How a Financial Transaction Tax would benefit us all

As a former hedge fund manager who supports a Financial Transaction Tax (FTT), I realize I am somewhat uncommon.

For the record, I’m not particularly keen on taxes.

Like most self-respecting capitalists, I just want to be left alone to get on with my business and keep as much of the money I earn as I can.

But I do think the FTT is a good idea.

Designed well, it will play an important role in stopping the kind of financial activity that has zero benefit to society and exposes us all to significant risks.

In their opposition to a European FTT – the final decision on which is expected at a meeting of EU Finance Ministers later this week – my colleagues in the finance industry raise two main objections: firstly, that it will reduce liquidity; and, secondly, that it will hit pensions.

Well, they would, wouldn’t they?

I often talk about “playing the liquidity card.” It’s meant to be the Ace of trumps, a debate-killer.

But that’s just not the case.

High-frequency trading

The type of financial transactions the FTT is designed to curtail – computer driven, high-frequency trading that sees shares change hands in a fraction of a second – does little for market liquidity.

Sure, they give the illusion that there is a lot of money swilling around the system, but the moment the market goes off message with something the algorithms haven’t seen before, you can bet that their plugs get pulled for “further research”, and liquidity dries up.

We saw this happen with the flash crash of 2010. Best, then, not to rely on something as fickle as high-frequency trading for your liquidity.

As for pensions, suppose that a small tax on transactions is passed on to the consumer, affecting their pensions. How large will that effect be?

If the pension is invested in some high-frequency trading, then maybe, yes, they’d lose out. But your typical pension fund holds onto its investments for months or years, not for milliseconds.

A FTT’s impact on someone’s pension will be tiny.

Flash crashes

On the other hand, if high-frequency trading causes more flash crashes, then that will have an impact, and it could be huge.

I can hear the apology now, “The bad news is that 20% of your pension has been wiped out in an algorithm-inspired crash. The good news is that we didn’t have to charge you £1.20 to cover the cost of the transaction tax.”

Penny wise, pound foolish.

Those who support the FTT often rail about the financial markets and ending the evil of speculation. This is, of course, silly.

Financial markets allow businesses to raise money for start-ups, or for expansion; they allow owners to move on to other things, to help people or businesses to control risks.

What we need is an FTT that protects the good bits of financial markets, whilst reducing the bad bits. My view is that this is perfectly possible.

Useful speculation

Much of the trading in the financial markets takes place over a period of weeks, months or years. You buy shares because you think the company will do well, and you anticipate holding on to them for quite a while. If you are right, then the share price rises and you’ve made a profit.

This is speculation, but much of it is very useful.

Contrast this with algorithmic high-frequency trading, where shares are owned for fractions of a second. Price is determined by computers trading against each other and the company is no more than its ticker symbol. This type of speculation can be very damaging for shareholders, for a company, its employees and the wider economy. It’s these latter forms of harmful speculation that the FTT could bring under control.

Trading happens for other reasons as well.

Consider hedging. Hedging is used to reduce risk, helping companies and investors minimize fluctuations in their costs and portfolio value.

Clearly hedging to control risk is beneficial. If a producer wants to protect from falling corn prices, for example, it can lock in the price in the futures market.

Finding balance

Such hedging can happen quite often, maybe trading several times a day; but this is very different to the high-frequency trading that can happen several times a second and which has no economic benefit.

For me, the question is not whether we should have a FTT, but at what level that tax should be set.

Too small and it will have no effect at all on high-frequency trading. Too large and it will hinder good hedging.

A level of around 0.01%, one basis point, on each transaction should strike the right balance.

Would this level affect good hedging? No. Would it affect speculation over medium and long term? No.

Would it dampen high-frequency trading, short-term speculation, and the kind of hedging strategies that have zero economic benefit and are financially destabilizing?

You bet it would.

This is the kind of nuanced approach we need.