Wednesday, April 16, 2014

High Frequency Trading and other tricks | The Tobin Tax

Please note that as this coming Friday (Good Friday, 18th April) is a holiday for all important Forex markets, there will be no OmiCronFX commentary on that day.

Since the publication of Michael Lewis’s new book “Flash Boys”, there has been much discussion of the way in which larger hedge funds and other traders utilise various methods of gaining an advantage over the great majority of traders, not only in Forex but wherever electronic trading takes place, whether that is in equities, indexes or any other asset class.

It turns out, however, that the regulatory authorities around the world had been examining these practices already. In Europe, in particular, there have been proposals, for some time, to curb activities that might be perceived to be anti-competitive. The most basic was the idea that a half-second delay might be imposed on the sending of a trade by a trader to an exchange. This would take care of, with one stroke, the activities of High Frequency Traders (HFTs), who utilise very high speed computer (low-latency) connections that allow them to capture trades as they are being transmitted by others to the brokerage servers, add on a tiny amount to the price for themselves, and then allow the trade to go through. This is known as “front running”. It is manifestly unfair.

But there are other ways in which advantage can be taken – other methods of front-running. One of these is the ability of well funded traders to purchase the outcome of reports that can be expected to move the markets, before these results are known to the bulk of participants. It is not suggested that this can happen in the case of, say, the US Non-Farm Payroll reports, as these are released by the government, but there are others where the playing field is not so level. One is the University of Michigan Consumer Sentiment Index, which is released in conjunction with Reuters.

The debate is on as to whether it is anti-competitive, on the one hand, to allow this, or a legitimate exercise in market analysis, for which the analysts deserve to be paid, on the other. Our own view is that the question, at this level at least, is not that important. The reason for this is that, very often, it would appear that when they get them, the recipients of these reports do not know what to do with them. There is often no consensus as the whether it is better to buy or to sell when the results are known. The chart above illustrates what happened in the minutes before, during and after the Univ. of Michigan / Reuters Consumer Sentiment Index release for January of this year.

Something similar happened on Tuesday of this week, when UK inflation figures were released. The consensus expectation was for a year-on-year drop to 1.6% from 1.7%. When this proved to be absolutely correct, the value of Sterling initially dropped, presumably on the belief that this is a low level for inflation. A few minutes later it reversed totally, when other traders seemed to come to the conclusion that, hey, this was as expected - at least the figure did not come in lower than that.

The point here is that any traders who had received this information ahead of time and had reacted as the first lot did when we were watching the chart, would have been burned. That is, unless the move down was an attempt to hunt for stops in the sure knowledge that the rate was about to rise thereafter. OK, call us cynical – and our stops were not triggered.

The Tobin Tax

Back in 1972 the economist James Tobin who, sadly, is no longer with us (he died in 2002) proposed that there should be a very small tax on currency exchange transactions in order to “cushion exchange rate fluctuations”. In his view this would limit the amount of volatility that takes place and which sometimes give rises to distortions, of exactly the kind that High Frequency Traders are sometimes accused of causing.

While the idea of a Tobin Tax is under active consideration in the Eurozone, it is opposed strongly by the USA. Britain and Ireland have made it known that they will veto the introduction of such a tax in Europe, as to allow it would mean the abandonment of London, in particular, by currency traders who would have no difficulty in today’s world of easy international communications in moving their operations elsewhere.

We sometimes wonder if it would not be better to allow a Tobin Tax, of a very small size, in return for the regulators making sure that High Frequency Traders cannot skim similar amounts off the value of trades that go through electronic exchanges but in what, up to now, has been a hidden and opaque manner. At least a Tobin Tax would have the virtue of being transparent.

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