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Tobin Tax Impact on Trading

Tobin Tax Impact on the Financial Markets

Despite vehement opposition from many quarters, the European Commission seems hell-bent on introducing the Financial Transaction Tax

The consideration of a financial transactions tax on bond, shares and derivatives contracts in Europe continues to be the subject of intense debate.  With the persistent financial crisis hitting the news, there has been frequent reference on the introduction of a financial transactions tax. This tax, commonly referred to as ‘Tobin tax’ after its original supporter, James Tobin, in the 1970s, would mean that individual transactions undertaken by a financial institution would be hit by a levy fee.

If the proposal goes through member states will start imposing a tax of 0.1% on trading of shares and bonds, and 0.01% on derivatives transactions.  However, the tax will not be introduced unless all 27 countries unanimously agree.  The majority of EUR countries including the bloc’s powerhouses France, Germany and Italy are supporting the introduction of the tax which is also known as the Tobin tax.  The European Commission is now expected to present a deeper analysis on the impact of the introduction of the Tobin tax on the European economy hoping to bring the opposing member states on board.

The 11 countries involved in the Financial Transactions Tax are Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia.  Everyone from the US Treasury to the UK government has told the EC to drop the controversial tax, but many tax experts believe the levy will be introduced at least by some countries.  International financial collectives including the International Swaps and Derivatives Association and the Association of Financial Markets in Europe have fiercely lobbied EU institutions with letters, media statements and at informal meetings.

Of course when the president for the European Commission, José Manuel Barroso came up with a proposed tax on financial transactions in Europe (Tobin tax), he clearly had the banks and financial sector in mind. The tax, if it were to be adopted, would impact financial transactions between financial institutions from 2014, charging 0.1% (10 basis points) against the exchange of stocks and bonds and 0.01% (1 basis point) across derivative contracts.  The tax is intended to apply to financial transactions where at least one of the parties to an applicable transaction is resident within the 27 member state European Union.  In fact the tax is broad in the sense that it catches a broad range of financial instruments, such as those negotiable on the capital markets, money-market instruments (except instruments of payment), units or stocks in collective investment undertakings, derivative transactions and the purchase and sale of structured products (including securitisations, warrants and certificates). It would also cover transactions that take place outside an organised market, such as Over the Counter trading in derivatives. The Commission believes that such a tax would contribute up to 57 billion euros per year, which would help ‘ensure that the financial sector makes a fair contribution at a time of financial consolidation’ taking into consideration, amongst other things, the heavy government bailouts to support the financial sector during the crisis.

The idea behind the tax was originally to punish high frequency traders but the result has been that institutional investors, sovereign wealth funds and almost every part of financial services will be hit as a result.  And most industry commentators agree that a Tobin tax is likely to hit pension funds and other investment schemes and middle-sizes enterprises which utilise derivatives to hedge against price fluctuations in currency and commodity prices because it would be hard for them to go round it. In such a scenario banks are likely to pass the costs of such a tax to their end clients while shifting their hedging outside of the European sphere while multi-nationals are also likely to use subsidiaries to avoid the Tobin tax. Meanwhile day traders are more likely than not to move offshore and shift more of their transactions from stocks and bonds (which would be taxed at 0.1% with the Tobin tax) to CFDs and other derivatives (taxed at 0.01%).

There is continuing opposition to a financial transaction tax, in both the continent of Europe and in the USA. In particular, critics fear that the tax could lead to a decline in economic activity and, thereby, a decline in overall taxable revenues. In the USA, proposals for a financial transaction tax  keep getting pushed behind due to opposition by main governmental authorities.

The tax may be controversial but pro-Tobin backers argue that such a tax would help harmonise and establish minimum standards for similar taxation provisions that have already been enacted by a number of European Member States. In the United Kingdom for instance, they have already imposed a tax on UK banks in the aftermath of the financial crisis, responding to popular demand and criticism brought about due to the huge bailouts that some UK banks recevied. In particular, in January 2011, the UK introduced a bank levy which is essentially based on the balance sheet positions of each financial institution at the end of the year, as opposed to a tax on every transaction that the institution engages in. The UK also imposes a 0.5% stamp duty levy on all transactions involving UK securities, which is in fact similar to the Commission’s proposed structure but covering a narrower range of transactions.

In any case I still have to question how and on what basis long term investors will benefit from a Tobin tax.. Such a tax would only serve to reduce market efficiency and increase costs which is unlikely to translate into benefits. The UK’s Government Office for Science conducted a review on High Frequency Trading where it emerged that much of the qualities which make up High Frequency Trading are good: transactions costs have been brought down and market efficiency has been improved so caution must be taken to avoid curtailing the many advantages that the high frequency markets have brought.

High Frequency Trading cannot be blamed for the May 2010 flash crash. In actual fact, the Securities and Exchange Commission/Commodity Futures Trading Commission investigation noted that the one-day stock markets crash was due to a long-term participant’s inflexible execution of a huge trade. High Frequency Trading temporarily removed liquidity in response to this, but other market maker participants did so as well. All participants follow the same exchange rules and will widen prices to adjust trading volumes if they are faced with abnormal market conditions in an effort to mitigate risk. On a number of key markets (NYSE Liffe, for instance) no party is obliged to respond to easy and every quote request, as for both conventional market makers and High Frequency Trading firms controlling their stock market trading is an important component of prudent risk management in an imperfect world. It is also worth mentioning that there has been many liquidity crisis in the past that haven’t involved High Frequency Trading as happened in 1987 and 1962.

London has thrived the financial sector despite stamp duty as the growth has been in foreign exchange, credit, debt, structured finance and other industry areas that do not by themselves attract stamp duty. Even in the case of UK securities, the stamp duty is not paid by most institutional investors as they make use of CFDs (contract for differences) which aren’t subject to the tax. It would be a great blow to the United Kingdom if it were to lose its financial sector as a consequence of imposing a Tobin tax as the past has shown that the industry has paid about a quarter of corporate taxes received, with its workforce paying 15% of income taxes received.  IG’s chief executive Tim Howkins told the Financial Times in March he was not expecting the tax to be introduced, calling the plans ‘political posturing’ and pointing to growing opposition from France’s financial community. But the reality is the tax could hit spreadbetters hard, particularly if they’re not prepared for it.

Financial institutions have to-date been able to trade efficiently with each others which has greatly contributed towards facilitating the low cost of lending to business entities and households over the last years. This is in effect a social utility. I can’t see any evidence that High Frequency Trading as an industry seeks to manipulate the market it serves. Manipulation of the stock markets is in effect illegal in many jurisdictions so is punishable by law. A financial transaction tax like the Tobin tax which is being proposed would cost the United Kingdom in terms of tax revenue and jobs while damaging private and institutional investors by raising costs, only to ultimately raise a lot less monies than expected. (and that would be given to the European Union) while volumes would collapse coupled with liquidity and market stability. Some analysts predict that such a tax could potentially reduce trading volumes in Europe by up to 30% although the tax is unlikely to take effect until 2014. According to the World Federation of Exchanges, last year, more than $10,000bn in securities trading switched hands on European markets. In any case although volumes are likely to go down and spreads increase, a financial transaction tax is unlikely to make high frequency trading disappear, far from it…

Germany and France in particular have continued to press the adoption of a European financial transaction tax.   But of course although proposal has much support within the European Commission  and political support it would need unanimous approval from the 27 Member States in order to pass into law and this is unlikely at present since the UK and Sweden are likely to veto such a proposal unless it is adopted on a global basis. A global agreement by the G20 also seems unlikely with the USA presently resisting such a transaction tax so chances are that even if such a tax was agreed it would not be brought into effect across all European Union countries. In such a case of partial adoption where the UK used its veto to block the tax, the Tobin tax would still impact UK institutions entering into transactions with counterparties located elsewhere in the UK without the United Kingdom getting any share of revenues. But of course such a step would also boost business to UK exchanges. A general adoption of the tax, even in a reduced geographical sphere, might provide sufficient upport for the tax and persuasion for global implementation at future meetings of the G20.

What’s the Cost?

The Global Financial Markets Association (GFMA) warned the FTT will hike the cost of trading foreign exchange by up to 18 times, and although it’s not talking
about the retail investment market, the implication is that the costs will impact on the price of spreadbetting and forex trading. There’s also a secondary impact to consider: namely a potential reduction in liquidity, leading to a widening of bid/ ask spreads. Another irritation is it’s not entirely clear
who will be tasked with collecting the FTT. Some think it will have to be collected by the tax authority where the trade takes place.

This means that London, as one of world’s leading financial centres, will generate the lion’s share of this revenue and act as collection agent despite the UK being outside the FTT zone and our government being vehemently opposed to the tax. Others think the burden will lie with the firms who oversee the trades. This would require significant systems change and investment, even for firms whose governments would in no way benefit from the revenues that were raised. The biggest criticism of the tax however, is that it won’t set out to achieve its aims.

For all of the handwringing about encouraging lower levels of risk, what this tax is likely to do is to simply change the way traders operate – which could actually lead to an increase in systemic risk. From ICAP’s report: ‘Systemic risk could increase as the FTT runs counter to G20 objectives and obligations under the European Market Infrastructure Regulation by disincentivising central clearing,’ the report says. ‘Treating overseas branches of the FTT-zone firms less favourably than those operating through subsidiaries is not compatible with the freedom of establishment required under EU treaty. The proposed FTT would also restrict the freedom of movement of capital.’ And the EC would fail in its objective to find an efficient means to raise capital, as it has, according to the Association for Financial Markets Europe, wildly underestimated the ration of GDP loss to tax revenue gained.

Update August 2012: France has become the first country to adopt a tax on financial transactions. The tax consists of a 0.2% levy on all stock purchases involving all publicly traded companies with a market cap of over 1bn euros. This essentially means that anyone buying shares in such companies (including credit default swaps) in about 109 companies will have to fork out the extra tax to the French Treasury. The tax is expected to raise around 170 million euros in 2012 and 500 million euros next year. Sweden and the UK still oppose the idea while Germany, Italy and Spain have voiced their interest in introducing a similar levy.

Update October 2012: 11 euro zone countries have reached an agreement to proceed with the tax on financial transactions. The initiative has originally been pushed by Germany and France but was opposed by the likes of Britain, Sweden and other proponents of free markets. However, the initiative gained popular approval at a European Union finance ministers’ meeting in Luxembourg, when more than the required nine states agreed in principle to the new tax. Luxembourg, Cyprus, Finland, Ireland, Malta and the Netherlands have chosen to stay out. Britain and Sweden, which are not in the eurozone, have also stayed out. If finalised, this will be the first time a tax is launched without the unanimous backing of the 27-nation bloc.

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