December 21, 2009

Much of the U.S. manufacturing has already moved to China, leaving behind scores of unemployed factory workers and foremen. The U.S. financial services system has stepped in to replace manufacturing as one of the key and too-big-to-fail pillars of the U.S. economy. Yet, a new threat to the U.S. financial services and, as a result, domestic economy as a whole comes in the form of Financial Transaction Tax (FTT).

The FTT, proposed by Congressman Peter DeFazio of Oregon, may create natural incentives for financial services companies to move overseas, just as their manufacturing brethren has done over the past two decades. The firms propped up by the now-repaid billions of the U.S. tax payer money during the last crisis may choose to relocate the bulk of their operations to China, taking with them many jobs and investment capital needed domestically. Who will benefit from the Financial Transaction Tax then?

On paper, the FTT proposal looks perfect: tax Wall Street to “Pay for Restoration of Main Street,” just as the Main Street had to conjure tax dollars to prop-up Wall Street when in the midst of the crisis. The proposal also aims to have a particular tax impact on high frequency trading, still little understood, yet immensely profitable set of computerized strategies that now comprise over 60% of trading on exchanges.

High frequency trading seeks to capture very small gains by holding short-duration trading positions multiple times throughout the day. Computers process data and make trading decisions at a much faster speed than humans possibly can. “Geeks” with advanced degrees in Statistics and related disciplines now instruct computers to sift through reams of financial data and negotiate trades. The FTT, the thinking goes, will transfer some of the gains of these trades to Main Street.

As someone versed in high frequency trading, I can attest that a FTT of any magnitude imposed on the U.S. markets will reduce profitability of high-frequency trading strategies currently executed in the U.S., putting selected high frequency traders out of business in the U.S. markets. This may be good news to some: thinning out the ranks of high-frequency traders may finally let certain groups of citizens relax: no more need to catch up with the Joneses! No more boring and complicated mathematical equations!

Three martinis for lunch, everyone! Add to that the FTT offsetting that IRS revenue currently derived from high frequency traders, one of the only financial professionals on Wall Street unaffected by the latest credit crisis. How much peachier can life get?

The situation, of course, is not so simple. According to a 2004 study by Jonathan Schwabish of Partnership for New York, the FTT would result in a “substantial” collateral damage to the economy. Per Dr. Schwabish’s estimates, if the FTT results in even as little as 10% decrease in trading volume on the exchanges, New York City alone would be shedding as many as 10,000 financial securities professionals.

While this number may seem lost in the total U.S. population count, consider the following statistic: every 100 financial security jobs are estimated to support 27 to 37 jobs in the retail sector, 72 to 91 jobs in the business services sector (think staples and copy machines), 79 to 112 jobs in the services sector (like dentists, nurses and gas station operators), and 5 to 12 restaurant and pub workers. Even the smallest FTT that reduces transaction volume by as little as 10% will, according to Dr. Schwabish, result in the loss of over 30,000 jobs just in NYC.

If history is any indication, the impact of the FTT will not stop at reducing the number of jobs ancillary to the financial services industry. Let us wind the clock back thirty years to the seemingly long-forgotten time when a version of the FTT existed on the U.S. soil.

Since 1966 through the 1970s the City of New York imposed a Stock Transfer Tax (STT), as the FTT was called then, on all financial transactions conducted within the New York City jurisdiction (from 1905 to 1966, the STT was administered by the New York State, yet in 1966 the NY State STT was replaced by an apparently higher STT imposed by the City of New York).

According to Jeff Meyerson of Sunrise Securities Corp., the NYC STT triggered the first mass exodus of financial services firms from NYC to New Jersey, where the STT did not exist.

A pan-U.S. FTT may seem like an easy solution to state-fleeing firms: make all the states subject to the same tax, and incentives for corporate moves disappear. Yet, this answer is not so simple in our increasingly electronic, transparent, property-rights enhanced global world, where financial transactions can be executed with equal efficiency in many countries.

U.S. trading may move to foreign soils. Sweden and Japan have already experienced emigration of traders in response to transaction taxes. In Sweden, 30% of the country’s trading volume moved to London after the Swedes imposed a 2% trading tax in 1984 (the tax was repealed in 1991). Japan had to stop taxing financial transactions in 1999 when the government found that the level of tax excessive to that charged by other countries (0% at the time in the U.S.) is likely to result in the Japanese financial markets moving away from Japan altogether.

The current pro-FTT economists’ argument is that everything will remain just fine if the FTT is set at the levels similar to that of the U.S. financial markets’ most prominent competitor, the London Stock Exchange. The implied rationale for the tax benchmark appears to be that the U.S. order flow will not deflect to the U.K markets since the U.K imposes similarly punitive taxation schedule.

May be such international leveling of the FTT will indeed preclude the capital move from the U.S. to the U.K., but what about to China, where financial markets are growing? According to Dealogic, a U.K-based information services solution provider to the investment banking industry, in 2009, Chinese stock exchanges (including Hong Kong) raised twice more money in initial public offerings (IPOs) than did the U.S. exchanges.

From the time Dealogic began tracking IPO activity, in 1995, through 2008, the U.S. was a global leader in IPOs, except for 2006 when the U.K. took the lead. Furthermore, per Financial Times, Hong Kong Exchange “has been aggressively courting overseas companies in a bid to challenge rivals in hubs like London and New York.”

The harsh reality of computational advances in today’s financial markets is that fluency in mathematical equations and computer-programming languages often generates higher profitability than fluency in English, if the two skills are compared side-by-side. It is also a fact that the Chinese have vast pools of enterprising talent well-versed in hard sciences and ready to absorb any financial services sectors the U.S. deems too profitable domestically.

Is this the restoration Main Street residents have in mind?

About the Author

Irene Aldridge is Managing Partner at ABLE Alpha Trading and author of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” published by John Wiley & Sons.