What if the Fed traded like a hedge fund, for profit?  How much money could it earn for the Treasury?  What would the tradeoffs be?

happy trading

I first wrote about this on an earlier version of this site, back in Feb of this year, when Congressmen began proposing a financial transaction tax to ““Let Wall Street Pay for Wall Street’s Bailout” (as they put it in the title of the bill).

I notice the tax proposal is back in the news, as are the Fed’s activities in financial markets.

So while I’m restarting this site, let me re-post (in abridged form) my modest proposal — which is a little bit tongue-in-cheek, but might contain at least the beginnings of a workable idea:

Considering the enormous and continuing federal budget deficit, and the likely difficulty in financing it (and rolling over existing debt) as we go forward, how long will our government be able to resist the temptation to skim some of the money traded in American securities markets?  From a fiscal perspective, these sums are truly mouth-watering – on the order of $1 quadrillion per year at least.

Yet to tax economic activity is to discourage it, and right now no one wants to put further drags on growth.  So … is there a way the government could divert some of these sloshing trillions without directly taxing them?

One way, in principle, would be for the government to become not a taxer of the markets but a player in the markets – a player with a subtle but consistent advantage that conceivably would allow it to reap hundreds of billions of dollars per year.

I guess that the normal reaction would be to rule out such an idea without further thought.  The government is supposed to be not a player but an impartial ref and a rulemaker, right?  For it to compete, in effect, with private enterprises would destroy the integrity of the market system, right?

But I’m not sure those knee-jerk reactions are right.  I’m not sure the negatives of this idea outweigh the tax-eradicating positives — and maybe a simple cultural inertia is really the largest obstacle to its being considered seriously.

The idea here is that the federal government would set up its own very large trading fund – a sovereign wealth fund on steroids, you might say.  The fund would be designed to take advantage of information to which only the government has access.  It would base most or all of its trades on its “insider” knowledge of soon-to-be-released economic data, unfolding international crises, and perhaps even secrets gleaned from spying operations.  In this scheme the foreknowledge even of government screwups would be tradeable – potentially making the fund a nice fiscal stabilizer.

I guess that an operation like this, with its informational advantages and practically limitless trading capital, could easily earn enough to make a big fiscal difference.  But if not, then we might consider also letting it tap into the stream of orders flowing through ordinary exchanges so that it can “front-run” – taking advantage of its momentary foreknowledge to make small profits, spread across all relevant markets at the highest volume the system could reasonably stand.

Would this destroy the integrity of the markets?  Arguably no, because the big money managers, floor traders and flash-order operations already have been exploiting such informational advantages for years and years — as have some other countries’ sovereign wealth funds, I’m sure.

Some devilish details would have to be addressed.  This federal hedge fund of ours would have to be able to conceal its orders via secure proxies or “dark pool” setups, and its trades would have to be spread thinly enough to avoid significantly distorting markets or drawing attention.  The entire operation would have to be subject to the kind of security measures normally used to protect the most sensitive defense and intelligence-related programs.  Its traders, instead of working and playing ostentatiously in Manhattan, might even have to work under dull-seeming cover in some remote, Area-51-type location.  Our federal hedge fund would be structured to stay out of sight, and (insofar as possible) out of mind.

In a broad sense this federal hedge fund’s advantages would indeed amount to a “tax” on other players in the market.  But the important thing is that it wouldn’t feel like a tax.  It would be as if the government set up a lottery with 100 winning tickets, and took, say, three for itself.  People who would have played enthusiastically for 100 tickets will still play enthusiastically if only 97 tickets are winnable.  (In reality, government-run lotteries typically skim half of bettors’ wagers.)

How much revenue could our federal hedge fund bring in?  Certainly it would depend to a great extent on the kinds of trades the fund would be permitted and whether it would also front-run exchange tickers.  Some information (the failure of some weapons system, for example) might be tradeable only narrowly, say, in the stocks making up a particular industry.  Bigger news (an unexpectedly large jump, say, in non-farm payroll numbers) could be played for billions across multiple international markets.  It seems to me that in cases where the information is plainly tradeable the only practical limit on profit potential would come from the need to avoid excessive market distortion.

What are these distortion limits?  I am no expert, but when you consider the trading that goes on around the world in stocks, bonds, currencies, commodities, and their derivatives, you are looking at day-to-day variations in value that sum to at least tens of trillions of dollars on average.  In this wavy sea of global money, a few billion dollars daily, spread out sufficiently, would amount to an unnoticeable ripple.  I doubt that our fed hedgies could achieve $10 billion per trading day, but it doesn’t seem completely outside the realm of possibility.  And $10 billion per trading day corresponds to $2.5 trillion per year, which is approximately the size of the FY2009 federal budget.

Numbers like these help to put the negatives of this scheme into proper perspective.  You don’t like the idea of Uncle Sam gaming the markets a little?  How about losing half of every paycheck instead?  Even to cut the existing average income tax burden by ten or fifteen percentage points would represent a fiscal revolution.  In such a case I think we would see ourselves not as the victims of our federal hedge fund but as its fortunate shareholders.


Postscript (12 Jan 2011):  Fed reports $80 billion trading profit in 2010.   Proceeds go to US Treasury.