The Transaction Tax Debacle

Bryan Wiener

On January 22, 2013, it was announced that European Union ministers from 11 countries, including France and Germany, approved the implementation of a financial transaction tax at the rate of 0.1% for share and bond values and 0.01% for any financial derivative contract.

This by no means is a new concept, as the London Stock Exchange created a stamp tax in 1694. John Keynes also proposed a financial tax on stock transactions, citing that high volatility by uninformed investors exacerbated the Great Depression.

Most recently in the US, as a result of the 2008 banking crisis, numerous groups have banded together in order to propel a similar movement. The Tobin Tax (and the similar Robin Hood Tax) is the most recent proposition that has generated some steam.

The most obvious problem is that a transaction tax does not solve market volatility and points the finger at the wrong cause of the banking crisis. Furthermore, it puts on display the timeless conflict of the academic vs. practitioner. We saw that the Black-Scholes option model, as brilliant as it was groundbreaking, was dead wrong with its presumption of a flat volatility surface. Imagine how absurd a congressional-backed bill would be with regards to a financial trading tax.

Simple Arithmetic

Here is the basic problem with the transaction tax: a tax levied on 1000 shares of a $100 stock is 10 times that of a $10 stock. Very simple math, even congress can get it. Therefore, would a stock market-maker rather trade a $10 stock with a lower transaction tax and less spread risk or a $100 stock with 10 times the tax and much greater spread risk? We know that answer to that question.

So now we have a problem with higher volatility in the $100 stock, as market makers stray away from that symbol and flock to the $10 stock. Ironically, this is exactly what John Keynes was hoping to avoid with his own variation of the transaction tax. Specific risk aside, symbols with lower stock prices will have more liquidity and lower volatility. This introduces the tangential problem that might arise: downward pressure on US stocks.

As we already know, high-frequency trading (HFT) is responsible for roughly 66% of US stock market volume. Furthermore, HFT generates revenue on high volume and miniscule edge (much less than $0.01). If you were an HFT, what would your natural bias be, given the proposed levies?

The most logical answer would be to bring stock prices down. Given the black-box nature and collusive shadow cast upon HFT, it is not unreasonable to assume that HFT would attempt to push EVERY stock price down when there is no overwhelming customer flow or corporate event. At the very least, they would be able to create volume from directional pressure and, as a result, an increase in volatility.

John Keynes would not approve.

Derivative Confusion

I can’t begin to explain how frustrating it is to hear how all derivatives are bad. Generally, people don’t know what constitutes a derivative, whether we’re talking about Congress or people in the street. So what does the word derivative mean?

From merriam-webster.com (for the purpose of legitimacy): a contract or security that derives its value from that of an underlying asset (as another security) or from the value of a rate (as of interest or currency exchange) or index of asset value (as a stock index). Great, so that narrows it down.

The angst against derivatives is derived (pun intended) from the banking crisis where VERY obscure Mortgage Backed Securities (MBS) were rated incorrectly from incompetent rating agencies and mispriced from large banks that just wanted to generate commission or disregarded outlier risk, resulting in their demise.

What does this have to do with someone trading Amazon AMZN options? Nothing at all. But some in Congress think otherwise because options are put under the umbrella of derivatives.

An MBS has noting to do with equity options. Equity and options trading has nothing to do with the banking crisis. Many of my industry colleagues made a lot of money during the crisis trading equities and options, but that was a side game. Even the guys that sold the bank stocks before the disaster were just following their models. They were the ones that actually knew what was going on before the banks themselves did.

Neither of the two profiteers should be penalized for doing their job, nor should others in the industry be penalized because they trade such vanilla products.

But hey, I’m not a Congressman. I know what a derivative is.