Are the Markets Too Efficient?

European regulators are suggesting implementing a 0.1 percent financial transaction tax, called the Tobin tax, on every equity and bond transaction in Europe—so they must think the markets are too efficient.

Experts quoted in a recent Reuters article say such a tax would eliminate nearly a third of the liquidity on the equities and bond markets

I doubt there is anyone in the capital markets who is unaware of the effects that electronic trading has on various markets. It speeds execution and tightens spreads. In short, it improves the efficiency of the market.

However, as electronic markets mature, the spreads get so tight that there are few trading strategies capable of wringing profitable trades out of them. High-frequency trading is the natural evolution of efficient markets. Only trades that leverage an economy of scale are able show a profit when a spread is at the smallest increment possible.

By adding the transaction tax, regulators would cut the profit so low in liquid issues that high-frequency traders would leave the market and take liquidity with them.

This would hurt the overall health of the market and hit the bottom line of the broker-dealers and vendors supporting high-frequency traders.

One somewhat perverse benefit of the Tobin tax is that the message volumes financial technologists need to support would decrease.

Over the years, the slope of the curve representing growth in overall message traffic has been outstripping the slope of the curve representing actual trades due to the increase use of cancel orders in high-frequency trading. Get rid of those messages, and message traffic would fall, or at least plateau for a while.

But this would be an expensive way to return message levels to a reasonable level.