabilizing losses. Indeed, liquidity that switches off when it is most needed is of no use at all. To the contrary, it destabilizes the market rather than stabilizing it." He adds that HFT is all about trading on unfair terms anyway; it "should qualify as inside information, and thus be illegal."

According to the FT today, Italy has plumped for a mixture of charges focusing on HFT and "side bet" derivatives - but exempting transactions by certain kinds of intermediaries. Tyler Durden at Zero Hedge notes that this is a horse-and-cart-sized hole in the rules and traders will scramble to redefine themselves. But according to Hutchinson, "a Tobin tax could severely hamper [the] trading revenue" of some major banks (Goldman Sachs, Citigroup, Morgan Stanley) as "these banks already are in bad shape"; so the market-maker exemption may not be about favoritism.

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