Three Strikes of the New Financial Regulation: Part 2: Dubious Economics of Financial Transactions Tax
by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin
You can read Part 1: The Financial Transactions Tax here.
For the global financial sector analysts, there are three major regulatory headaches these days: the looming threat of the Financial Transactions Tax, the pressures of the evolving European Banking Union and the spectre of the risk weighting regulations.
In the first post of the series covering the biggest regulatory innovations in finance,1 we looked at the revenue generating side of the Financial Transactions Tax (FTT) proposal. This time, let's take a look at the economics of FTT.
Do no harm?
In adopting any measure, policymakers should first demonstrate the evidence of actual harm done by the activity that is being restricted. In the case of FTT, this requires showing that over-trading in the financial markets induces damaging volatility across the financial system as a whole.
In general, there is a lack of robust empirical evidence on the potential links between transaction volume and turnover and variation in asset prices. And there is very little evidence to assert that transaction volume and/or transactions turnover contribute to deviations of asset prices from the levels justified by market fundamentals.2
One recent study3 that departs from consensus shows that "long swings [in the asset prices] result from the accumulation of extremely short-term price runs over time. Therefore a (very) small FTT – between 0.1 and 0.01 percent – would mitigate price volatility not only over the short run but also over the long run."
But in preponderance of evidence, the very logic of enhanced efficiency arising from FTT introduction is faulty. HFT can induce high frequency volatility or the short-lived multiple-sigma events. Such spikes and crashes in data do capture imagination of the media and the public, but they are not as disruptive as structural crises caused by sustained market-wide failure to enforce existent regulations, and/or long term misplacing of risks not subject to FTT constraints.
Migration risks under the FTT establishes the core case against tax introduction across 11 European states, as envisioned in the EU agreements of 2011-2014.
Per Schulmeister, exclusion of London subsidiaries of banks established in EU11 FTT-covering countries more than halves the FTT revenues potential. And Schulmeister only considers the possible loss of one side of the taxed transaction and even that only to one global financial centre: London. If the entire transaction (both sides of trade: buy and sell) migrates out of the FTT-covered jurisdictions to the likes of London, New York, Zurich or elsewhere, the revenues raising capacity of FTT will be even lower than the lower bound estimates suggest.
There is too much legal warring going on around the FTT measures to assess the risk of such migration of transactions at this time,4 but in some countries that have introduced FTT previously the effect of the tax was to nearly shut down the domestic markets for taxed activities.
In Sweden, introduction of FTT in 1984 has resulted in a 50 percent decline in trading on Swedish exchanges by 1990, with corresponding volume of trades moving to the UK.5 By the end of 1991, when the tax was abolished, only 40 percent of all Swedish equities were traded in Sweden. At the same time, within the first week of tax introduction, volume of fixed income securities traded in Stockholm fell 85 percent, while volume of interest rate derivatives went down 98 percent.6
In one area of financial markets activity – securities lending – the FTT can lead to a 65% loss in the EU-11 market share, according to the estimates from the International Securities Lending Association.7
Set at 0.1% for equities and 0.01% for bonds transactions, the FTT will penalise trading in shares, while imposing much smaller (by a factor of 10) tax on bonds. This is likely to further skew European financial markets in favour of debt, away from equity – something that runs contrary to the European policymakers' objective to gradually reduce companies' dependency on bank debt finance.8
The imposition of FTT in Europe will likely shift some of the higher volume traded instruments outside the jurisdictions covered by the tax and into over-the-counter and proprietary dark pools trading. But it is doubtful it will curb high frequency trading much. It will also likely widen the bid-ask spreads to reflect the tax wedge, which will allow market makers to pass the cost of transactions, partially, to long-only investors. Finally, reallocation of trades to off-FTT jurisdictions and the potential reduction in securities lending can lead to an increase in naked shorting activity in the markets, further rising costs of trading and inducing potentially higher volatility at major inflection points in share prices.9
By penalising equity over debt, and by loading some of the costs of trading onto the shoulders of ordinary long-only investors, the FTT (commonly dubbed the 'Robin Hood Tax') will do little to curb excesses in the financial system that commonly result in systemic crises. All at a risk of inducing lower liquidity and impeding price discovery in the markets – a perfect case of a politically motivated policy to further mess up the market.
2. Schulmeister et al. (2011), Implementation of a General Financial Transactions Tax. WIFOPublikation
3. Stephan Schulmeister "A General Financial Transactions Tax: Motives, Effects and Implementation According to the Proposal of the European Commission", WP: 461/2014 Österreichisches Institut für Wirtschaftsforschung, February 2014
8. See EU Commission (2015) "Green paper: Building a Capital markets Union" Com(2015) 63 final, Brussels 18/2/2015:
9. One interesting effect, not considered in the literature on FTT, is the increased incentives (under tax) to carry out trading via over-the-counter markets platforms, including the dark pools. FTT can de facto disincentivise fragmentation of orders by making multiple transactions more expensive. This can lead to larger orders migrating to the less transparent and, potentially tax-free, proprietary platforms, where best execution principles can be more lax. This can raise the cost of transactions even further and reduce transactions visibility and informational value to the markets.