Author: Harald Hau (INSEAD and CEPR)

The financial crises that have plagued the global economy over the last decade have rekindled an old debate surrounding the use of transaction charges, such as the ‘Tobin Tax’, as a way of reducing volatility in financial markets. This debate comes at a time when regulatory, organizational and technological changes have considerably reduced the costs of buying and selling shares. It has been argued that destabilizing speculation has played a decisive role in a number of financial crises and a small charge on transfers could dampen speculation and the proceeds could be used to raise money for worthy causes. Despite the prominence of this idea and its popularity among certain sections of the public, the existing empirical evidence points to transaction costs raising financial price volatility. However, measurement problems in previous studies have made it difficult to pinpoint the causes of volatility and meant that the evidence has not been conclusive. CEPR Discussion Paper No. 3651, written by Professor Harald Hau of INSEAD and CEPR, addresses this gap in the literature by using a large dataset of French stock transactions between 1995 and 1999. This research provides the first robust and conclusive empirical evidence that higher transactions costs increase volatility:

• The research strategy used in this study exploits a technical peculiarity in the electronic quoting system of the French stock market. If a stock price at the Paris Bourse passes the rises above 500 French francs, it is subject to a different electronic quotation regime with larger price quoting steps (known as ticks).

• This research shows that transaction costs increase by approximately 20 per cent for stocks that pass the 500 French francs mark and that the stock price volatility also increases by approximately 20 per cent.

• Unlike many other studies that focus on a one-time market-wide change in the quotation rules for stocks, this research looks at the volatility effect of a transaction cost change whenever a stock passes the 500 French francs threshold. This allows for a stronger analysis that identifies the positive relationship between transaction costs and price volatility.

• This evidence bears directly on the historical debate surrounding of de-stabilizing role of short-term speculation. Higher transaction costs fall disproportionately on short-term speculators. Their speculative activity is clearly discouraged by higher transaction costs. But whether reduced speculation by short-term traders increases or reduces price volatility has always been controversial. This Paper finds that lower transaction costs stabilize prices, clearing speculators of contributing to financial crises.

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