Inside investment: Stupid is as stupid does
Banks need to be better regulated. But a financial transactions tax is more than wrongheaded. As currently formulated, it would be hugely damaging.
At the end of an article in the Financial Times last month about Europe’s proposed financial transactions tax, an official at the European Commission in Brussels commented: "...we have to do something. We’ve said too much." One might think that verbal incontinence is a good reason to shut up. But apparently this is how policy is framed by the European Union. The biggest losers, as ever, will be ordinary citizens trying to do the right thing and save for retirement.
Eleven European countries have said they will put a financial transactions tax (FTT) into force in January 2014: Austria, Belgium, Estonia, France, Greece, Italy, Portugal, Slovakia, Slovenia and Spain. France and Italy have already put a version of the FTT in place. The plan is to tax trades in bonds and equities at 0.1% (10 basis points) and derivatives at 0.01% (1bp). The intellectual case for the tax is that excessive trading is not socially useful and that it was this hyperactive capitalism that helped precipitate the crisis. The fiscal case is that it will raise up to €35 billion annually.
This is presented as robbing the rich to give to the poor. There is a small grain of truth in this: European governments are hugely indebted, in part because they bailed out their errant banks. But all taxation has an impact on economic activity, and the effect of this tax is likely to be very negative. It will rob the financial sector to impoverish everyone. At an economic level, one European Commission research paper suggested that the tax would generate the equivalent of 0.2% of GDP across the FTT 11, but there would be a 0.4% detrimental impact on growth. Even the more optimistic official impact assessment acknowledges that long-term growth will be damaged.
This is justified because of the wider social good of curbing speculation. The argument goes that long-term investors will not be affected and neither will their clients. This is disputed by the European Fund and Asset Management Association, which estimates the annual cost of the FTT to Europe’s Ucits funds at €13 billion. Those costs will be passed on. Given the current level of government bond yields, an individual investor or pension fund would effectively halve their yield return if they indulged in the ultra-high-frequency trading strategy of buying a five-year Bund in January and selling it the following year.
This direct impact on savers (and companies engaged in legitimate hedging of foreign exchange and other risks) is compounded by its indirect consequences for financial markets. Transaction taxes are as old as trading. The UK has imposed stamp duty on share transactions since 1694. However, these charges are borne by the end investor. The FTT ‘cascades’, to use the jargon; it affects every party to the transaction. In markets such as repo and securities lending this is disastrous. Banks that have an inventory of bonds repo them to get cash back in return and buy other securities. They then repo them again or put them out on loan. This collateral use and re-use keeps the financial markets turning.
If banks and investors were taxed on these low-margin, high-volume, endlessly recycled trades, they would become untenable. The first thing that would happen is that the already challenging liquidity environment in many markets would worsen dramatically. Under new regulatory rules, holding stock and bond inventory on balance sheet already attracts higher capital charges. If the repo and stock-lending markets stopped functioning, banks would retreat further from market-making businesses. Liquidity would dry up, making price discovery extremely difficult. Markets would become more volatile as the ability of the system to absorb changes in sentiment diminished.
An FTT is also completely inconsistent with other regulatory goals. For example, Mifid II envisages a consolidated trade ‘tape’ for bond markets to improve post-trade transparency. No fund manager will want to sign up to that in illiquid markets. Emir (the European Market Infrastructure Regulation) has introduced centralized clearing for OTC derivatives. Clearing requires the posting of initial and variation margin, often cash or high-quality fixed-income securities. Some are already questioning if there is enough collateral to cope with these demands. If the FTT destroys the repo market, it is hard to imagine how Europe’s collateral markets will function.
If the target of the FTT is high-frequency trading, a far better policy would be to force exchanges to change their fee structures to discourage the practice. If the aim is to curb excessive risk-taking by banks, then the path policymakers are already pursuing of better regulation, higher capital requirements and workable resolution mechanisms is a far more effective solution. If the goal is to stop banks earning super-normal profits or economic rents, then direct bank levies achieve the same ends with fewer unintended consequences.
It is no wonder that departing Bank of England governor Sir Mervyn King said that "within Europe I can’t find anyone in the central banking community who thinks it [the FTT] is a good thing". Fortunately, all policy decisions are on hold until after the German elections in September. There is still time to walk away from the FTT.