Why taxing high-frequency trading won’t work

Democratic presidential candidate Hillary Clinton is proposing a new tax on high-frequency trading as part of a "Wall Street reform plan" Such an action is unnecessary and could result in unforeseen consequences that often accompany the best-intentioned regulation.

A better approach would be to build a powerful regulatory capability based on data, one where market manipulators can be detected and put on notice quickly. Such a deterrent capability should accomplish what we need without losing the benefits associated with allowing markets to function freely. Illegal behavior such as market manipulation can be punished swiftly if regulators have the means for rapid detection.

Democratic presidential candidate Hillary Clinton speaks during a community forum campaign event at Cornell College in Mt Vernon, Iowa, October 7, 2015.
Scott Morgan | Reuters
Democratic presidential candidate Hillary Clinton speaks during a community forum campaign event at Cornell College in Mt Vernon, Iowa, October 7, 2015.

We have every reason to be concerned about the stability of financial markets. There is concern, and rightly so, that given the speed at which trading occurs, rapid computer-based trading can result in over reactions, which destabilize markets.

HFT currently makes up roughly 49 percent of trading in U.S. equity markets, according to TABB Group. Proponents of HFT point to the increased liquidity, tighter spreads and a dramatic reduction in trading costs, down roughly by two-thirds from the early 2000s on more than double the volume.

Opponents point to the potential for instability that can result from ceding control to computers that can withdraw from the market at will and take away the liquidity they provide in normally functioning markets. What this line of reasoning ignores is that humans do the same, and there is sufficient evidence that liquidity from all sources will retract during extremely volatile periods. It also ignores the larger regulatory landscape such as Basel III that has already forced traditional liquidity providers out of market making by making it expensive to take risk. The new breed of liquidity providers use smarter computers that get out of the way when they smell serious trouble, as one should expect. Should we penalize them for their intelligence?

A good metaphor for understanding the fears is concern about the famous Rumsfeldian "unknown unknowns," the lurking factors we don't know even exist. Markets are complex social systems where we have witnessed manipulations in the past by humans, but computers bring in a new set of fears because of their speed. The data that can be analyzed digitally also enables astute players to detect and exploit fleeting opportunities. Where it gets tricky is when participants create these fleeting opportunities illegally, comfortable with the fact that regulators don't have the capability to detect their behavior. So why not kill the entire HFT ecosystem by making it prohibitively expensive for them to trade frequently via a tax?

It's the wrong solution because a tax does not resolve a thorny definitional problem. While we may charge the Hounslow trader Navinder Singh Surao based on intent to manipulate markets, it is very difficult to provide a definition of manipulation. For example, what number of order cancellations would be considered "excessive?" If you take the view that in fast moving markets an investor must be vigilant and constantly adjust one's risk, placing and canceling orders frequently might be perfectly desirable by a rational agent to protect capital. Is it fair to curtail the ability to adjust risk in real time as new information becomes available? How do we draw the line?

That said, we could take the view that we can recognize outright market manipulation versus risk taking when we see it. If traders who engage in illegal activity place a high chance of such activity being detected in close to real time, would they not be sufficiently deterred? Such a regulatory capability is possible to create on the basis of the same data and resources being deployed by HFTs. We don't need to impose taxes on HFT and expose ourselves to the risks and unintended consequences associated with such a policy.

We should not let populist opinion drive regulation: it doesn't make sense to kill high frequency traders and the associated liquidity they provide just because they make money through intelligent machines. However, if the data quickly reveal patterns of behavior that destabilize markets, we should take focused action on the basis of such evidence.

Vasant Dhar is a professor at New York University's Stern School of Business. He is also the founder of SCT Capital Management, a firm that specializes in quantitative-trading strategies. Follow him on Twitter @vasantdhar.