Why we need a financial transaction tax

The Sustainable Shareholder

Why we need a financial transaction tax

growth in pennies

The financial crisis, from which the global economy is still rebounding, demonstrated a variety of systemic risks associated with the practices of financial institutions.

While most regulatory reform efforts have focused on the mortgage industry and lending practices, there are other significant threats to the financial system that remain unregulated and threaten the stability of global markets.

Of particular concern is the investment industry’s reliance on computer-driven, high-frequency trading on global stock exchanges. As an Accredited Investment Fiduciary®, my role is to identify investments that have perceived long-term value. But the majority of trades on the exchanges today are conducted by high-frequency traders using enormous computers and sophisticated algorithms to buy and sell individual stocks multiple times in a fraction of a second. This approach is designed to maximize micro-profits with each trade, and aggregating them over time can yield positive results.

The problem with this approach is that a company’s fundamental financial value is completely overlooked by this type of investor. The threat to society from this activity is not hypothetical. Two years ago, the so-called "flash crash" took the Dow Jones average down more than 1,000 points in a matter of minutes.

While these glitches are eventually identified and explained, they illustrate the vulnerability of technology and its impact on investor confidence in the markets. For when the markets are volatile, investors park their money in cash. The purpose of investing is to raise capital in pursuit of enterprise, profit and economic growth, and this is simply not possible when investors are afraid of the infrastructure and an environmental of stability that facilitates such investment.

Photo of growth in pennies provided by Martin Kemp via Shutterstock.

While many of the Dodd-Frank rules have yet to be written, largely due to objections from Congressional Republican who obviously can’t remember what cause the financial meltdown, it is essential that the federal government provide financial disincentives to short-term trading.

At a Senate hearing on this issue last month, many of the witnesses suggested that automation combined with high-frequency trading strategies has disrupted the smooth functioning of the markets because the computers react long before people can react; as such, the computers are in many ways dictating consumer sentiments before such feelings surface, in essence leading investors to adopt trading behaviors instead of the other way around.

For this reason, the sustainable, responsible, and impact (SRI) investing industry favors legislation establishing small financial transaction taxes (FTTs). The SEC already charges a .00257% tax on transactions, increased from .0017% back in 2010, that generates $1 billion annually, to fund the SEC itself.  Since the SEC is grossly underfunded to enforce existing laws and craft rules for new ones, the agency needs additional resources to protect the American people from fraud and other illegal practices.

While the concept of taxing transactions is not new, the proposed FTTs will re-enforce the prudent longer-term investment perspective and discourage trading practices that only create instability in our financial markets. Financial transaction taxes can be small –a fraction of a percent per trade – but they would diminish the incentive to pursue speculative short-term trading. As many notable economists have observed, a modest transaction tax will actually improve the functioning of markets.

The European Commission and many G20 countries support the FTT concept not only because it addresses liquidity concerns and volatility spikes, but because it does not harm long-term investing. The UK, South Africa, Hong Kong, Singapore, Switzerland, and India, already have FTTs on particular asset classes that raise billions of dollars per year.

The simple truth is that investors need to trust the markets if they’re going to invest in them again. As long as people are afraid that the system has run amok, can’t moderate volatility, and is not accountable for severe losses or unethical practices, they will take their capital elsewhere, which one could argue is precisely why the economic remains stagnant.

Reducing volatility will lead to increased investment while restoring the credibility of the financial sector. Capital lubricates the economy and is responsible for the employment rate, so regulators should be encouraged to immediately take any step that will restore investor confidence in the markets. The FTT is an important step in this direction, and should be supported without reservation.