The stock market has become a war between algorithm-based robots, a war for speed where the winners trade 10 microseconds faster than the losers. But all sides of this war have armed themselves so well, have reduced the timing of trades so much, that high frequency trading no longer makes much money.
Now it appears the advantages of speed are starting to dissipate, and being the fastest trader isn’t worth what it once was. High-frequency trading profits are expected to fall 35 percent this year, 74 percent below their peak in 2009. In an ironic twist, high-frequency traders have gotten so fast, they seem to have outrun their own profitability.
Though a lot of trading has migrated off exchanges into private trading venues known as dark pools, high-speed traders still operate largely on exchanges. But while the traders have continued to get faster, pouring millions of dollars each year into improving their execution times through better software and equipment, the exchanges haven’t kept pace.
As a result, the firms that show up first in line to execute a trade have to wait for the exchange to catch up, and in a matter of microseconds, their speed advantage disappears.
In fact, because the algobots get stacked up for trades, they now withdraw them when they become less advantageous, and so a large chunk of the activity of high frequency trading now goes to not making trades. Moreover, the lack of volatility in the market drives down HFT profits, because they cannot rely on arbitraging some quirk in the trading data.
The big brains on Wall Street think they can crack this nut by reprogramming their computers to guarantee profits in this changed landscape. But the real question to ask is what social and economic utility this serves. High frequency trading is a sophisticated way to break the law. It’s structurally similar to front-running, which consists of trading with advance knowledge. The faster the trade, the more “advanced” the knowledge becomes. But the SEC has not come close to banning HFT, despite the distortions it creates.
There’s a simple solution to all of this: a financial transactions tax, which in this case would operate like a vice tax and discourage undesirable activity.
The primary objective of a transaction tax is like a vice tax: its primary objective is to discourage activity, not make money, although a transaction tax would generate a decent level of revenues at low cost. It’s no where near as radical as the banksters would have you believe: the United Kingdom, Hong Kong, Singapore, and (gasp) the US have forms of transaction taxes.
A new transaction tax of one basis point on securities transactions would pretty much end the HFT business, since the average trade generates less profit than that, while having a trivial impact on retail investors (a $2000 trade would face a $0.20 charge). A bill before Congress (Harkin-DeFazio, S. 1787) is revenue rather than behavior oriented, and calls for a three basis point charge, and claims it would raise $350 billion in 10 years. That seems high, since it also appears to assume that the junk trading would remain in place. But even if this number is overestimated, it’s a nice chunk of change, particularly given that transaction taxes are easy to collect.
This obviously won’t happen, say, tomorrow, or probably not in the next Congress. But it’s something to place on the board for the next time our lawmakers have to show that they care about fixing the financial markets. You cannot get simpler than a financial transaction tax to put the algobots out of business.