This year has ushered talk of implementing a tax on stock transactions in the U.S. and especially Europe. For the time being, lawmakers on both continents appear to have put the idea on hold, but rest assured it will reemerge. The culprit? High-frequency trading. Torben G. Andersen, a professor of finance at the Kellogg School of Management, tells Insight about high-frequency trading, how it affects the market, and why a transaction tax is not necessarily the way to go.

A New Market Maker
In the old days, the orderly functioning of markets was left to specialists. Tasked with facilitating fair—and steady—trading, specialists were obliged to step up to the plate themselves should other buyers or sellers suddenly dematerialize. Occasionally this would put them on the wrong side of deals, but in return they received (among other perks) the gap between the bid and the ask price, more or less guaranteeing they’d be rewarded for providing liquidity to the market.

But the rise of high-frequency trading has left the old ways looking as quaint as telegram service. “We now have these fancy electronic limit order books,” explains Andersen. “People can directly indicate where they want to buy and where they want to sell. If there are enough people who do this, we don’t really need anybody to mediate. They’re creating liquidity themselves.” Spreads—the gap between bid and ask prices—have lowered dramatically, as have tick sizes—the minimum amount a price can change. This paved the way for a new market maker: the high-frequency trader.

High-frequency traders rely on proprietary algorithms that predict where stock prices are trending. These traders don’t worry about carrying a diversified portfolio, or where natural gas prices will be in a decade. Instead, they focus on where prices are going now, buying and selling securities frantically in the hopes of making a cent or so of profit on each. Along the way, they do provide liquidity, offering a nearly never-ending supply of quotes to long-term investors wanting to trade. Only, unlike their predecessors, they have no particular obligations to make sure the market functions.

The Obnoxious, the Illegal, and the Terrifying
This has led to some rather interesting predicaments. Some portfolio managers complain, for instance, that when they attempt to make a trade, they cannot always obtain the quotes they see on the screen. “So you see what amount of shares you’re supposed to be able to buy at that price,” explains Andersen, “and if you try to do it, it doesn’t work. You only get a fraction of those shares. If you want to buy more, you get a higher price. In the worst case, you have to pay more for all of them.” How could this be? High-frequency traders may be front-running—swooping in to either purchase the cheapest stock just before it can be purchased by another party or cancel their own position in a book that another party is trying to purchase. “If somebody sees that your order is on the way, they then buy the cheaper stuff. You end up having to buy at the higher price—and what they bought has already increased in value,” says Andersen.

Such behavior—though obnoxious—is perfectly legal. But there are also some concerns about outright manipulation, where traders execute a sequence of trades intended to cause stock prices to crash. The same traders can then buy up this bargain stock, knowing that it is likely to rebound. Manipulation is illegal, explains Andersen, but it is exceedingly difficult to punish. “Regulators always lose because they cannot prove [the] intent of an algorithm to cause something to crash and then benefit from it.”

Then there is concern about so-called flash crashes. On May 6, 2010, the Dow Jones Industrial dropped—and then recovered—over 600 points in less than an hour.  High-frequency trading may have been at least partly to blame. That’s because when markets were volatile, and securities prices began to plummet, there was nothing preventing high-frequency traders from simply ceasing to trade. “They may say ok, we’re usually trading multiple times a second. Now things are not working as usual and we’re not trading anymore,” says Andersen. “And since there’s nobody dedicated to be a market maker, that may mean there’s nobody putting up reasonable prices—and if people get scared, you get these really wide spreads suddenly.… You get this collapse of liquidity, and prices do wild things.”

A Transaction Tax?
So what can exchanges or regulators do to minimize the risks that high-speed trading poses to the system? Might it be a good idea, as legislators have suggested, to discourage it altogether by imposing a modest transaction tax? That’s not necessary, says Andersen: “We finally have markets that don’t have too many obstacles.” Why would we want to make them less efficient?

Instead, he recommends regulation that guards against algorithms gone berserk, and limits the amount that security prices can drop over a short period of time. The latter could be accomplished by temporarily pausing trading once a price movement passes (or is about to pass) a predetermined threshold. “You don’t pause for a long time,” says Andersen, “but you pause enough that people have a chance to digest: Is it sensible that the price is dropping like this?” Some exchanges have in fact already implemented such safeguards—though Brian Weller, an assistant professor of finance at the Kellogg School, notes that the jury is still out on their effectiveness, as they “generally are loose enough to allow plenty of odd, price-impact-driven behavior.”

Other exchanges have implemented speed limits of sorts. The Royal Bank of Canada’s trading desk, for instance, slows incoming orders to dissuade front-running. It also dampens the incentive to invest in ever-faster fiber optic cables and algorithms, which are helpful for beating out other high-frequency traders but of dubious benefit to the rest of us.

A Different Kind of Tax
The one tax Andersen might consider: an infrastructure tax, if you will. High-frequency traders flood the markets with quotes, the vast majority of which never result in trades. They do this because it gives them a better chance of being first in queue to make a trade—on either side of a transaction. “So you’re sitting on both sides, and you have the ability of getting out of the way if you think you don’t want to be hit, or you have the chance to be one of the first to actually do the trade if you think it’s going to be beneficial,” says Andersen. “That’s really how they make their profits, I think.”

Though exchanges charge transaction fees, they currently charge no fees for quotes that do not result in transactions. Maybe high-frequency traders should have to pay any costs to the system—such as slower trading channels—currently borne by others. “It’s a little like a highway and they drive 98% of the time,” says Andersen. “These guys are the ones driving and wearing out the highway. Well, should we all equally pay the taxes to keep the roads intact, or should they pay as a function of how much they drive?”

In the end, though, the solution to challenges posed by high-frequency trading may simply be more high-frequency traders. “If competition is allowed to play out in the long run, maybe there’ll be a lot of firms trying to do this,” says Andersen. “There should be a lot of people making a regular amount of money and there shouldn’t be anything too devious about that.”

Photo Credit: Mattia Landoni for Wikimedia.