Treasury has been warned against plans to impose a higher "message tax" on high frequency traders because it will reduce liquidity and increase volatility in the sharemarket.
Capital Markets Co-operative Research Centre chief Mike Aitken said regulators should instead consider introducing an auction system in the sharemarket to limit the speed advantage of high-frequency traders.
"Policymakers around the world recognise the benefits of encouraging efficiency, proxied by liquidity, and legislate broad policy objectives accordingly," Professor Aitken said.
"Our research shows that implementing messaging taxes inhibits these macro policy objectives, and suggests that the imposition of messaging taxes is a retrograde step, damaging to market quality."
Treasury is reported to be planning to announce a higher tax on order messages with no exemptions for market makers who provide liquidity to the market for less traded stocks.
A message tax was imposed in January last year to discourage high frequency traders from placing excessive orders in the market and help cover the increased cost to the Australian Securities & Investments Commission of supervising the market.
High-frequency traders typically place a large number of orders in the market, and withdraw them almost immediately as they attempt to pick off buy and sell orders ahead of more conventional share traders.
According to ASIC, the order-to-trade ratio on the Australian Stock Exchange was steady in the last six months of the year at seven to one.
But on rival exchange Chi-X it fell from 23 to one to 15 to one over the same period.
Professor Aitken said a study by Alexander Sacco and Andrew Lepone of Canada's recently implemented integrated fee model found it had coincided with a decline in quote submission, trades and volume, and deterioration of liquidity.
"Messaging tax-style regimes have been talked about in various jurisdictions both to quell HFT and to appropriate funds to use for more regulation," he said.
"The problem is that these proposals haven't been tested or modelled before being implemented, leaving whole markets open to the law of unintended consequences."
Professor Aitken said an auction system where a buy or sell order would be held in the market until the best price was reached would be more effective in curbing HFT because it would reduce the importance of speed in completing trades.
The Industry Super Network has also argued in favour of frequent auctions through the day to level the playing field between traditional buy-and-hold investors and high-frequency traders who are in and out of a holding within seconds.
