A Solution to Market Liquidity
Sarkozy and Merkel were out today with a proposal to put a transaction tax on the financial markets. Jeff Carter has a rundown.
This is a very bad idea. I've gotten into arguments with billionaires over this, but I'll restate my case.
Financial markets exist as a centralized loaction to facilitate trade.
For the markets to work properly, liquidity is needed.
If the government taxes transactions, it creates an artificial disincentive to provide liquidity, which will hurt the markets.
Want to know what an illiquid market looks like? How about the past 2 months, the flash crash, and 2008.
A Better Solution
The issue here is not active traders, or even high-frequency trading.
The issue is when there is an illusion of liquidity. Orders are often put in the market not to facilitate trade but to create an arbitrage opportunity.
Consider a fund or manager that wants to get long 30,000 shares of a stock. She may not want to take this price, so she will flash a large block order on the offer.
Other traders see this, start to sell ahead of this order and lower price. The manager is buying up these orders, then the block order is cancelled, and an edge was made on the back of the illusion of liquidity.
So if we are to provide a disincentive to anything, it should be on cancelled orders. If a trader or computer creates the illusion of liquidity, they should get dinged. This will reduce their edge, and may improve the market.
Now this all sounds good on paper but I don't know if it can be properly implemented. In fact, I would look at one modification.
Market makers will often cancel orders in markets but then adjust the price to still create the liquidity. So if an order is cancelled but is done so only to change price, then the trader shouldn't get dinged. This would keep the market makers happy as they could raise the ask and lower the bid without getting hit.
This kind of incentive structure is an anti-transaction tax, and it should improve liquidity as well as the overall transparency of the markets.
Thoughts? Am I full of it? Am I a genius? Let me know in the comments section.