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Old 12-10-2009, 02:17 PM   #21
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I've read that "high frequency traders" execute 70% of the stock market trades.

The claim is that these traders help the long term investors.* I don't see how, but I will quickly admit very little understanding of what they actually do.

I can imagine this scenario. A professional short term trader is responsible for tracking a list of 20-40 stocks. He is constantly watching news stories that might impact these stocks. If something happens that is positive for XYZ Corp, he immediately buys XYZ. Later in the day, other traders (that might include individuals) see the same story. It is just enough to nudge some fence-sitters into adding the stock to their long term portfolios, so they buy the stock. Since the st trader bought sooner at the lower price, he can sell to the slower-reacting group at a profit.

In this case, it seems that the st trader's profit comes directly from the long term investors.

BUT, I assume there are lots of other ways that the very active traders make money. Maybe some of them actually help the rest of us. Can someone give me some specific examples?


* Note: I'm assuming this article, by some well-known economists, is typical
Quote:
Often mischaracterized as speculators, high-frequency traders scour markets for minor mispricings and arbitrage trading opportunities. They buy and sell stocks in an instant, hoping to earn pennies on a trade. Far from destabilizing or creating volatility in the market, their actions significantly increase trading volume, reduce spreads, promote price-discovery, and ultimately reduce transactions costs for long-term investors. Such trades might not be doing God's work, but they are socially useful.
Burton G. Malkiel and George U. Sauter: A Transaction Tax Would Hurt All Investors - WSJ.com
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Old 12-10-2009, 05:26 PM   #22
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Originally Posted by Independent View Post
I've read that "high frequency traders" execute 70% of the stock market trades.

The claim is that these traders help the long term investors.* I don't see how, but I will quickly admit very little understanding of what they actually do.

I can imagine this scenario. A professional short term trader is responsible for tracking a list of 20-40 stocks. He is constantly watching news stories that might impact these stocks...
Oh, high frequency trading is much more bizarre than that. High frequency trading is done by computer, using algorithms (pre-planned strategies and tactics, basically) to hunt for "signals" (triggering actions, typically specific stock price and volume fluctuations) and execute trades in microseconds.

High frequency trades are so time-sensitive that the computers running the trading algorithms are co-located in the exchange's computer facilities, as the hundreds of microseconds of delay as data is routed and switched to corporate data centers in nearby buildings would delay the trades too much to let them be profitable. Renting this space is very profitable for the exchanges.

One of the more suspect tricks this permits is a form of front-running, or getting an order onto the exchange microseconds before a customer order so as to move the price to the detriment of the customer. That's something the SEC has been asked to look at.

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Originally Posted by From the NY Times
It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.
Karl Denninger wrote up a nice explanation of how this works:

Let's say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40.

But the market at this particular moment in time is at $26.10, or thirty cents lower.

So the computers, having detected via their "flash orders" (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) "immediate or cancel" orders - IOCs - to sell at $26.20. If that order is "eaten" the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.

Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become "more efficient."
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Old 12-10-2009, 05:35 PM   #23
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Oh, there's a nice graphic that the NY Times did that makes how this works more obvious.

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Old 12-10-2009, 05:42 PM   #24
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Hmmm. That doesn't look like it should be legal. It's certainly not ethical if NASDAQ is deliberately taking steps to provide info about pending sales/purchases to some entities before they are even executed or available to others. It's not the same as a trader relocating a server closer or building a super-fast machine to look at the trades more quickly after they hit the market.

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Oh, there's a nice graphic that the NY Times did that makes how this works more obvious.

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Old 12-10-2009, 06:19 PM   #25
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The financial crisis was primarily a liquidity crisis and a credit crunch, and the major problem with collateralized mortgage-backed bonds was that they declined significantly in value and became illiquid. A transactions tax that would have reduced trading and made repurchase agreements more costly, could have made the problem even worse.
This is kind of funny, and actually probably closer to 180 degrees opposite of the truth. The illiquidity was a result of poorly designed and highly leveraged transactions. Once a security is trading at 20 cents on the dollar, an additional $0.0025 charge isn't going to have much of an impact on whether someone is willing to buy it or not. But conversely, a $0.0025 charge on each of the various transactions needed to put one of these complicated deals together, may have prevented them from getting done in the first place. The reason that these deals used so much leverage is that the margins were skinny. They needed the leverage to make it worthwhile. A small tax like this may have totally depleted whatever margin was there and made them completely uneconomic from the start. So rather than making the crisis worse, the tax may have prevented it from happening at all.
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Old 12-10-2009, 07:54 PM   #26
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This is kind of funny, and actually probably closer to 180 degrees opposite of the truth. The illiquidity was a result of poorly designed and highly leveraged transactions. Once a security is trading at 20 cents on the dollar, an additional $0.0025 charge isn't going to have much of an impact on whether someone is willing to buy it or not. But conversely, a $0.0025 charge on each of the various transactions needed to put one of these complicated deals together, may have prevented them from getting done in the first place. The reason that these deals used so much leverage is that the margins were skinny. They needed the leverage to make it worthwhile. A small tax like this may have totally depleted whatever margin was there and made them completely uneconomic from the start. So rather than making the crisis worse, the tax may have prevented it from happening at all.
Sure. But then why tax all equity transactions? Why not limit it to the transactions involving derivatives, which is what ultimately caused the economic collapse. Equity transactions had nothing to do with it.

Here's an analogy of what seems to be going. Somebody violated curfew. And to resolve it, our solution is to burn down the entire neighborhood.

Once the tax is implemented, volumes will drop, which will cause bid ask spreads to widen. Once they widen, everybody will be hit with worse prices, higher mutual funds fees.

The retail industry stock industry has come out against this for good reason. If you today were to buy $25,000 worth of stock from Scottrade, it would cost you $7. But, with this tax, you would now have to add the following:

$25,000*0.0025 = $62.5

So $7 + $69.5 = $76.50. $76.50 instead of $7.

There will be lots of jobs lost from companies such Scottrade, Etrade etc. I get the "punish Wall Street" mantra. But this tax would not do much to punish Wall Street. It would punish Main Street.
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Old 12-10-2009, 08:08 PM   #27
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I realize that as Americans, we reflexively oppose all tax increases, and I don't like taxes any more than the next guy. But I think this bill has merit.

First, IRAs, Keoghs, etc. are exempted as I understand it.

Second, as I read the literature, the everyday investor (read you and me) is losing a lot more than .25% per trade due to high-frequency trading which this legislation opposes.

Are we so sure this is a bad idea? Most people on this forum don't strike me as frequent traders.
Yes, they claim that they are exempted. But in reality they are not. Once the tax is implemented, volume will for sure drop. Either volume will move to foreign exchanges, or simply disappear. Once that happens, the spreads between bid and ask prices will widen. For many stocks today there might just be a penny difference. Many years ago, the spreads were 1/8, 1/4 or even greater. We are likely to see those types of spreads once again if this tax is implemented.

The increased spread will be charged to the mutual fund holder in form of an increase to their the regular fee. I hope nobody is under the illusion that the mutual fund will eat this cost.

So, it won't really matter if you are a frequent trader or not.

Perhaps this bill should be renamed "Rewarding Wall Street by Punishing Small Investors for Big Banks' Mistakes".
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Old 12-10-2009, 08:29 PM   #28
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Sure. But then why tax all equity transactions?
As I understand it, the intention is to tax all financial transactions. The idea is similar to the one floated by James Tobin to discourage disruptive currency speculation. The central tenet is that rampant financial speculation is bad and can destabilize the financial system. A tax on short-term trading would reduce "undesirable" hot money flows.

Those of us who buy and hold would be relatively unaffected. And the higher taxes from such a proposal would not nearly offset the significant tax benefits currently afforded capital gain and dividend income relative to the much higher tax burden imposed on earned income.
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Old 12-10-2009, 08:42 PM   #29
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As I understand it, the intention is to tax all financial transactions. The idea is similar to the one floated by James Tobin to discourage disruptive currency speculation. The central tenet is that rampant financial speculation is bad and can destabilize the financial system. A tax on short-term trading would reduce "undesirable" hot money flows.

Those of us who buy and hold would be relatively unaffected. And the higher taxes from such a proposal would not nearly offset the significant tax benefits currently afforded capital gain and dividend income relative to the much higher tax burden imposed on earned income.
The proposal in both Senate as well as the House include stocks. Here's per the link in the original posting of this thread:

"The 0.25 tax would be levied on stock, futures, derivatives and other transactions. The financial industry strongly opposes the tax and argues it would hurt the economy as it begins to recover."

By the way, we had a similar transaction tax during the crash of 1929. So, such a tax would not be a magic bullet. Instead, what they should focus on is going after the margins and the type of leverage that speculators are allowed to get. Then again, I doubt their motive is to go after the speculators. If that truly was their motive they wouldn't go after all equity transactions. I think they are simply trying to find yet another new revenue source. And considering all the unintended consequences of this proposal, there gotta be better ways to balance our budget.

By the way, you mentioned that buy and hold investors would be relatively unaffected. It depends on what type of buy and hold investor you are. If you are simply holding a mutual fund, you are highly unlikely to escape this as you are likely to be passed on higher fees.
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Old 12-10-2009, 08:52 PM   #30
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And the higher taxes from such a proposal would not nearly offset the significant tax benefits currently afforded capital gain and dividend income relative to the much higher tax burden imposed on earned income.
Huh? Not relevant. What has the difference in tax rates between CG and earned income got to do with this?

But, we can discuss the pros/cons of the CG rate vs earned income if you like. Let's start with some discussion of why cost basis isn't indexed to inflation.
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Old 12-10-2009, 09:09 PM   #31
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Huh? Not relevant. What has the difference in tax rates between CG and earned income got to do with this?
For one, it's hard unseemly for someone benefiting from an exceptionally good deal to complain when their deal becomes slightly less good.

Second, it's not clear to me why passive income should be treated more favorably than earned income. Right now it is, massively so. Are we really saying that as a matter of public policy we want more investment and less labor? That is how our tax incentives are structured. If you want to equalize those rates and let the market figure out what we need more of, either labor or capital, than you've got a long way to go from where we are now. A .0025% transaction tax doesn't even scratch the surface.
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Old 12-10-2009, 09:11 PM   #32
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As I understand it, the intention is to tax all financial transactions.
If this is the case, the tax would basically wipe out the Treasury bill market, as a 0.25% tax is greater than these securities currently yield.

With regard to derivatives, the tax would be particularly onerous if it were applied to the notional amount. For example, it could significantly cut the returns on many popular options strategies, such as writing covered calls.
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Old 12-10-2009, 09:40 PM   #33
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For one, it's hard unseemly for someone benefiting from an exceptionally good deal to complain when their deal becomes slightly less good.
It's not a "good deal." It's "the deal" and if we are going to change the deal it makes the most sense to discuss that on its own merits, not compared to some other unrelated tax rate on another type of income that is treated separately in the tax code.

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Second, it's not clear to me why passive income should be treated more favorably than earned income. Right now it is, massively so. Are we really saying that as a matter of public policy we want more investment and less labor? That is how our tax incentives are structured. If you want to equalize those rates and let the market figure out what we need more of, either labor or capital, than you've got a long way to go from where we are now. A .0025% transaction tax doesn't even scratch the surface.
At the risk of implying logic in the writing of our tax laws (where little evidence of such exists), not all taxes are designed to encourage some behaviors and discourage others. Do we tax low income earners at lower rates because we want to encourage people to earn less?

The lower rates on cap gains serve to encourage the investment of capital needed to build businesses (and the formation of jobs that come with them). Regarding the market for labor and capital: I'm not clear on how a higher CG rate would favor labor. I do see how a lower CG rate helps encourage job growth.
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Old 12-10-2009, 09:57 PM   #34
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Lest we forget this tax is designed to raise revenue and lots of it $150 billion per year. Eliminating the illegal/unethical front ending trading isn't the goal of the legislation, it is to punish Wall St. Since I believe the financial IQ of the average Wall St type is way way higher than the average financial IQ of Congressman I have severe doubts that it work as intended. The bill's sponsor DeFazio (D-OR), is my Mom's congressman much to her dismay and pretty much an idiot.

Even if the trade volume remain the same (or don't flee overseas). This would still raise the expense ratio of even conservatively managed mutual funds. For example Wellesley ER would increase from .25% to .38%, Vanguard Windsor .30 to .58%. Fidelity Magellan .71% to 1.05% due to the transaction tax. The ER of index funds would also rise but a pretty minor 3 to 5 bias points. Still a million $ portfolio of funds like this is paying an extra couple thousand a year in taxes/expense. An amount which is likely to be at least as much as we would see due to higher income tax or raising LTGC from 15-20%.

Derivatives such as options are taxed at a lower rate .02%. However it is still a fairly large tax so if I sell 10 covered calls on $50 stock @ $.50 a contract, right now my profits is $500 less the $15 in commission cost, I would now owe an additional $10 in taxes.

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Old 12-11-2009, 03:15 AM   #35
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I thought the main reason for the 'collapse' was that the true risk of the derivatives was covered up - i.e. the ratings given were false, so people thought they were investing at a certain risk, when in fact they were investing at a much higher risk. How does a tax on transactions help a problem of misinformation or disinformation?

I agree with the posters that say this is another way to generate revenue for desired government projects. Unfortunately, the 'rich' aren't the only ones that are going to be affected by this - over the years, the strategy used for retirement savings has evolved to one which is based on people having their own independent holdings in the market - as they buy-in to build assets or sell-out for income during retirement, this will affect them. To say this tax will inhibit the behavior that brought on the 'collapse' in the first place is disingenuous.

Second topic - thanks to the poster who brought up the millisecond 'jump' for high frequency trading - that is a 'foul' and should be stopped. Although with technology one finds barriers are usually jumped or gone around once put in place. It is very hard to stop the progression.
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Old 12-11-2009, 09:18 AM   #36
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Oh, high frequency trading is much more bizarre than that. High frequency trading is done by computer, using algorithms (pre-planned strategies and tactics, basically) to hunt for "signals" (triggering actions, typically specific stock price and volume fluctuations) and execute trades in microseconds.

High frequency trades are so time-sensitive that the computers running the trading algorithms are co-located in the exchange's computer facilities, as the hundreds of microseconds of delay as data is routed and switched to corporate data centers in nearby buildings would delay the trades too much to let them be profitable. Renting this space is very profitable for the exchanges.

One of the more suspect tricks this permits is a form of front-running, or getting an order onto the exchange microseconds before a customer order so as to move the price to the detriment of the customer. That's something the SEC has been asked to look at.



Karl Denninger wrote up a nice explanation of how this works:

Let's say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40.

But the market at this particular moment in time is at $26.10, or thirty cents lower.

So the computers, having detected via their "flash orders" (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) "immediate or cancel" orders - IOCs - to sell at $26.20. If that order is "eaten" the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.

Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become "more efficient."
Thanks for the response. The front-running example seems like a very clear case of the high-frequency trader hurting the long term investors. It looks like this tax would make it unprofitable (I'm not saying that it shouldn't be banned even if the tax doesn't pass, but the tax is a different way of getting the same favorable result).

Your first paragraph says there are a lot more strategies. Do you have an opinion on whether they are a net positive or negative to long term investors? (The claim I quoted is that high-frequency traders are a net positive for the rest of us.)
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Old 12-11-2009, 09:26 AM   #37
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A .0025% transaction tax doesn't even scratch the surface.
Just for the record, it is a 0.25% tax, not a 0.0025%. In reality this would make an average commission 10 times what it is today at your regular discount broker. I would be chocked if our retail stock industry even remotely would have a chance to survive this tax.

So, to claim that this tax won't even scratch the surface seems far fetched. I have a friend who works at Schwab who is worried about losing his job because of this tax.
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Old 12-11-2009, 09:45 AM   #38
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Yes, they claim that they are exempted. But in reality they are not. Once the tax is implemented, volume will for sure drop. Either volume will move to foreign exchanges, or simply disappear. Once that happens, the spreads between bid and ask prices will widen. For many stocks today there might just be a penny difference. Many years ago, the spreads were 1/8, 1/4 or even greater. We are likely to see those types of spreads once again if this tax is implemented.

The increased spread will be charged to the mutual fund holder in form of an increase to their the regular fee. I hope nobody is under the illusion that the mutual fund will eat this cost.

So, it won't really matter if you are a frequent trader or not.

Perhaps this bill should be renamed "Rewarding Wall Street by Punishing Small Investors for Big Banks' Mistakes".
Can you explain why bid-asked spreads widen? And by how much?

In my (simple) view, high-frequency traders stand between two long term investors. They buy from one and sell to the other. In order for the hf trader to cover his expenses plus make a profit, he has to have some mark-up on the total buy-sell roundtrip. My gut feeling is that markup must be more than any transaction efficiency that could get captured by long term investors.

Maybe you can make a good argument that it isn't, but I'd want to see the specifics.


Regarding the "lose jobs" argument, we have that for virtually all taxes.* In general, if you tax something you get less of it. In a very few cases we actually want that result (taxing cigarettes), but it's usually an unfortunate byproduct. So does a financial transaction tax do more harm to the economy than an increase in taxes on labor income?

Some jobs produce positive externalities, some negative, and some are pretty neutral. The proponents of this tax suggest that we'd be better off if some of the very bright people on Wall Street (or in classrooms at Harvard) decided that their futures would be brighter in some other line of work, maybe one that generates those positive externalities. The opponents of the tax claim that HF traders are already doing the rest of us a lot of good. Hence, I'm asking for the step-by-step explanation of how I benefit from this activity.


*(In fact, we see that argument used against efficiency gains, too. For example, if the bid/asked spread went down, did that cost people jobs? If so, was it a bad thing that we should reverse? I'm guessing the answers are "Yes" and "No". I don't think that any job loss is bad.)
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Old 12-11-2009, 10:18 AM   #39
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Can you explain why bid-asked spreads widen? And by how much?
With many more market participants we are likely to have a more efficient market. As an example look at what we had in the 1960's where the bid ask spread was 1/8, 1/4 or wider. Because of technology, discount brokers, 401ks etc we have a completely different market place than we had 50 years ago. We have many, many more participants. As a result, we no longer have the wide bid ask spreads as we had then. If most of these participants disappear (which even the proponents in Congress acknowledge), we are bound to see a market place that we had 50 years ago again and thus a less efficient market. I hope my explanation makes sense.

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Regarding the "lose jobs" argument, we have that for virtually all taxes.* In general, if you tax something you get less of it. In a very few cases we actually want that result (taxing cigarettes), but it's usually an unfortunate byproduct. So does a financial transaction tax do more harm to the economy than an increase in taxes on labor income?

Some jobs produce positive externalities, some negative, and some are pretty neutral. The proponents of this tax suggest that we'd be better off if some of the very bright people on Wall Street (or in classrooms at Harvard) decided that their futures would be brighter in some other line of work, maybe one that generates those positive externalities. The opponents of the tax claim that HF traders are already doing the rest of us a lot of good. Hence, I'm asking for the step-by-step explanation of how I benefit from this activity.
I'm guessing we are talking apples and oranges. I think the proponents want to punish "Wall Street" (whatever that is). But in their eagerness to do so they, with this tax, are also punishing Main Street. The brokers at Scottrade, who may have a branch down at the downtown mall in middle America, would likely lose their jobs if their commissions would jump 10 fold.
I don't get why. Why not instead directly go after what caused the problems the last couple of years. Why declaring war on people that had absolutely nothing to do with it? And why would it benefit society to no longer have Etrade, Schwab etc. Or to make a greater point; we have the best stock market in the entire world. It is something we should be proud of. Why would we voluntarily relinquish that title?

Finally, take a look at Sweden. They implemented their transaction tax back in 1984. They abolished it less than 8 years later. Why? Because volume left Sweden or just disappeared. Sweden still hasn't recaptured all their volume that they lost. While Sweden is not the US, the principle applies. Unless every country on the planet agrees to the same tax, it will not work.
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Old 12-11-2009, 10:50 AM   #40
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Any ideas on who to email in government to voice objections to this 0.25% tax idea? Maybe just our state's senators? I did find this link: http://www.govtrack.us/congress/bill.xpd?bill=h111-1068
Hopefully the bill will go nowhere.

If the tax were maybe .0025% I could live with it. My average ER is around 0.25% and I figure maybe 1 trade/yr on average. So 0.25% would double my ER, ouch.
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