Four years ago today, the Dow Jones dropped almost 1000 points in minutes. This frightening episode, now known as the Flash Crash, demonstrated how computerized high-frequency trading (HFT) could exacerbate swings in financial markets to dangerous magnitudes.
On this anniversary, coincidentally, several European nations announced that they have agreed move ahead with a multi-national financial transaction tax (FTT) by the start of 2016 at the latest. While originally proposed in response to the 2008-09 world financial crisis, the EU FTT has received renewed attention as an instrument to help slow down overheated trading as well.
Especially since the release of the best-selling book about HFT, Flash Boys, the media and regulators are taking a fresh look at the potential pitfalls of turning over so much -- possibly a majority according to many estimates -- of our markets to computer algorithms. As the New York Times editorial board noted last month:
There are several good arguments for a financial transactions tax, a small per-trade levy. It would raise needed revenue from an undertaxed sector and foster greater income equality. It would also curb speculation, making the banking system more stable.
And there’s its potential effect on high-frequency trading.... As Nelson Schwartz reported in The Times, many tax experts have pointed out that a financial transaction tax could help to put the high-frequency traders out of business by denting the profits made from each transaction.
CEPR's Dean Baker has been one of the leading proponents of the FTT for over a decade. Most recently, he pointed out how it could effectively stem the problems caused by high-speed computerized trading while leaving regular investors essentially untouched:
There are many complicated ways to try to address this problem [HFT], but there is one simple method that would virtually destroy the practice. A modest tax on financial transactions would make this sort of rapid trading unprofitable since it depends on extremely small margins.... Most research indicates that other investors will reduce their trading roughly in proportion to the increase in the cost per trade, leaving their total trading costs unchanged.... The Joint Tax Committee projected that this tax would raise roughly $400 billion over a decade.
There currently are a few bills before Congress (including ones introduced by Senator Tom Harkin, Representative Peter DeFazio and Representative Keith Ellison) that would introduce small FTTs in the U.S. As folks reminisce today about the scare caused by the Flash Crash, as well as the potential market flaws it uncovered, let's hope policy makers and regulators also take a look at a financial transaction tax as a tool to stabilize the markets.