Saturday, March 8, 2014

8/3/2014: FTT - More Benign Estimates of Impact?

In recent years, I have written extensively about the problems relating to the introduction of a Tobin-styled FTT, including as proposed by the european authorities.

Last year, I cooperated with an academic survey of the extent literature on FTT across various asset markets and instruments. Using meta analysis that study concluded that on the net, FTT will likely result in:
1) revenues well below those expected by the policymakers, and
2) significant reduction in markets efficiency and price discovery, including potential for adverse changes in liquidity risk environment in the markets for major financial instruments.

This February, a new working paper, titled "A General Financial Transactions Tax: Motives, Effects and Implementation According to the Proposal of the European Commission" by Stephan Schulmeister (WP: 461/2014 Österreichisches Institut für Wirtschaftsforschung, February 2014 Source: summed up "the main arguments in favour and against a FTT" and provided "empirical evidence about the movements of the most important asset prices."

The author 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."

In this, the paper conclusions are not novel.

It is generally accepted that efficiency-enhancing FTT will require extremely low rate of taxation in order to 'separate' HFT activities from long-only investment activities. The premise for this is well established in the literature: it is believed that higher order volatility in the markets is induced by HFTs and not by long-only or covered shorts positions.

Alas, I am not entirely convinced that we should be concerned with higher order volatility. Short-lived multiple-sigma events - capturing imagination of the media and the public - are not as disruptive as structural crises. And we all know that structural crises have nothing to do with either naked shorting, leveraged shorting or HFTs. These crises are not caused by the active trading. They are caused by active and sustained fraud or passive and sustained failure to enforce existent regulations, or both. On behavioural side, they are also caused by the 'exuberant expectations' - a situation where individuals mis-price directional risks. None of these causes is subject to FTT constraints if the tax is set at the levels where it is not impeding lucidity and price discovery.

So from the very top, the rationale presented in the paper to support FTT introduction (high frequency volatility) is distinct from the rationale presented by the EU leaders for introducing FTT (structural crises).

It is worth noting that Schulmeister puts heavy emphasis in the causality argument on the feed through from HFT to algos, relying on short shocks propagation mechanism via algos-induced changes in the trend.

The problem with this argument is that

  1. It ignores the existence of arbitrage opportunities (lack of contrarian algos is hardly consistent with Schulmeister's worldview)
  2. It also fails to account for reversion to the mean property of algos.

The paper "discusses the most important implementation issues if only a group of 11 EU member countries introduces this tax (without the UK). If London subsidiaries of banks established in one of the FTT countries are treated as part of their parent company, overall FTT revenues of the 11 FTT countries are estimated at € 65.8 billion, if London subsidiaries are treated as British financial institutions, tax revenues would amount to only € 28.3 billion."

The problem with the above that while the amounts are small, potential disruptions to the markets generated by, say, a 10bps tax can be significant. Take equities portfolio, returning 5% pa gross FTT will reduce the base by 0.1% or 0.2% on trade covered by a derivative contract. Thus, for full execute of a simple long-only strategy, involving simple one-direction hedge, the total tax exposure under the 0.1% FTT is 30 bps. Which is consistent with a 6 percent drop on gross return.

Thus, even if FTT were to deliver reduced short-term volatility, since long-only holders face a new tax, equivalent to roughly 1/5th of the CGT (if CGT is set at 30%). This is hardly immaterial.

Another issue arises in the context of the numerical estimates presented in the paper. The upper envelope estimate of EUR65.8 billion is based on the assumption of zero migration by institutions. EUR28.3 billion lower envelope estimate is based on the assumption that some migration is possible to the UK, with such migration triggering FTT application only to one side of trade (the side domiciled in FTT-imposing country). Alas, obviously, the exercise fully ignores the possibility to both sides of the trade migrating to non-FTT jurisdiction.

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