Efficiency: Sometimes More is Less

Listeners of the Radiolab podcast might recall an episode earlier this year about how the stock market works.  For those who do not listen, Vice’s Motherboard blog  (URL below) provides a handy catch-up.

The advent of High Frequency Trading (HFT) has the potential for extreme market disruption, as the world witnessed on May 6, 2010.  A mutual fund firm out of Kansas placed a large sell order for a particular security, and HFTs–which can conduct billions of transactions in a single day–precipitated a “Flash Crash” wherein the Dow dropped by almost 1000 points, the largest intraday loss in history.The HFT algorithms, which were unable to distinguish between an impending crash and a large, one-off order, began automatically selling and buying back securities at volumes and prices that  had no real basis in the market.

 

Some European countries have responded to the advent of High Frequency Trading by introducing the one thing that is sure to cause “friction” in an otherwise “efficient” process–a tax.  Both the French and Italian governments have passed laws that tax acquisitions and dispositions of covered securities in an attempt to reduce the effect of high frequency trading, but it is questionable whether such a thing would ever happen in the United States.  The idea is basically that instead of opting to conduct millions of trades to exploit price differences of as little as $0.0001, traders will balk at the additional tax liability and record-keeping burden that attaches to each exchange.  Even Americans, who may trade in American Depository Receipts (essentially securities that represent shares traded in French or Italian markets) will pay taxes to these foreign governments in the form of fees that are passed on to them from the in-country subcustodians.

 

Given Americans’ typical aversion to new taxes, what are our options?  The SEC has partially responded by introducing rules against fraudulent trading, which can provide an after-the-fact enforcement of rules designed to prohibit such practices, but the additional time and expense of conducting investigations and prosecutions renders it a slower and less effective (?) method of deterring high frequency trading.

 

What do you think are the best ways to approach the problem?  SEC rule-making? Levying a transaction tax?  Or is it even a problem, given that some proponents believe that high frequency trading provides liquidity to the market?

 

 

Mother Jones Article (includes Radiolab podcast):

http://motherboard.vice.com/blog/what-high-frequency-trading-looks-and-sounds-like

 

SEC Findings Regarding the Flash Crash:

http://www.sec.gov/news/studies/2010/marketevents-report.pdf

 

Information on the Italian Transaction Tax:

http://www.nortonrosefulbright.com/knowledge/publications/74950/italian-financial-transactions-tax-italy-imposes-tobin-tax-on-financial-transactions

High Frequency Trading:

http://www.scienceworldreport.com/articles/11053/20131120/supercomputers-vs-high-frequency-trading-analysis-leads-to-new-regulatory-law.htm

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