This blog post previously ran in The Guardian’s Business section.
A tax on financial transactions can calm the frenzy of speculation fuelled by computer-driven algorithms
The dark side of the world of algorithmic trading in financial markets has twice been in the spotlight this week. First was the release of Michael Lewis’ explosive new book, Flash Boys: Cracking the Money Code, which highlights many worrying practices in a sector that accounts for about half of all trades on the New York and London Stock Exchanges. Second was the FBI’s announcement on April 2 that it would begin a criminal investigation into wrongdoing in the sector. During 18 years with JP Morgan and for more than a decade since, I have watched and participated in the inexorable transformation of the markets, enabled by advances in technology. Their primary role of raising capital, allocating resources efficiently and mitigating risk has been slowly but surely drowned out by a cacophony of frenetic speculation. The capital markets are no longer the means to serve the capital allocation needs of the real economy, but have become ends in themselves. That end is the “business” of speculation, which is way out of balance and therefore unhealthy for the real economy. As initially designed and utilized, derivative contracts connected domestic capital markets into a more efficient, interconnected global market for the benefit of borrowers, investors and intermediaries alike. They were also used for genuine risk management purposes, where, for example, a trucking company buys a petroleum hedge to ensure its operating costs are predictable. But they have become a tool of choice for aggressive mega-scale speculators. Nowhere has technology had a greater impact on finance than in the rise of algorithmic trading, a subset of which is so-called “high-frequency trading.” Initially, computer-driven algorithms enhanced the efficiency of human traders and so enhanced liquidity, thereby reducing costs of buying and selling. Over time, these same quantitative trading strategies became centers of speculative proprietary trading themselves, at times quite predatory in nature. Their dominance has already led to “flash crashes” such as the one in May 2010 when the Dow Jones index dropped 9% in a matter of minutes wiping billions off the value of companies. While algorithm-driven trading has many legitimate applications, high-frequency trading is, at its worst, systematic front-running of order flow. We call that theft. No wonder the FBI is investigating. Systems scientists understand that, in any given system, there is a need to balance system efficiency (resulting in high throughput) with system resilience (resulting in an ability to withstand shocks). Yet in the case of financial markets, the balance has tipped too far in favor of speed and perceived efficiency, leaving markets highly brittle and more susceptible to collapse. High degrees of financial leverage compound this, leaving them vulnerable to events like the 2008 financial crisis and the numerous mini-crashes that have occurred since and are continuing. There is a counter-argument that increasing transaction volume is good since it helps markets respond to and absorb shocks. But this confuses volume with liquidity. The former vanishes in times of crisis as speculators turn their algorithms off and pull their (faux) liquidity out of the market. It is little more than a mirage. This can trigger a cascading effect as real money investors pull back in self-defence and at times flee in panic. Suddenly, markets are empty of true liquidity at the time it’s needed most. That is why I am a supporter of policy that itself is making headlines at the moment – the Financial Transaction Tax or Tobin Tax, consistent with the initiative of the 11 European countries implementing the proposed FTT of between 0.01%-0.1% on trades in stocks, bonds and derivatives. The tax falls disproportionately on short-term speculation, such as the worst of high-frequency trading, and probably eliminates it much more effectively than complex layers of new regulation. It will, as James Tobin put it 40 years ago when he proposed the FTT, throw “sand in the wheels” of international trading markets, encouraging market participants to shift towards longer-term genuine investment strategies where the tax consequences will be inconsequential. If the FTT causes a shift that even modestly reduces the fragility of markets and the risk of deepened future crises – both highly detrimental to the long-run efficiency of the real economy, which is the efficiency that really matters – it will have been worth it. If, in the process, the FTT encourages a few “rocket-scientists” to apply their creative talents to a purpose more productive for society than speculating, so much the better. And we can certainly find good uses for the incremental revenues, measured in the tens of billions. The 11 European countries implementing the FTT will not be setting a precedent. Numerous countries, including those with deep and fast-growing markets, such as Hong Kong, Singapore, South Africa, India and Switzerland, have FTTs that raise their governments billions in revenue every year. The world’s two largest financial centres that remain opposed to the European FTT – the US and Britain – already have small FTTs of their own, although you never hear them acknowledge it. There is seldom, if ever, a word about problems to the real economy or even the capital markets caused by the existing well-functioning transaction taxes because they are virtually invisible, seamlessly integrated into trading systems and investment practices. They should, however, be applied evenly to all trading instruments. As a former banker, I fully appreciate that the FTT is not, as some hope, a miracle cure that will address all the wrongs of Wall Street. Only structural reform of the kind Teddy Roosevelt understood can accomplish that. But it is a proven revenue raiser and a laser-sharp policy intervention that helps combat the negative effect on the wider economy by a financial sector ridden by corrosive speculation. John Maynard Keynes, a speculator himself, perhaps said it best: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.” A lesson we ignore at our peril. For John’s other pieces on this issue, please see here.