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A High-Frequency Tax: Paving the Way for a Fair Market, or a Roadblock to Efficiency?

As lawmakers and federal officials ponder fees for high-frequency traders in order to cover the steep cost of monitoring them, industry experts warn that an added tax could stifle the very segment that accounts for most of the nation’s equity volume.

As lawmakers and federal officials ponder fees for high-frequency traders in order to cover the steep cost of monitoring them, industry experts warn that an added tax could stifle the very segment that accounts for most of the nation's equity volume.

In recent months, officials at the U.S. Securities and Exchange Commission (SEC) have weighed new fees that are likely to discourage certain lightning-quick trading techniques. The Wall Street Journal reported in May that U.S. Sen. Charles Schumer (D.-N.Y.) urged SEC chairwoman Mary Schapiro in a letter to tax high-speed traders in order to pay for a system that can track all U.S. stock trades in real time.

Schapiro estimated last December a $2 billion price tag for this type of consolidated audit trail. Calls for a platform to facilitate such transparency reached a crescendo in the aftermath of the May 6, 2010, Flash Crash, for which regulators struggled for months to pinpoint the cause.

But even as increased surveillance has become a necessity in a marketplace where stock transactions often occur near the speed of light, forcing high-frequency traders to pay the lion's share of regulatory costs ultimately will make trading more expensive across the board, market participants say.

"If something like this gets layered on the market, it's not going to just be the high-frequency firms that pay for it, it's going to be everyone," says Larry Tabb, founder of research and advisory firm Tabb Group. "It'll dry up liquidity and force some players out. It'll also widen spreads and make it more expensive for institutional investors to trade. The bid and offer will be wider."

HFT Firms Forced to the Sidelines

For high-frequency traders - whose profits are driven by the enormous number of trades they're able to execute at warp speeds - even a nominal fee of an additional penny per hundred shares traded would have a damaging impact, contend critics. By the sheer volume of trades they process - billions of shares are exchanged per day - HFT firms now provide the majority of the liquidity floating throughout the nation's marketplace.

Yet an additional fee could drive down the number of trades these companies transact. And with the high-speed players sitting on the sidelines, liquidity would become more difficult to find and more expensive - a scenario that hurts all investors, according to Tabb.

"They're going to either be buried and not be enticed into the market when it becomes too competitive, or they'll only be in when the spreads widen," Tabb says of HFT firms. "Which means the cost of providing liquidity goes up."

Transaction fees also could drive more trading firms to do business outside of the United States, an exodus that's already underway due to reduced domestic market volumes and brutal competition that's reining in growth prospects for many companies.

"The danger is the unintended consequence, which is actually happening now. People are saying, 'You know what, I'm just going to take my business offshore,'" says Steve Hotovec, the COO and overseer of proprietary investing at Alchemy Ventures, which has allocated more than $250 million through its risk managed account platform since 2005. "If regulators go down this route, they're going to be adding to the detriment of the same U.S. financial system they're actually trying to repair," he adds.

Under current guidelines, trading firms pay transaction fees of about 5 mils per share, a figure so small it generally goes unnoticed by institutional and retail investors. But for high-frequency traders, those fees represent an enormous tax, one that can swallow up to 40% of their gains, according to Manoj Narang, the founder and chief executive of Tradeworx, a hedge fund and high-frequency trading firm based in Red Bank, N.J.

Narang says his firm already pays more to regulators in fees than the total he doles out in annual salary and bonuses for each of his employees. (Tradeworx employs fewer than 20 people.) So regulators could actually be driving a stake through the heart of the sector with an additional tax, he argues.

"Subjecting high-frequency trading to a 40% tax before corporate and income taxes are even applied is borderline preposterous," Narang contends. "It already operates at such a razor-thin profit margin that any additional punitive measures would put it out of business."

Nevertheless, market participants concede that the SEC is woefully behind the times when it comes to monitoring today's highly complex marketplace. But rather than saddle high-frequency traders with the bill, the cost should be distributed evenly across all market participants, Tabb says.

Meanwhile, Narang reveals that his firm has offered to modernize the SEC's capabilities and get them on par with the most sophisticated trading systems currently in use for a fraction of the cost estimated by Schapiro.

"Our high-performance trading infrastructure is widely regarded as the most impressive in the market, and a variety of firms - from ultra-high-frequency trading shops, to large banks - use it to execute over 150 million shares per day," Narang says. "Let us see if the Commission's professed interest in upgrading its capabilities to match those of today's traders is equally serious." As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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