Sunday, September 01, 2013

It's time for a 1% tax for Wall Street

I just read this fascinating article on high speed trading on Wall Street. In the article, we learn that Terrence Hendershott, a professor at the Haas business school at the University of California at Berkeley, has discovered how the biggest Wall Street trading firms can make zero risk trades in the stock market. How could that be?

Some trading firms on Wall Street have figured out how to beat the street by simply having a faster connection to the trading servers that everyone else on Wall Street. This connection gives some traders advance notice of the stock prices thus allowing them to trade on advance information. These very special traders gain advance notice of a stock price due to latency in the network feeds.

If you have your trading server in the same room and connected directly to the servers that manage all trades in the exchange, you learn of the next stock price quote before all others. This is called "latency arbitrage", which means that if you have even a few milliseconds advantage over everyone else, you can trade on that information. With advance information, you can profit on every trade with zero risk.

Does this create jobs? Unless you're a very good programmer, network engineer or lawyer, probably not. But if you are, you're going to make a very good living doing that work for Goldman Sachs and other firms who can weasel in on a good connection to the trading servers.

Does this help the small time investor, you know, the guy who just wants to manage his IRA account? No, it actually drains profits from the people trying to grow their retirement accounts. The money has to go somewhere and it's certainly not going into the value of the stock. All they are doing is taking advantage of a few milliseconds of advance notice of what the stock price will be before they trade a stock. No one else has that kind of information or connections.

This has been going on for years and as computing power increases, so does the frequency of the trades. Traders say that there is no way around this problem, that there will always be someone with an advantage. I'm inclined to agree. The way things are set now, a small, select and privileged class of people can make trades all day long with zero risk. For the rest of us, well, we assume the risk.

There is a suggested solution, to freeze the market at short, regular intervals, so that no one gets advance notice of a change in stock prices. That solution attempts to address the fact that traders who perform latency arbitrage are taking advantage of information that no other traders have and profiting handsomely for it. I can appreciate the suggestion and I think that for awhile, a solution that is tested and shown to be effective could work.

However, I understand a small bit about the hacking world. Let me give you an example. Years ago, when DVDs first came out, they were formatted with an encryption system call CSS. The system would only work in DVD players and on Windows and Mac systems, but not Linux. The encryption system was broken in 3 days by programmers and engineers who wanted to play DVDs on Linux. 3 days. 3 days to break a system that was years in the making.

No matter what system our securities exchanges come up with, the incentives to hack the system to find an unfair advantage are too great. A 1% tax on trades in our exchanges is in order. The United Front Against Austerity has an interesting proposal for such a sales tax. How much money would 1% yield? Well, more than $5 quadrillion passes through Wall Street every year. Hmmm. Our economy is valued at $16 trillion. A qadrillion is one thousand trillions. Do you think we'd have a federal budget deficit anywhere with a small tax on that kind of money? I don't.

A 1% tax on securities trading would hardly be noticed by the small guy, and retirement account trades could be exempted if we wanted - we want that exemption. Such a tax would almost certainly put the kibbosh on high frequency trades and get our economy back to basics. You buy a stock because you believe in what the company does, not to flip it for a few cents profit on thousands of shares every few seconds of every trading day.

A 1% tax on Wall Street trades would most certainly pay for the the federal debt in a year. This is not a pie-in-the-sky dream. Lawmakers are talking about it, but they're doing that talking very quietly. You won't see much about it in the news.

High frequency trading isn't helping anyone except the wealthiest of the wealthy and allows a privileged few to profit on trades with zero risk. It is but one example of how nearly all of the economic benefits of technological innovation are being diverted to the very top. That is behavior that can destroy a democracy and a culture. A 1% tax seems quite reasonable to pay for the messes that kind of behavior can create. Wouldn't you agree?
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