Articles published in February, 2013
Computers have reduced the cost of buying and selling financial assets, but the gains from further speed seem unclear
In 1987, Thomas Peterffy, an options trader with a background in software, sliced a cable feeding data to his Nasdaq terminal and hacked it into the back of a computer. The result was a fully automated algorithmic trading system, in which Peterffy’s software received quotes, analysed them and executed trades without any need for human intervention.
Not long after, a senior Nasdaq official dropped by at Peterffy’s office to meet what he assumed must be a large team of traders. The official was alarmed to be shown that the entire operation comprised a Nasdaq terminal sitting alongside a single, silent computer.
From such humble beginnings, computerised trading has become very big business. High-frequency trades take place on timescales measured in microseconds – for comparison, Usain Bolt’s reaction time in the Olympic 100m final was 165,000 microseconds.
There is a variety of motives for high-speed trading. Statistical arbitrageurs look for pricing patterns that seem anomalous, and bet that the anomaly will be short-lived. Algo-sniffers try to figure out when someone is in the process of placing a big order and leap in to profit. (Algo-sniffers are likely to fall prey to algo-sniffer-sniffers, and so on ad infinitum.)
Then there are quote-stuffers, which produce and immediately withdraw offers to trade, perhaps in the hope of provoking other algorithms, or perhaps with the explicit aim of gumming up trading networks and exploiting the confusion. And the algorithmic trading game is constantly evolving.
If this sounds unnerving to you, then you have something in common with Thomas Peterffy, now a billionaire on the back of his electronic brokerage firm. Peterffy told NPR’s Planet Money team that “whether you can shave three milliseconds off the execution of an order has absolutely no social value”. It’s hard to disagree. Computers have reduced the cost of buying and selling financial assets, but the gains from further speed seem unclear, and must be set against the risks. Several recent financial “accidents”, including the May 2010 “flash crash” and the implosion of Knight Capital in August last year, attest to the hazards of high-speed trading.
But what is to be done? In a new paper, “Process, Responsibility and Myron’s Law”, the economist Paul Romer argues that we need to start paying attention to the dynamics of how new rules are developed. (“Myron’s Law” is that given enough time, any particular tax code will end up collecting zero revenue, as loopholes are discovered and exploited. Tax codes must therefore adapt. So must many other rules.)
Romer contrasts the box-ticking approach of the Occupational Safety and Health Administration – which has a detailed and somewhat contradictory rule, 1926.1052(c)(3), about the height of stair-rails – with the principles-based approach of the Federal Aviation Administration (FAA), which “simply” requires planes to be airworthy to the satisfaction of its inspectors. Romer argues that financial regulations now resemble the OHSA’s rule 1926.1052(c)(3) more closely than the FAA’s “airworthy” principle – and that this is a problem.
Peterffy’s experience is instructive: the Nasdaq official withdrew, consulted a rulebook and declared that the rules required trades to be entered via a keyboard. Peterffy’s team responded by building a robot typist, and he was allowed to continue. Box-tickers everywhere would be proud, and the actual merits of banning Peterffy did not need to trouble anyone.
The real question here is a question about process – about how new rules are developed, and who takes responsibility for the decisions made. Because as the algorithmic traders are demonstrating, even rules that work today will have to adapt tomorrow.
Also published at ft.com.
A financial transaction tax would at best be irrelevant to financial stability
‘The eurozone’s biggest economies would raise €30bn-€35bn from their planned levy on financial transactions, according to an expansive European Commission proposal that ensnares trades executed in London, New York or Hong Kong.’
Financial Times, January 30
That’s going to spoil your day. You’re always grumbling about new taxes.
Well, it’s no fun paying taxes. But of course, it is very nice having schools, a police force and a health service. So the question is whether this is a good tax or not.
The Robin Hood Tax campaign claims such taxes could raise hundreds of billions of pounds, fight poverty and won’t affect the ordinary public.
Really? If you believe that I have a very nice bridge you may be interested in buying.
Sarcasm is unbecoming, especially in an economist. I expect you’re going to tell me that the tax will be simply avoided?
Well, of course the tax will be somewhat avoided. All taxes are somewhat avoided. There’s even evidence sharp reductions in inheritance tax temporarily reduce the death rate, as people wait for the tax to fall before they expire. Zero tax avoidance, then, is an unfair benchmark to apply to any tax. Incompetently designed transaction taxes are easy to avoid – the poster-child of how not to do this is Sweden, for much of the 1980s. Several European countries – notably Germany – have scrapped their financial transaction taxes. But it is possible to collect revenues through determined FTTs – and ironically, given British opposition to this proposal, the world’s most successful FTT is perhaps the UK’s stamp duty reserve tax, a transaction levy on trading shares. It’s still called that because back in the day people used to stamp things.
And the stamp duty has clearly failed to extinguish share trading in the City.
But it has helped fuel the market for derivatives contracts, which don’t attract the same tax. And banks are exempt from stamp duty, even if they’re trading for their own profit. As a result, most trading in London is exempt, and the International Monetary Fund argued that by promoting trade in share-substitutes, the tax increases “financial leverage and risk”. But it’s certainly true that it is possible to levy an FTT and raise some revenue without causing the tax base to evaporate completely. But I am wondering why anyone would want to.
To reduce volatility in the financial system and to make bankers pay for the mess they’ve caused. And to end poverty.
I support your goal, but it would reflect better on development charities if they argued aid costs money but is worth it. As for reducing volatility in the financial system, that’s not clear. Let’s assume that an FTT neither drove transactions overseas nor created side-markets; it would then reduce the volume of transactions.
And thereby reduce volatility.
How? It will reduce liquidity, which in most theoretical models and most empirical studies increases short-term volatility. Admittedly that’s probably manageable. It will encourage longer-term holding of shares, which in principle increases short-term pressures on companies: locked-in investors must worry about dividends today because they can’t sell their shares purely on the basis of a company’s long-term prospects. With a small tax the effect will be tiny, but it’s still an effect in the wrong direction. The FTT should reduce flash trading by computers, which might be a good thing, although flash trading is not a European vice now. But flash trading needs direct regulatory attention – the problem at the moment seems to be quote-stuffing, in which no transaction takes place at all.
Did you not notice the gigantic financial crisis?
The crisis was the result of complex mortgage-backed assets, insurance companies writing suicidal credit default swaps and highly leveraged banks – and nothing to do with short-term share trading. The exception is the overnight repurchase market, which suffered the equivalent of bank runs and involves short-term trading. But the repo market is excluded from the new European Commission proposal. So the FTT is at best irrelevant to financial stability.
But surely you’re not saying we shouldn’t tax banks and bankers?
Of course we should. I’m with the IMF on this: the FTT is feasible but we have better options, including value added tax on financial services or taxing balance-sheet debt to reduce leverage. To invert an old saying, the FTT is the best possible tax on banks – apart from all the other ones that have been tried.
Also published at ft.com.