Should We Tax High Frequency Trading?

About a year ago, we experienced the now infamous "flash crash." You might recall that the stock market suddenly plummeted one seemingly arbitrary May afternoon, with the Dow Jones Industrial Average quickly shedding nearly 1,000 points for no apparent reason. We eventually learned that high-speed computerized trade functions exacerbated a software error, which caused the market to briefly hiccup. Since then, high frequency trading has been in the spotlight. This week, we learn that Senator Chuck Schumer (D-NY) wants to tax these transactions to pay for the additional regulatory oversight that they would require. Is this a good idea?

Here's the news blurb, via Jacob Bunge at the Wall Street Journal:

"In the aftermath of last year's Flash Crash, the need for more coordinated market surveillance has never been clearer," Mr. Schumer wrote in a letter to Securities and Exchange Chairman Mary Schapiro, a draft of which was reviewed by Dow Jones.

The SEC desired such a "consolidated audit trail" even before the market plunge of May 6, 2010, but its high price tag--estimated by Ms. Schapiro in December at around $2 billion up front--and other priorities like implementing the Dodd-Frank financial law have held it up.

It's the SEC's job to understand what's going on in the markets. So its surveillance function is vital. Without it, the regulator can never hope to effectively catch the problems that may arise quickly and deal with them effectively. So if the SEC lacks the ability to oversee high frequency trading, then this needs to be corrected.

The question, then, is: who should pay? Schumer is right to say that the burden should fall on the shoulders of those who benefit from the market. Think of an analogy. If a particular community is built in a very-low flood zone, then it should have to pay an additional premium for flood insurance. Residents living in higher-elevations shouldn't also bear the cost. Similarly, those who choose to participate in high frequency trading are reaping benefits from this relatively young market. So they must be on the hook for costs associated with its functioning effectively.

The trick is getting the tax right. Currently, the market is not efficient: high speed trading looks disproportionately profitable, since its cost does not include the regulatory oversight it requires. But an equal and opposite problem arises once a tax is put in place if it's too high: if it produces more tax revenue than is needed for the regulatory burden it creates, then market inefficiency occurs since high frequency trading incurs more cost than it should.

Care must be taken when figuring out how to properly create this tax. Although there is a significant upfront cost (explained in the excerpt above), the ongoing cost is likely to be much, much smaller. So if these firms are assessed initially in some aggressive fashion, any ongoing transaction tax should be very low.

This will create a problem, in practice. The government will almost certainly be tempted to set this tax too high. First, it will likely be designed to pay for the large upfront cost relatively quickly and may not be revised once that revenue has been collected. Second, the rhetoric in the WSJ article suggests that Schumer (and no doubt others) wants the tax to be somewhat punitive to discourage high frequency trading. Finally, politicians know that financial firms often make quite high profits, and they may see this as an opportunity to spread a little bit of that wealth around.

But then, that's what lobbyists are for. And Wall Street has an army of them. So we'll have to wait and see how they shape this coming battle. If they're ineffective, then the tax will be set too high. But if they're too effective, then we may never see the tax at all.