• A tax that could change the trading game
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     | February 24,2013
     

    To the dismay of the U.S. government — not to mention Wall Street — much of Europe seems poised to begin taxing financial trading as soon as next year.

    The idea is hardly new, but until now financial markets and institutions have been able to ward off any such tax in most major markets. The financiers claimed a tax would hurt economic growth and raise the cost of capital for companies. They said it would drive trading to other countries, leaving the country that adopted it with less revenue and fewer jobs.

    But those arguments have not proved persuasive in Europe, which thinks it has found a way to keep institutions from avoiding the tax.

    If Europe proves to be correct, it could turn out to be a seminal moment in the relation of governments to large financial institutions.

    The tax would be tiny for investors who buy and hold, but could prove to be significant for traders who place millions of orders a day.

    Under the proposal, a trade of shares worth 10,000 euros would face a tax of one-tenth of 1 percent, or 10 euros. A trade of a derivative would face a tax of one-hundredth of 1 percent. But that tax would be applied to the notional value, which can be very large relative to the cost of the derivative. So a credit-default swap on 1 million euros of debt would have a tax of 100 euros, or about 0.4 percent of the annual premium on such a swap.

    I’ll get to how Europe thinks it can prevent widespread evasion in a minute. But for now, assume the Europeans could accomplish that. And assume, as European officials say they hope will happen, that the tax spreads to other major markets, something Europe is trying to encourage by offering to share the tax revenue with other countries that impose a similar tax.

    What would happen?

    It would not destroy markets that have good reason to exist — that is, markets that serve actual investors. The tax would be far smaller than the fixed commissions that U.S. investors once took for granted, and even less than the costs implicit in the fact that until decimalization arrived in 2001, that most stocks could move only in increments of one-eighth of a dollar, or 12.5 cents. Markets, and the U.S. economy, managed to prosper.

    But there would nevertheless be significant changes — changes that might be for the better in some ways.

    High-frequency trading, which was encouraged by allowing prices to move in increments of a penny or less, and by technological advances, would be discouraged. So too would be some of the strategies used by hedge funds that involve trades expected to yield very narrow — but presumably very safe — profits.

    To make such trades worth doing, funds borrow a lot of money and make the trades using very little equity. That is a strategy that is guaranteed to work — or to blow up disastrously if markets do not act as expected. Discouraging it might be a good thing.

    But can Europe pull it off? Will trading simply migrate to other jurisdictions, such as the U.S. and Britain, which want nothing to do with the tax?

    Europeans seem confident. The tax would be owed no matter where the trade took place, as long as a European security or European institution was involved. The law has been written so broadly that if a French bank bought shares in a U.S. company on the New York Stock Exchange, the tax would be owed.

    Manfred Bergmann, the European Commission director for indirect taxation and tax administration and a primary designer of the tax plan, calls it a “Triple A approach — all markets, all actors and all products.”

    There is every chance that markets from other countries will not be very cooperative, meaning that to learn if a German bank traded in New York the authorities might have to rely on the bank to report it to them. But then there would be the risk that the tax authorities would learn of it otherwise, perhaps through an audit or from a report by an Italian bank that happened to be on the other side of that trade.

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