Thursday, January 28, 2010

Efficient capital allocation doesn’t require perfect liquidity

Trading Fees

Of the host of proposals for new regulations that are floating around, the one that makes the most sense is the idea of fees (a tax) on trading. The economic purpose of financial markets is efficient allocation of capital. A fee will reduce liquidity by raising transaction cost. That liquidity cost is a cost that has to be added to the fees. But, if kept low and uniform across forms of investment, the increased transaction costs should not produce a marked change in the efficiency of capital allocation.

It is legitimate worry that the fees will get too high. Governments tend to raise taxes once they are in place. But, transaction fees probably could get global support and that is a necessary aspect of any plan to reduce systemic risk. The global competition for trading activity should keep the fees from getting too high. Traders and investors will be affected directly, but hopefully they are not going to sink or swim on the slightly different margins the fees might produce. Many people who do not know they are investors will have to depend on their pension fund manager to respond to the fees.

Part of the loss of liquidity will be a transfer from high frequency traders to brokerage firms. Institutions trading large blocks of financial instruments will also experience an impact. The liquidity issue will be more important for institutions such as pensions and mutual funds than for individual investors or even individual traders. But, institutional investors charge adequate fees to support the professional staff required to address the issue.

One reservation is that the proceeds will probably be treated by governments similar to the way any other revenue is treated. Before long it will just be like SS payments, just more money for government to spend. But, what could really make fees a disaster would be if the government can’t resist its tendency to want to pick winners and losers. In order to work, the fees need to apply to all financial transactions even to the issues of the politicians’ pet causes.

Thus, since it is doubtful the money from the fees will be there to insure against the risk, the reason for favoring the fee is exactly the source of many economists’ and market participants’ concern. It reduces liquidity. By so doing it will reduce the ease by which problems jump across markets that make up the shadow banking system. But, in order to have that effect it has to be uniform across all types of trades.