One of the more controversial financial regulation proposals out there would be a tax on securities trading. The intent with such a tax would be to curb speculative trading and provide Uncle Sam with more revenue. But according to a Bloomberg article from yesterday, such a tax could drastically harm liquidity. It could kill up to 90% of trading volume. If that's true, then this tax would clearly do more harm than good.

The bill, sponsored by Rep. Peter DeFazio (D-OR), would do the following, according to Interactive Brokers Group Inc. Chief Executive Officer Thomas Peterffy:





DeFazio's proposal would put a tax of 0.25 percent on stock transactions and 0.02 percent on derivatives including futures, options, swaps and credit-default swaps. A transaction of 200 shares at $40 each would result in a $20 tax, compared with a commission of $1 for active traders at Interactive Brokers, Peterffy said.





That sounds like a pretty severe tax to me. Here's what he sees as the outcome:





"The mother of all creators of havoc on Wall Street is this looming transaction tax," said Peterffy, who is also president of the brokerage and automated market-making company, in an interview yesterday. Interactive Brokers is based in Greenwich, Connecticut. "Trading volumes would plunge by about 90 percent, markets would become illiquid and tens of thousands of people would lose their jobs."





Sending a fee to the government for every transaction would hurt asset managers, brokerages and so-called high-frequency traders, a group that accounts for 61 percent of volume, according to New York-based research firm Tabb Group LLC. Interactive Brokers handles about one-seventh of U.S. options that change hands.

The bill's sponsors have "no understanding whatsoever" about its likely effect, Peterffy said.





I think that last line is probably true. I went ahead and looked up the bill to see if Peterffy's interpretation was accurate. It's hard to tell. The way I read the bill, the tax rate would depend on how much the U.S. government needs in order to recoup the TARP bailout money and Federal Reserve assistance. That still, however, seems like an awfully large tax to impose on trading. So even if Peterffy's calculation isn't exactly right, I do agree that it would have a very significant effect on liquidity.



And that's probably not wise. Liquidity is a good thing. I understand that speculation is looked at very negatively, but speculation is precisely what creates market liquidity. That's particularly true in the derivatives market. There is often a fine line between a thoughtful investment decision and a speculative bet. After all, even the most thoughtful investment decisions could go awry. It's impossible to know what the future holds, so all investments have a speculative nature, though some more than others.



So the government faces the question of whether it can stomach the harm this tax could do. If it really wiped out anything near 90% of the trading volume, then mass layoffs across Wall Street would certainly follow. I know everybody hates bankers and traders these days, but is Washington really prepared to unleash thousands of more jobless Americans on the economy to curb some speculative trades? That's all it would really accomplish, as the tax revenue would end up being far lower than expectations, since it would deter trading so greatly.



Luckily, I would be quite surprised if this tax actually ended up getting through Congress. The idea of passing a bill with the expressed purpose of harming market liquidity shortly after a credit crunch is pretty clearly misguided. If the government wants to recover its bailout money, there are surely safer ways to do so that won't bring securities trading to a grinding halt.

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