About half of all stock trading in the U.S. is computer-driven, algorithmic high-frequency trading. As a result, more than six billion shares of stock are traded each day. This is mostly a game played among Wall Street industry moguls — and it is a highly profitable game.
Do high-frequency traders’ profits come out of thin air? No, they come at the expense of retail investors — “little guys” with 401(k) plans and pensions invested in giant mutual funds.
On January 15, Rep. Peter DeFazio (D-OR) introduced the Wall Street Tax Act of 2021, which proposes charging a 1/10 of 1% financial-transaction tax (FTT) on purchases of securities including stocks, bonds and derivatives. Sen. Brian Schatz (D-HI) introduced the companion bill last year in the 116th Congress and is expected to do so again this year.
The Congressional Budget Office and Congress’s Joint Committee on Taxation have estimated that the FTT will raise $777 billion in revenue over 10 years — an amount sorely needed to help fill the federal budget gap and pay for important government programs such as infrastructure repair.
On cue, we will hear renewed disingenuous and cynical arguments from the financial industry. They will claim, for example, that “A Financial Transactions Tax Would Be a Huge Blow to the Little Guy.” In fact, the opposite is true. The tax would have a huge impact on high-frequency traders but almost none on “the little guy.” It could also relieve the little guy from the “tax” inflicted by high-frequency trading itself, because to earn their profits, high-frequency traders target pension funds and mutual funds — known as “whales” — that individuals invest in.
When these big players buy and sell securities, their huge bulk doesn’t allow them to move fast, so they can easily be set upon by fast-moving, high-frequency traders. For example, suppose that 1% of a $50 billion fund is invested in Microsoft, and it wants to increase the position to 1.1% of the fund. To do so, it will need to buy $50 million in Microsoft shares.
Since the fund is a whale, it can’t buy all at once because the piranhas in the market will notice immediately and raise the price. So the whale tries to disguise the purchase, buying a little at a time. But high-frequency algorithms can detect this activity and “front-run” the fund’s purchases, buying quickly to sell to the fund at a higher price.
Put simply, the high-frequency trader wins while the mutual fund — in which many “little guys” are invested — loses.
A financial transaction tax will create problems for high-frequency traders and severely impact their business. That is why in Hong Kong, for example, there is little high-frequency trading, because Hong Kong has a FTT called a “stamp duty” that is twice as big as the one proposed for the U.S. This has not prevented Hong Kong’s stock market from thriving; in fact, it is the third-largest in the world, after New York and London.
The negative effects the the FTT will have on the high-frequency trading industry is why it has been fighting so hard against it, through its lobbying arm Modern Markets Initiative, using the canard “The Financial Transactions Tax is a Retirement Tax.”
Yes, individual investors will pay the FTT too. But the richest 10% of U.S. households hold 84% of the stock market, so if “little guys” are the other 90%, and they own only 16% of the market, this tax won’t affect them much.
The best estimate is that the FTT would cost the average middle-income family about $13 a year, if the family has a retirement account. But what that family saves as a result of the tax will be much greater, because mutual funds will not be nibbled at by high-frequency traders.
The opposition to the FTT claims that high-frequency traders improve price discovery and liquidity, but this is disputed. High-speed algorithmic trading can cause runaway price cascades, as it most certainly did on at least two occasions in the U.S. market: the May 6, 2010 “flash crash,” and October 19, 1987, when algorithmic trading caused the Dow Jones Industrial Average DJIA, +0.30% to drop more than 20%. Furthermore, such incidents caused by high-speed algorithmic trading threaten the stability of the entire financial system itself.
The financial industry has been a cynical purveyor of disinformation long before our present disinformation crisis. It’s time to see through this disinformation and reject it decisively. A good start would be to dismiss the completely false depiction of the FTT’s impact on the “little guy.”
Michael Edesess is chief investment strategist at mobile financial-planning software company Plynty and a research associate at the EDHEC-Risk Institute. He is the author of “The Big Investment Lie” and co-author of “The 3 Simple Rules of Investment.”