After 11 European Union nations finally agreed this week to impose a financial transaction tax across some parts of Europe, new academic research claims that the move will undermine market quality and increase volatility to equity markets.

Using a loophole to push through laws without the backing of all 27 member states, in a process called ‘enhanced co-operation’, a French and German backed initiative found enough support—a minimum of nine nations were needed—to push ahead with the controversial levy.

Austria, Belgium, Greece, Portugal and Slovenia joined initial proposers France and Germany but a late push saw Italy, Spain, Slovakia and Estonia swell their ranks.

It means that a two-speed Europe will be created in which many of Europe’s biggest stock markets—including Frankfurt, Paris, Milan and Madrid—will be affected by the tax, while others, such as London, Amsterdam and Warsaw, will not.

Proponents of the tax believe it will make the financial services sector ‘pay their way’ for causing the global financial crisis, while critics think that a financial transaction tax will merely reduce growth and see an exodus to jurisdictions where no such tax exists.

The introduction of a financial transaction tax could also have severe repercussions for certain sections of the market. High-frequency traders—who perform millions of rapid trades, each yielding a tiny profit— and proprietary trading firms would likely be hit hardest by any levy as their profits would diminish and liquidity would potentially vanish from the markets. Market structure could also break down and many buy-side institutions are also against such a tax as they fear wider spreads, higher transaction fees and a dramatic drop-off in volumes.

A new study entitled ‘The diversity of high frequency traders’ by Björn Hagströmer and Lars Nordén at the Stockholm University School of Business, argues that the introduction of a financial transaction tax would be catastrophic for equity markets.

“The tax, which would render most HFT strategies unprofitable, would primarily hit market makers and increase market volatility,” said the report.

The report says that “any policy aimed at limiting the scope of HFT activity as a whole would primarily hit market making strategies” as the majority of HFT trading volume is associated with market making strategies.

“Thus, financial transaction taxes such as the one proposed by the European Commission can be expected to undermine market quality,” said the report.

“As market making is generally considered to be good for market quality, our results indicate that a financial transaction tax would be negative for equity markets. As market making activity is regarded as positive for market quality, whereas opportunistic trading can potentially amplify price fluctuations, the distribution of HFT activity is important for policy making.

“Any policy making HFT activity in general more expensive, such as the proposed EU transaction tax, would primarily hit market making activity. Based on our event study results, market making is a HFT activity that mitigates volatility. Thus, as market making constitutes the majority of total HFT activity, the proposed EU financial transaction tax is likely to increase volatility.

“In general, our findings imply that policy makers, both regulators and exchanges, should encourage HFT market making.”

The original European Commission proposal was for a 0.1% tax on all share and bond transactions and a 0.01% levy on derivatives trades, although this could be subject to change as the 11 nations involved may only use this as a template and opt for an even stricter regime.

“We have received a clear—and very welcome—signal that there will be enough member states on board for an EU financial transactions tax,” said Algirdas Semeta, the European commissioner in charge of tax policy, earlier this week.

“The requests are to move ahead on the basis of what the Commission proposed last year. I proposed this tax as a source of new revenue from an under-taxed sector, and a means of encouraging more responsible trading. The financial transactions tax is about fair taxation, smart taxation and a stronger, more co-ordinated approach to taxing the financial sector. These objectives remain valid and fully achievable. So now it is the time for swift progress.”

The European Commission hopes to have draft legislation in place by November. The tax, which would generate billions in revenue for the Commission, is unlikely to be in operation until the second half of 2013. An EU-wide financial transaction tax, which would have needed unanimous support from the 27-nation bloc, was kicked into touch in June after the U.K., Sweden and several other member states rejected a European Commission proposal.