Recs

2

Will EU Taxes Send Machines After Your Stocks?

Watch stocks you care about

The single, easiest way to keep track of all the stocks that matter...

Your own personalized stock watchlist!

It's a 100% FREE Motley Fool service...

Click Here Now

The EU's crusade against high-frequency trading continues apace. Austrian, Spanish, and Belgian finance ministers are increasingly agitating for a eurozone financial transactions tax. The tax, also favored by EU heavyweights France and Germany, proposes to tax stock and bond trades at a 0.1% rate. American politicians are getting in on the action as well, with two Democrats introducing a bill to tax financial transactions at a 0.03% rate.

The EU proposal stands a greater chance of passing, even considering the fragmented nature of its fragile political alliance. Proponents say it might raise up to $79 billion in new revenue each year, but the greatest flaw of this idea is its supporters' failure to understand that HFT trading systems have no need for national boundaries. Restrictive taxes in one region would only serve to concentrate HFT in more amenable markets, particularly U.S. exchanges.

Numbers don't lie
In order to find out how HFT endeavors might lose out under the new tax code, it's first necessary to pin down HFT's potential profits. The taxes proposed would be levied based on the value of the assets, so a transaction tax would come down on anyone buying or selling at the cost of the equities. But most HFT profits typically aren't calculated in terms of equity value; rather, they're based on sheer transaction volume. Both NYSE Euronext (NYSE: NYX  ) and Nasdaq OMX (Nasdaq: NDAQ  ) offer rebates for HFT activity, amounting to fractions of a cent per share moved, and other estimates of profitability are also available. With these numbers, we can begin to get a view of how HFT works.

Sources: Nasdaq OMX, The Wall Street Journal, and author's calculations. All trades are round trips (one buy plus one sell) and are assumed to be 100-share blocks.

Stock price doesn't matter in this chart. The trades could be done with penny stocks like Sirius XM (Nasdaq: SIRI  ) or high-priced megacaps like Apple. Both companies have the characteristic heavy volume that can reveal stocks with high HFT activity, and as long as the HFT trader can cover the financing costs of its microsecond-length transactions, it makes about the same amount of profit whether each block of 100 shares is worth $175 or $40,000.

The hammer drops
Here's where it gets interesting. The transaction tax, as previously mentioned, is levied on the value of the assets. As the calculation increases it becomes quite apparent that the more restrictive EU taxes would chase HFT out of the eurozone:

Sources: Nasdaq OMX, The Wall Street Journal, news reports, and author's calculations. All trades are round trips (one buy plus one sell) and are assumed to be 100-share blocks, and taxes are netted against $0.10/100 share profits.

These losses were calculated based on rebates at $0.10 per 100 shares. However, basing estimates on a $0.00295-per-share rebate also resulted in losses, although these were somewhat smaller.

Both tax laws, if implemented, would force HFT systems to operate in a narrow band of penny stocks. Even with the most generous per-share trade rebate, the EU tax would block any profit past the $3-per-share range, and U.S. proposals would cut off HFT around $10 per share. This is essentially the same as cutting off HFT entirely -- by my calculations, only the shares of Sirius XM, Sprint Nextel (NYSE: S  ) , Alcatel-Lucent (NYSE: ALU  ) , Chimera Investment (NYSE: CIM  ) , Regions Financial (NYSE: RF  ) , and few others would have the combination of volume and low price that would allow effective HFT operation.

Machinations against machines
But how likely is it that either will be implemented? American politics increasingly resembles a boxing match between armless participants, and any form of tax increase is likely to be rejected by the Republican-controlled House. If such a bill miraculously makes it to the White House, it's likely to be vetoed. President Obama favors a financial crisis responsibility fee, intended to zero out TARP losses by extracting payments from Wall Street firms at the heart of the crisis.

That leaves the EU. While Britain isn't likely to go along with such a tax, its refusal to participate in the euro means that its influence will be weak at best. The EU proposal will be debated next week in Brussels at a meeting of finance and economic ministers, many of whom have come out with public support for the plan. The Italian debt crisis isn't likely to sway regulators away -- the desperate need for cash is likely to add pressure to pass revenue-raising legislation.

A fool's (not a Fool's) errand
$79 billion in new tax revenue? Try zero. The only thing keeping HFT from leaving would be the ideal locations of companies' server farms, and equipment can always be shipped elsewhere. American exchanges have been aggressive in courting HFT operators with rebate schemes. This could result in American shores being invaded by hordes of machines, all hell-bent on one thing: squeezing every last fraction of a penny they possibly can out of the market.

If volatility keeps you up at night, it could get worse. And it could start making even less sense. Let's hope European regulators wake up and realize that taxes on globally active systems will only send those systems elsewhere, to everyone's detriment.

If you're looking for opportunities to escape machine manipulation, take a look at the Motley Fool's free special report on two small caps the government won't let fail. Get security through obscurity with government-supported companies that fly under the radar of most HFT systems. The report's only available for a short while, so get your copy today.

Fool contributor Alex Planes holds no stake in any company mentioned here. Add him on Google+ or follow him on Twitter for more insights and the occasional random link. The Motley Fool owns shares of Apple and Chimera Investment. Motley Fool newsletter services have recommended buying shares of Apple and NYSE Euronext, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 11, 2011, at 8:12 PM, evo34 wrote:

    You don't really have a handle on what high-frequency trading is. It's not all about collecting rebates. That's what market makers are doing in theory. Most high-frequency trading firms are not formal market makers; they are acquiring positions whenever they feel there is a short-term probability of a profitable move -- usually a move that is more lucrative than the rebate profit (if any). These positions may be acquired by adding liquidity (collecting rebate) or by taking liquidity (paying the rebate). The positions may be held for a couple seconds, a couple minutes or a couple hours. The target profit may be 0.02%; it may be 2%. There is an infinite number of possible strategy algorithms. So your broadly painted characterization of how much money HFT firms make and precisely how they make their money is not particularly useful at best, and misleading at worst.

    Finally, the idea that HFT firms will simply move business from a higher tax country to a lower tax country is not realistic. Most trading firms are already global and the only reason they may be more involved in one market than another is that there is more opportunity for profit. I.e., these firms that would allegedly "move" their business from EU to US trading are likely already maximizing their US business -- that is, taking every edge they have uncovered and scaling it up as much as possible. Losing a certain line of business will not make it any easier to ramp up a remaining, saturated line of business.

    Obviously, any transaction tax hurts any active trading strategy. But the idea that a 3 bps tax would kill off HFT in all but penny stocks is simply misinformed.

  • Report this Comment On November 11, 2011, at 9:00 PM, TMFBiggles wrote:

    @ evo34 -

    I see why you believe I said it's all about collecting rebates. This is my fault and is due to a mis-wording. Was it this sentence: "These losses were calculated based on rebates at $0.10 per 100 shares" that led you to the conclusion? It should read "based on profits of $0.10 per 100 shares." There are a couple of uses of "rebate" that should be "profit" instead. Apologies.

    $0.10 per 100 shares was put forth as the profit for an average HFT system in a Wall Street Journal piece. Some trades will lose a little, some gain a little, but the overall profit comes to about that much. The other figure is actually higher and seems less realistic to me, but I like having something to compare to.

    If some traders make higher profits they may survive the tax, but the proposed EU tax on trades would destroy profits for those HFT systems that only make that $0.10 profit per 100 shares. That's what my calculation resulted in, based on publicly available info.

    It certainly is a broadly-painted picture, but would you prefer I go around to all the HFT companies in operation in the EU and ask them how much profit they make per share? In volume operations the most prudent way of assessing profit is doing so per share traded, and that's what I've done. The numbers show a destruction of profits at very low share prices.

    If any HFT firms have a number on profit per share traded, I'd love to see it. These two were actually the most generous estimates I could come up with, and I used them because I wanted to give as high a ceiling as possible when assessing potential profit.

    Thanks for reading! I hope this cleared it up.

    -Alex

  • Report this Comment On November 15, 2011, at 2:39 AM, evo34 wrote:

    Not sure I buy that there were multiple typos -- each time using "rebate" for "profit" -- given your level of experience. Furthermore, your article makes even less sense if the word "profit" was, in fact, what you had meant to write. Trading firms do not measure profit in "cents per share traded." Profit is measured by percent of notional value traded. So whether you are trading 100,000 shares of $1 stock or 1,000 shares of a $100 stock, it's the same notional value. And a 3 bps tax would have the exact same impact on each of these two trades.

    What is measured in "per share" terms is broker commission and the exchange rebate/fee. But these costs are known and not threatening to change. No one is proposing a per share tax, so the argument that HFT firms will be limited to low-priced stocks if a percent-of-notional tax is enacted makes zero sense.

  • Report this Comment On November 15, 2011, at 8:28 AM, TMFBiggles wrote:

    @ evo34 -

    It was written as "profit" in my drafts and was changed to "rebate" through the editing process. So I apologize for the confusion. I was confused myself to find the wording changed.

    The profit calculation I originally dug up was presented as a per-share calculation.

    Here is the source:

    http://online.wsj.com/article/SB1000142405297020422620457660...

    In an effort to dig up more complete information for this debate, I found one assessment that calculates profit as a fraction of share value:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1938769

    Based on the figure presented here ($0.000072 in profit per dollar traded), your argument is correct. But based on the other calculation, my argument is correct. Since the new source is hosted on what appears to be a properly-vetted research site, I concede the point.

    Thank you for the well-reasoned argument. Please don't hesitate to reach out to me (contact info is posted at the end of the article) if you have any further information on HFT that would be useful for my research.

    -Alex

  • Report this Comment On November 15, 2011, at 9:06 AM, TMFBiggles wrote:

    @ evo34 -

    It was written as "profit" in my drafts and changed to "rebate" during editing. I used "profit" because the WSJ article I used as a reference point mentioned profits in terms of 10 cents per 100 shares. Other sources cite profits as you have, in terms of percentages of the share value.

    The problem with making such a calculation is that while my source is pretty cut-and-dried devastating to profits, a tax calculated against profit as a percentage of the overall trade would be heavily dependent on how much profit is actually made. Morgan Housel has an article recently posted about the US transactions tax, quoting a source saying that even these low tax rates would destroy HFT.

    My calculation might be overly simplistic, but the reality is hard to pin down.

    How about we agree that it's more likely that profits are made in the way you described, but that the amount of profit is the key issue as to whether or not these taxes do as I suggest? They may not be restricted to a narrow band of stock prices, but they would be devastated just the same, assuming profit margins are low enough.

  • Report this Comment On November 15, 2011, at 9:08 AM, TMFBiggles wrote:

    Didn't think the first comment posted, hence the repeated comments. At any rate, you can see what a tricky issue it is to analyze.

    Here is the Housel article:

    http://www.fool.com/investing/general/2011/11/14/taxing-the-...

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1588275, ~/Articles/ArticleHandler.aspx, 10/25/2014 7:21:24 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Alex Planes
TMFBiggles

Analysis at the intersection of economic history and technological futurism.

Today's Market

updated 10 hours ago Sponsored by:
DOW 16,805.41 127.51 0.76%
S&P 500 1,964.58 13.76 0.71%
NASD 4,483.72 30.92 0.69%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/24/2014 4:00 PM
NDAQ $40.88 Down -0.42 -1.02%
Nasdaq Stock Marke… CAPS Rating: *****
NYX.DL $0.00 Down +0.00 +0.00%
NYSE Euronext CAPS Rating: *****
ALU $2.51 Down -0.06 -2.33%
Alcatel-Lucent (AD… CAPS Rating: ***
CIM $3.09 Up +0.02 +0.65%
Chimera Investment CAPS Rating: ***
RF $9.44 Up +0.03 +0.32%
Regions Financial… CAPS Rating: ****
S $6.08 Down -0.01 -0.16%
Sprint CAPS Rating: **
SIRI $3.37 Down +0.00 +0.00%
Sirius XM Radio CAPS Rating: ***

Advertisement