Plenty has been written about financial transaction taxes (FTTs), mostly arguing over the politically charged issue of who pays: Main Street or Wall Street. Largely absent from the conversation have been the risk transfer (RT) markets—futures1 and options.2 RT is a massive, largely unappreciated economic phenomenon that could be severely impacted by any FTT, even microscopic-sounding ones relative to the face value of the instruments being traded.
FTT proponents seem to think an FTT would hardly be felt by users of the markets while falling heavily on the supposedly obscene profits of cyberpirate middlemen. These perceptions are simply wrong. First, end user activities in the RT markets are complex and far more exposed to an FTT than tax advocates appreciate. And second, the much-maligned middlemen provide absolutely crucial, low-cost-per-trade services of market making and “shared liquidity.”
Shared Liquidity
Whole families of instruments have been developed to provide ever more precise RT. One consequence of this proliferation is that all but the most established markets have trouble attracting enough trading interest/liquidity to serve hedgers efficiently. The solution is shared liquidity, which means that a bid in one market can quickly result in bids in partly related markets. The key to this is having middlemen specializing in the relationships between different instruments and markets.
Shared liquidity is transaction intense, with the middlemen needing to do a minimum of four transactions—buy A, sell B, and later do the reverse. In doing this they have to earn their profit, not from how far A or B moves, but how far these closely related instruments move relative to each other. These services would be greatly impacted by an FTT or unprofitable to offer at all.
The End Users
Hedging is nowhere near the same thing as buying a long-term productive asset with a face value equal to that of the instrument being traded. These instruments aren’t the underlying assets, just limited slices of risk. (And options on futures are slices of slices of risk.) Also, hedges are rarely “one and done,” but are often combinations of instruments needing frequent adjustment.
An FTT would be especially damaging to industries that use futures for more than just hedging simple price risk. Futures can be used to offer pricing flexibility to customers and also to eliminate credit risk between contracting parties. Being able to do the latter means a business can contract with almost anyone rather than with just a limited number of carefully vetted customers.
As an example, when I worked for a bullion dealer, every inventory purchase was immediately hedged, and price quotes throughout the industry were generally in the form of point differences above or below futures. Our trader and a customer would agree on a differential to futures rather than on a specific price; the customer was then free to fix his price at a time of his choosing by purchasing futures.
When the time came for goods to change hands, the customers would do an “exchange for physicals” with us where their long futures position liquidated our short futures hedges. They would then pay us cash equal to the then existing futures price plus the agreed-upon differential and receive the goods. Note that if either party defaulted, nobody got seriously hurt since each was fully hedged right up until the goods changed hands.
An FTT could upend whole industry-wide ways of doing business, even apart from the disastrous impact on vital middleman services.
Risk Premiums
If businesses are unable to hedge, they must take unwanted risks themselves, which they don’t do voluntarily unless they are compensated, i.e., can charge a “risk premium.”
For example, a chocolate manufacturer with a hedge would not fear a spike in cocoa prices and could offer retailers year-long contracts for candy bars at, say, $0.50 each. But without a hedge he could be clobbered by a price spike and would only want the business if he were compensated for taking that risk, say by inserting a $0.10 risk premium and only offering bars at $0.60.
Whole supply chains take a hit when any link insists on a risk premium. At $0.60, the manufacturer will sell fewer bars to retailers, who will charge customers more. Shippers get less business and less beans are demanded from growers. The manufacturer will then make smaller, less efficient production runs, hiring fewer workers, etc. And in something of a double whammy, companies hurt by upside price surprises and those vulnerable to downside ones each impose risk premiums on the same supply chain, whereas with hedging in the RT markets, they could have effectively offset each other’s risks.
One might ask: What about that $0.10 risk premium? Isn’t it being paid to someone in the supply chain, so not a big deal economically? No, the supply chain has a new expense, effectively hiring one of its members to do something additional, but something with zero economic value. The manufacturer is being paid for worrying. Worrying is about as useful as digging and refilling holes. It is a pure burden on the supply chain and roughly break even for the manufacturer. He would just as soon give up the risk premium and not have to worry. The risk premium is like a welfare payment to the manufacturer extracted from the supply chain.
If an FTT impairs the RT markets, a mass of risk premiums that had been avoided through hedging will flood supply chains throughout the economy.
An FTT Is a Terrible Way to Tax
The RT markets perform their magic by providing forums to lay off risks through an ever-increasing assortment of specialized instruments and by disassembling and recombining risks to enable those with varying degrees of overlap to be offset against each other. The process is transaction intense, which multiplies the impact of any per-trade expenses, such as an FTT.
Taking on the price risk inherent in a large asset for a brief time is not the same as buying it to consume it or acquiring it as a long-term investment. If this distinction is ignored in an FTT, a seemingly microscopic tax relative to “face values” could devastate the whole RT industry. However, even a lesser FTT could prove massively disruptive. Trading volumes would be reduced and could collapse, resulting in shrinking collections, while the impact on other tax receipts throughout the economy would be hefty. An FTT is likely to be a net tax loser.
The ideal way to tax is to allow the economy to optimize output and then skim some off the top, as with income and sales taxes. An FTT, in contrast, reaches deep into production processes throughout the economy, impairing or eliminating important services while unleashing a flood of costly risk premiums.
A financial transaction tax in the risk transfer markets is a terrible idea!
- 1Futures are standardized exchange-traded commercial contracts for various commodities, financial instruments, currencies, etc., intended primarily for hedging risk rather than acquiring the underlying asset. They may specify delivery of the asset or be tied to a published price index, but this is done to guarantee that the future’s price tracks real-world values. Few users expect to hold their contracts until expiration; they are in and out in a week, a month, or however long they have price exposure.
- 2Options (puts and calls) are the right to buy or sell something (but not the obligation to do so) at a certain price (strike price) until a stated expiration date. The buyer pays a “premium” in cash (anonymously via the exchange) to the seller (grantor) and is entitled to the value of any movement beyond the strike price. Options enable someone to buy very specific bits of risk protection. By buying and selling combinations of options, he can also swap risks he doesn’t mind taking for ones he needs protection from.
