Friday, November 27, 2009

A tax on financial transactions: Good or Bad Idea?

In recent days, we have heard talk from Congress about imposing a tax on financial transactions. While there has been heated debate on the topic, there seems be more smoke than substance in most of the arguments. This morning, Paul Krugman, who seems to have made a speedy and seamless transition from economist to polemicist, has an article on why such a tax is a good idea:
http://www.nytimes.com/2009/11/27/opinion/27krugman.html?ref=opinion
As always, Krugman sees the villains here (the speculators, who else?), decides that this tax will not have much effect on the good guys (a group of long term investors, into which he puts himself and his readers) and sees potential benefits to markets from the action.

Very convenient, but not very balanced!!! I would like to provide a counter, by first examining the motives for a transactions tax and then considering the laws of unintended consequences.

Motives
As I see it, there are three motives for a transactions tax.
1. Revenue generation: As government budgets get squeezed and deficits mount, legislators are flailing around for ways to raise revenues in fragile economies. Given the sheer volume of trading volume in financial markets, even a small tax seems likely to raise huge revenues. (In a classic example of how governments compute potential revenues from taxes, the estimated tax receipts are computed by taking the existing dollar value of trades in a market and multiplying by the tax rate.... If only we lived in a static world...)

2. Punish bad behavior: As a bonus, the tax will fall most heavily on those who trade short term or in derivatives markets. If we assume, as Krugman has, that these trades are for the most part speculative, the tax punishes that "bad" behavior. (It is the same rationale that allows governments to raise taxes on tobacco and alcohol...)

3. Target the "right" entities: The perception on the part of many is that the biggest traders in derivatives markets are investment banks and hedge funds. The billions of dollars that these entities are reporting in profits, in conjunction with their absence of suitable remorse for their role in creating the banking crisis of last year, has made them easy targets. (I am quite surprised that legislators have not proposed a windfall profits tax on just the bad guys, at least as they see them... they would probably call it the Goldman tax!!)

So, what can go wrong?
1. Motives are internally inconsistent: There seems to me to be a direct contradiction between motives 1 and 2. Put another way, the only way in which this transactions cost will raise revenues is if the bad behavior in question (short term trading) continues in the future. I think legislators need to specify what their primary objective and not try to argue out of both sides of their mouths. (I know little or no chance of this happening, but no harm hoping..)

2. Speculation versus Investing: As I have argued before, I am very uncomfortable drawing the line between speculation and investing. While I might not see much benefit to short term trading, I can see how others might. To label myself as the investor and the others as speculators is self serving and wrong. Furthermore, the notion that derivatives trading is driven primarily by speculation is fantasy. I can see plenty of reasons why a long-term, value investor may use derivatives to protect and augment his returns.

3. Liquidity costs: Even if we accept the premise that short term investors create noise and pricing bubbles, long term investors benefit from the liquidity they bring to the system. In fact, the markets where long term investing is most difficult are markets where there no short term investors. (Consider the market for fine art or even real estate.... Transactions costs inflate for everyone and insiders end up dominating the market)

4. Market mobility: As trading moves of exchange floors into ether space, it is difficult to visualize how a transactions tax will work, unless it is globally coordinated. All you need is one rogue player for the system to start coming apart at the seams. Krugman argues that the clearing systems for many of these markets are centralized and that the tax can be therefore collected at these locations. While this may work in the short term, how long will it take for an offshore location (say the Cayman Islands) to set up a competitive system? (It will cost money but the potential benefits from the system will be huge.) Once that happens, any chance of regulating these markets, even in sensible ways, becomes remote.

All in all, I think this is a dumb idea that should be throttled early in the process. I am sure that you will hear variants of the concept, and they will all share a common feature. They will try to focus the tax on what they view as the markets or securities that they view as most speculative and argue that only the entities in these markets will be affected by the tax. I don't think so. Ultimately, we will all bear the cost.

63 comments:

Mahesh Sethuraman said...

What's your opinion on the tax on Foreign capital recently introduced by Brazil? Hailing from India, I witness the volatility in both Equity and FX markets caused by the FII's decisions to pour in or pull out from the market frequently - Wouldn't this kind of a tax help reduce the volatility in both equity and FX markets?

Aswath Damodaran said...

Let me pose a counter-question to you. What would India's markets and economy look like today, if you had no foreign institutional investors in the market? The benefits of having these investors in emerging markets has vastly exceeded the costs. If you don't believe so, go back and look at transactions costs, liquidity and the capacity to raise new equity capital in the 1980s in India.

Mahesh Sethuraman said...
This comment has been removed by the author.
Mahesh Sethuraman said...

The answer is obvious. The benefits have far outweighed the costs. Not for a moment am I suggesting to think of FII's as villains who make the markets volatile. It’s surely not a question of FII's or no FIIs.

But if I can temper the volatility (without getting judgmental about whether it is good or bad behavior) by charging a marginal tax to discourage frequent float of capital either side - then why not?

If the investors/speculators are serious enough about India growth story, they would anyways bet on Indian Market and this minimal tax is not going to change the behavior much considering the kind of returns Indian market has delivered over the last 5 years. But it might just be a motivator (however small that is) to avoid frequent shuffle of capital.

This will not affect the liquidity much as anyways there are enough domestic players who provide liquidity with short term trades and even FII's who see profits to be more than the tax will continue to bet short term as well.

arun said...

Its a trade off between better price discovery and increased volatility that accrue consequent to greater investor (both domestic and foreign) participation.

Liberal said...

Nicely said sir. Don Boudreaux offers a similar (though not as comprehensive) rebuttal to Krugman on his blog. cafehayek.com
Can you please explain to me how wealth is created? Sorry for the off-topic question, but as I was discussing with a leftist friend of mine, I was unable to explain to him how wealth generation is not a zero-sum game (my wealth need not make someone poorer). Can you please explain that in layman language? Thanks in advance

Aswath Damodaran said...

Wealth ultimately is created by growing the real economy. Thus, the connection to product markets is obvious. If I create a product that meets a unmet need or advances technology, it will generate wealth for me and for those involved with the product, while making the customers who buy it better off. Thus, entrepreneurs from Henry Ford to Bill Gates have mades thousands of others wealthier and happier, while becoming wealthy themselves.

The connection to financial markets is more tenuous. Here, the benefits from my trading (and attempting to get rich) are tangential, The existence of well-functioning financial markets was a pre-condition for the success of both Ford and Gates.

Aswath Damodaran said...

Wealth ultimately is created by growing the real economy. Thus, the connection to product markets is obvious. If I create a product that meets a unmet need or advances technology, it will generate wealth for me and for those involved with the product, while making the customers who buy it better off. Thus, entrepreneurs from Henry Ford to Bill Gates have mades thousands of others wealthier and happier, while becoming wealthy themselves.

The connection to financial markets is more tenuous. Here, the benefits from my trading (and attempting to get rich) are tangential, The existence of well-functioning financial markets was a pre-condition for the success of both Ford and Gates.

shalu said...

In very simple terms this tax would increase the bid-ask spreed. Increase the cost of equity for a company and hence impact the upcoming projects.
Lower transaction cost is a must for a well functioning financial market. Speculators or noise traders (as black calls them) are essential part of trading in financial market.

Sudeep said...

I agree that this is a bad idea and your points about liquidity issues, emergence of Cayman based trading centers etc are spot on. However I don't think motives 1 and 2 are internally inconsistent if you define motive 1 as Expense Reduction instead of Revenue Generation. Part of the reason Govts are getting squeezed is due to all the bailouts, raising of unemployment benefits (caused in large part by credit crunch etc etc. So if such 'speculative trading' were to decrease in the future, while the Govt Revenues from a trading tax would decrease, so would their expenses in the form of bailouts etc. Still, I agree that this is a bad idea.

Aswath Damodaran said...

I would agree if the funds raised went into a dedicated fund to cover future bailouts. That would make it more like deposit insurance accounts. However, this is a tax going into a general fund and we all know where the revenues from that fund will go in the near term. Governments seem incapable of maintaining rainy day funds.

perpetual wonderer said...

Slightly off topic, but somehow, it seems like the different economies in the world oscillate between the extremes of a free market and a highly regulated market. These oscillations seem to be taking place over decades. But it is intriguing that economies that have traditionally advocated government regulations on almost everything possible are opening up whereas economies that have advocated free markets (like the US in this context) are moving towards increased systemic intervention (transaction taxes and what not).

I wonder if eventually most of the economies will arrive at a somewhat similar governance model (probably a mix of free markets that are only suitably regulated). Is it likely that all these oscillations will have the same mean position eventually?

Clark said...

Sometimes I honestly wonder what world you academics live in. If you work in the financial markets, it's really pretty obvious what is speculation, and what is investing. And trades with microsecond time scales are simple financial speculation. You can argue that speculation cum arbitrage is necessary and blah blah blah, but then you would expect markets to get more and more efficient and closer and closer to equilibrium as they get more liquid, which certainly doesn't appear to be the case. The point here is not to stigmatize liquidity, but simply to realize that more is not necessarily better.

Aswath Damodaran said...

Interesting.. So, if you work in financial markets, you know when someone is investing and when someone is speculating? Your entire analysis seems to rest on whether the trade is a short term or a long term trade. So, all long term traders are investors and short term traders are speculators?

As for the Blah, blah, blah.. That does add to your argument, since much of what you do in markets amounts to exactly the trading equivalent of those words...

perpetual wonderer said...

I am not sure I should be posting this. But this was just too sweet a reply! Especially the blah blah part. Nice!

Clark said...

Congratulations and all on the snappy put-down, but I find your reply to my blah blah blah sort of odd. Aren't you defending exactly any excess trading that I might do (were we able to define such a thing if I understand your view correctly) as improving the liquidity of markets? You should be quite happy to have really dumb traders/investors like myself around. As a smart market participant you can make money off my errors, and as a defender of any and all liquidity I must inherently be making the overall market more complete and efficient. Or have I misunderstood your argument?

My point was actually that a long time horizon is necessary but not sufficient for something to qualify as investing. Investors discount cash flows over the life of an instrument. Speculators seek to find someone willing to pay more for the instrument. It's pretty hard to discount cash flows if you hold everything for a few microseconds, so I conclude that people with such time horizons are speculators. I don't see how this distinction is controversial. I can imagine having a debate about how speculation is necessary and improves markets, but I don't see how you can claim that speculation is impossible to see. Just go down to Wall and Broad and ask some folks why they buy or sell what they buy or sell.

Aswath Damodaran said...

I am not making some abstract and unrealistic arguments that all trading is good. In fact, I don't think I used the word arbitrage in my post or argued that trading improves market efficiency.

Assume that a lot of trading is speculative or noise trading. My point is that it is not easy separating noise trading from informed trading. Much as I may prefer to trade long term, I can think of several informed trading strategies that are short term.

Even if you take the best case scenario and can separate noise traders from informed traders, it is not a slam dunk. The former add to market volatility (which is bad) but they also provide liquidity (which is good). In my experience, the latter, in the aggregate, is greater than the former.

We really do not realize the value of liquidity until we lose it. In fact, one could argue that the biggest shock of the market crisis of 2008 was how quickly liquidity can dry up and the drastic consequences.

Clark said...

I completely agree that there are informed speculators and uninformed speculators, just as there are informed investors and uninformed investors. And I would agree that the only way to separate the informed from the uninformed in either case is by looking at who profits and stays in business, and who does not.

But does this really address the fundamental issue? Technology and financial engineering allow trading to move faster and faster. The Federal Reserve is equipped to provide unlimited liquidity in an emergency. I would argue that these factors create a systematic bias towards more liquidity in our capital markets. If all liquidity were good liquidity, then this would not be a problem, but sudden stops in liquidity such as we saw last year seem to involve a negative externality -- I might not use that liquidity, but as a taxpayer and an investor, I just paid for it. Rather than saying that we don't appreciate liquidity till we lose it, I would say that we come to believe in an artificial liquidity, and use this ability to change our minds in lieu of sound judgment.

So I don't think the trade off is just between volatility and liquidity, but has to include the volatility of liquidity, if you will. I had understood a financial transactions tax as a way to dampen this volatility and ensure that liquidity is paying its way and providing a useful function that we don't later all have to pick up the tab for -- not as a way to discourage uninformed trading, something which the market does quite well.

Aswath Damodaran said...

Now I think we are talking. Your points about dampening volatility make sense but here is why I think it is a package deal. For whatever reason, liquidity and volatility seem to be two sides of the same coin. Any attempts to curb the latter (restricted short selling, trading curbs etc.) seem to also affect the latter. Transaction taxes have been tried before and they have always failed. I don't see why this new iteration is going to be any different.

perpetual wonderer said...

Clark, inasmuch as I don't agree with taxation as a deterrent in general, I have to agree with you on one point. That in this case, it will probably get the job done.

The Prof. has argued quite well in his post about how the motives are inherently inconsistent and how they are likely to cause other problems and such. But I wonder if its a totally bad idea if it gets the job done. Yes, liquidity will suffer as a trade off in the favor of stability. But I don't think levying a tax will affect liquidity to an extent that it will go missing alarmingly. In fact, for the informed investor (whether short term or long term), it will only be another addition on the cost side of an investment that he will factor into the price. And he will continue to be on the market. So liquidity won't be affected as far as the informed investors are concerned.

However, for speculators (and I am assuming that those who speculate know it for themselves, even if we can't point them out cleanly), trading leans more towards assumptions and conjecture formed on 'information' or 'tips' or even rumors. For these folk, it won't be as easy task to factor in the transaction tax into the price of the investment, simply because speculation by its very virtue is not a very scientific activity, which means that speculators probably don't arrive at a threshold 'buy price'. If they are just trading on hunches or gut feels or even tips, it is likely that this tax will deter them somewhat by simply raising the price of investing, if nothing else.

Also, I am not too sure of another aspect- the liquidity. Yes short term trading (speculation included) adds to the liquidity of the market and it is very beneficial for several reasons. But these short termer speculators are also the ones who will exit the market at the slightest and first sign of danger. Which means that the liquidity they are supposed to bring to the table in times of strife goes missing right before the crisis anyway! So what liquidity are we rooting for when we fear that the tax will drive out liquidity that is required during crises?

Mahesh Sethuraman said...

@perpetual wonderer

Just like how an informed investor adds the tax to the cost side of his investment, why can't a speculator do the same?

Also your point the speculator (I don't really know how to differentiate between a speculator and an informed investor anyways) exiting at the slightest hint of danger is a little deviant from reality. When the whole market is moving in one direction invariably a speculator will bet on the opposite - so if anything he provides the much needed liquidity at that time. And even if speculator goes with the momentum, the informed investor would anyways intervene with the momentum when he sees something as overbought or oversold. But again I don't see how this tax will be deterrent to the
extent of either the speculator or the informed investor betting against the momentum.

Its a different story that I don't understand how this tax will help curb excess speculation either. But I think it's an experiment worth considering whose costs are not as high as made out to be.

perpetual wonderer said...

@ Mahesh:

When I classify someone as a speculator, I believe they don't make their decisions to buy or sell after thorough analysis. This is what sets them apart from an 'investor' at the most basic level. So, while an investor would factor the tax into the price of the investment, he would arrive at a 'buy' or 'don't buy' decision after discounting the future cash flows expected from that instrument. However, a speculator (and we assume this) indulges in very little analysis and hence doesn't really have a 'buy-don't buy' threshold price. So, if you are simply relying on a hunch or a feeling about an investment, the more incremental the cost, the less likely you would be expected to put your money into it. This is where I think the tax will be effective in weeding out the 'unwanted' speculators (basically volatility). Whether that intention is a good one is of course, debatable.

As for the second part of your argument, where you say that during times of crisis, speculators bet in a direction opposite to that of the larger market instead of exiting it, well...I am not too sure. What you say holds true in your usual ups and downs of the market. But when there are signals of a long lasting, sustained crisis, I still believe the speculators get their money out first. Which is why you hear of only a few people (like Paulson) minting money during crisis. If speculators are as big a nuisance as they are pointed out to be and if they are present in sizeable numbers, and like you say, they don't exit right before the crisis, I would expect a much larger number of people who made it big by speculating during a crisis. This I think, goes ahead to support my argument that speculators do bring in liquidity, but not when it is needed most. In a perfect world, I would want speculators to supply the liquidity when long term investors are wary of the times and are holding on to their money. Does that happen? Not too sure. When liquidity dries up, it dries up, speculators and investors alike.

You might argue that if there were many people getting rich in a crisis, they would call themselves investors and not speculators! Funny dichotomy that!

Which brings us to the profs dilemma again...how do you call out a speculator from an investor before you secure the system from one of them!

All I am saying is, if at all there is a distinction between these two classes, then even though we might not be able to identify them from each other, the tax might still go ahead and deter the most blunt, rash, and crudest of them.

Mahesh Sethuraman said...

I agree with your view that "the tax might still go ahead and deter the most blunt, rash, and crudest of them." But might is the operative word there.

Let's assume we have a clear distinction between a speculator and an investor. What kind of bets would a speculator take - my sense is any bet that he expects would give him a huge return, search of a multi bagger or catching a swing in momentum at the right time etc...Given this kind of a rationale, would a small tax act as a deterrent to his bet? I am not so sure.

Similar to your dichotomy point, any guy who expects only a nominal return for his investment would never like to be seen as a speculator! So assuming a speculator as someone who expects a huge return on his investment is not way off the mark I reckon.

Also I can even argue that it might act as a deterrent to the rational investor from investing since factoring in this tax might make a security more expensive than what he may have calculated/thought was the fair price!

perpetual wonderer said...

Oh no! The magnitude of profit has nothing to do with being an investor or a speculator. Thats one thing that people confuse a lot. You will see thorough bred speculators who will be very satisfied with a nominal return intra day. I know guys who are more than content to make 10% in a day over a very small amount. They get tips from their brokers and they go ahead with small sums. So if they lose, its not that big a loss. And if they make money, they are happy they made something. I agree such small timers probably don't influence the liquidity aspect the way institutional investors do. But even the big ones don't always run behind gargantuan profits.

If that is the basis for classification, if I were to analyze a growing firm, find out that it is grossly undervalued currently, invest in it and make a windfall over a week and then exit when I find it fairly valued, what do you think I am? Just because I invested short term and made a huge profit does it make me a speculator? No Sir! Its not the period or the profit percentages at all. Its about the approach. Which is why we can't segregate them black or white.

And I don't think for an investor, the tax will be a deterrent. Since the tax is going to be a market wide phenomenon, affecting all the participants, it simply increases the price of the security, and in turn the returns expected by the investors. So as long as the PV future cash flows discounted at this higher rate of expected return is greater than the price of the security plus tax, it will make no difference to the investor.

Not so for a speculator.

Mahesh Sethuraman said...

That’s interesting.

In fact after writing that point on classifying speculators even I was not sure about it. But what I was sure about is that speculators surely can't be classified based on time horizon of investment alone - So I thot this is a better classification.

Also When I said huge returns I meant on a % annualized basis. So 10% in one day is a huge return isn't it? It’s beyond me to think of a speculator as betting on something which would give him a nominal return. I mean you can argue that he got some inside info which he was very sure of materializing and if that happens he would surely profit say 5 or 10% and therefore he has the inclination logic. But then I can classify this as an informed investor who is taking a calculated call. Really I don't understand how's a guy who uses a DCF framework to value company and invest in what he perceives to be a undervalued company any different from a speculator or vice-versa.

So for the sake of differentiation I can only think of a speculator as someone who despite knowing that a security is overvalued bets that it can be overvalued even further in future by the irrational market and puts his money on that. (Damn, I somehow seem to think that even this can be argued as an investment – if investing in an undervalued company is a bet on market returning to what the investor perceives as rational, then investing in an overvalued company can be seen as a bet on markets continuing to be irrational. Like prof’s next blog states, there must be equal research findings to prove both that the market is irrational or that it is rational). I am giving up on this differentiating speculator from investor game!

I agree with you that the deterrent for an investor is a market wide phenomenon but to say that it won’t be a deterrent to the investment decision is too simplistic. I might choose to invest in an FD with a bank or a security based on risk/return preference. Now if returns on FD is taxed differently from returns on a security then assuming everything else is equal (expected return vis-a-vis the corresponding risk assumed), the added tax might act as a deterrent for the investors in the security and move them to other avenues of investment - agreed that its applicable for all participants but its a deterrent nevertheless. So there is some merit in the argument that this tax can impact liquidity adversely - how big an impact is debatable.

perpetual wonderer said...

Well, first let me clarify my statement about speculators going behind non gargantuan profits too. I know that 10% in a day is totally huge, but only in percentage terms. There are people who will play as little as 200 bucks on a day and be happy to go home with 220. But that doesn't happen everyday, which is when that 20 bucks a day doesn't look that great.

"Really I don't understand how's a guy who uses a DCF framework to value company and invest in what he perceives to be a undervalued company any different from a speculator or vice-versa. "

Well, lets not get into semantics here. Basically, there has to be a rationale for your investment for you to be called an investor. If you can back up your decision with some kinda logic that is convincing enough to an average player in the market, I would say you are an investor. However, "Buy this stock cuz I know for sure its gonna go up" doesn't sound like solid logic. And thats what most speculators do. An investor would rely on the authenticity of financial modelling and the truthfulness of its assumptions whereas a speculator would rely on the tip that he got from a friend of a friend. Which of the two is more likely to be true and consistent over time is anybody's guess. So you might argue that all investors are speculators cuz they get their tips from financial engineers. But I think logic that has reasonably stood the test of time and has some sort of historical evidence that can be extrapolated is far more reliable than random tip offs.

As for the later part, you can almost be sure that there will be some sorta shift between preferences for different securities. Thats no biggie. Like you said, if FDs and returns from the stock market are taxed differently, investors will factor it in and accordingly alter the composition of their portfolio to suit their risk appetite. Thats a given.

Mahesh Sethuraman said...

Let's agree to disagree on tha investor vs speculator differentiation part. Atleast I can't get it.

The point is not about investor factoring in the additional tax on one mode of investment and therefore shifting to other avenues of investment - of course that's a given. But such a shift can lead to lesser liquidity in one of the the investment avenues (where the additional tax is levied) was what I was saying.

Gaurav Mehta said...

Sorry to be jumping in late into the argument but just couldn't resist looking at the argument.

However, I fail to understand how can a tax that's obviously not too large fail to curb investment or trading. Let's face the fact, if a tax law gets passed it'll affect the market for a day or two and then it will be discounted by the market, markets forgets big stuff in a second ....this is just a tax... all its going to do is add to the investment cost for everyone ... which too everyone will get used to living with one week post the taxes are introduced.

I definately don't think a trader will start behaving like an investor and move in and out of markets in much more non volatile manner because there is a TAX..... think of it .... a trader buys on a rumour, tomorrow the news gets out, he'll sell as most traders do when the news is out, he certainly won't think of the tax because if he stays out in the first place he can make no money and if he stays in, when the news gets out, he might loose more than what he made.

As for volatility , more than the investors and the speculators, its the environment that brings about volatility, if the economy is stable and growing markets have limited volatility and when the economy goes into a crisis volatility starts to increase....and volatility too is good for option traders, just because we like investing doesn't really mean volatility in itself is bad because for every investor there is an option trader who's loving every bit of the volatility.

I mean this was a crisis that we went through after close to 70 years ... lets give it respect and not bring in all the taxes in the world and all the regulations in the world ..for the next crisis will not in any ways look like the present crisis.....

And for that matter ....Crisis are important to clean out the systems and excesses in the systems .... How would have the real estate companies/banks ever get a chance to clean up their balance sheets but for the crisis? All painful stuff is not always bad, you need these stuff once in a few years because people love taking everything to the excesses.... and you need a way out to clean the system up sooner rather than later or the whole system would get messed up like it did for Japan..

Amit said...

I want to understand why investment banks can currently charge the premiums they do in arranging financing for large business transactions. If the markets were truly efficient, shouldn't this premium converge to just the marginal cost, which should at least be sublinear of the amount being financed, if not independent. Again, I want to stress that I am not happy if the premium is "low" e.g. 0.1%, since this is still linear in the amount being financed.

Why does this happen? Is there not enough competition among banks, or not enough liquidity in the markets? Is there some sort of implicit insurance being provided?

I might hope that instituting a very low tax would at least have the effect of sharing this premium with the people, although I think most would be happiest to just find a way to eliminate this phenomenon.

Thomas Paine said...

Sorry to be jumping even later into the argument.

To Gaurav Mehta: I would like to answer your question regarding how this tax could curb investment or trading.

I have no comment about the "buy on rumor, sell on news" stereotype you seem to have regarding what a trader does. Rather, a more realistic perspective is to look at this from the point of view of a liquidity provider. Such a market participant (who, in aggregate, accounts for a huge fraction of daily market volume) is looking to make a small spread on a large number of transactions each day. It is a very small margin business (essentially like a grocery store). The percentages being discussed in the current incarnations of the transaction tax proposal would make it impossible to turn a profit on virtually any transaction. This puts liquidity providers out of business overnight.

This will, in turn, cause ripple effects that will impact the long-term investor such as a widened bid-ask spread and poor market depth. Even if individual retirement accounts are made exempt from this tax, these effects will still act as a drag on long-term returns. I have a post showing the effects of this on my blog (Misconception #1: Long-term investors need not fear a financial transactions tax.). It is basically just an extended rant on compound interest but, in reading around on various sites, I am surprised at the poor intuition that people seem to have about this topic. I hope that clarifies the issue for you.

To Professor Damodaran: I wanted to thank you for making such useful material available on your website. I always thought it was very nice of you so now is my chance to say thanks!

Gaurav Mehta said...

Interesting points to consider firstly i do agree with you that if liquidity was affected as you are are suggesting, the long term investor will definately be hurt. Getting that out of the topic, lets talk about the initial point you made.

" I have no comment about the "buy on rumor, sell on news" stereotype you seem to have regarding what a trader does. Rather, a more realistic perspective is to look at this from the point of view of a liquidity provider. Such a market participant (who, in aggregate, accounts for a huge fraction of daily market volume) is looking to make a small spread on a large number of transactions each day. It is a very small margin business (essentially like a grocery store). The percentages being discussed in the current incarnations of the transaction tax proposal would make it impossible to turn a profit on virtually any transaction. This puts liquidity providers out of business overnight."

When i talk about buy on news and sell on rumor... i was actually talking from a practical prespective. Not that i am a full time trader but from little trading that we're involved in as a brokerage business and from most traders that i know of and some of who work for banks, financial institutions are never looking for a very small spread that trading would go out of picture on a transaction tax, simply for the reason that big traders put in a lot of money and only do trading when they feel there is a good oppurtunity to go long or go short. Trading is not always a one day activity as u seem to suggest, a trader takes a call on the market when he feel that there is a good chance that the market/stock will go up and sets his target and stop losses and once any of those are met his trade is over. The only time i have seen trading to fall is when there is lack of momentum in the market, thats what keeps the traders away the most if you see the market being undecisive and moving in a very small range because thats when traders find it difficult to call a trade correctly and chances of a loss increase. Goldman has made a lot of money on trading in the last two quarters and those were not because they traded on small margins but because they took a bet on the markets in Feb-Mar to go long on the market as they felt the markets would bounce back and cyclical companies were the ones which they asked every one to buy and bought a lot of that themselves, secondly the profits came from the difference between the bid ask spreads which you seem to suggest will grow if there is lack of liquidity due to taxes.... but then again people like goldman are going to close down on that spread. (not my own inputs, reports on bloomberg,to be precise they made $100MM of trading profit per day on 34 days an absolute record in 1Q'09)


What you seem to have got confused is when people actually work on small spreads i.e. arbitrage opputunities where they like to find mispriced quotes on two markets anywhere in the world. This is where the transaction tax can affect the trading volume but this in any case should not affect the volatility as these are seconds trades and just show an artificial volume. Though i am not very sure about arbitarge trading as i haven't seen this on a practical basis. Maybe our prof can shed light on the same and also collaborate about whats the correct thought behind this.

Thomas Paine said...

Thanks for the reply, Gaurav. Just to clarify something, I am a full-time trader so I am well aware of all the different market participants. I just thought I would shed some light on how the participants who work on the smallest time frame operate since this seems to be a very misunderstood group. I didn’t really want to comment on the longer-term participants since I think this is better understood.

Just some points on your reply…

1. A bank has many different trading desks (as do the large hedge funds) and the profitability of each varies depending on what particular strategy happens to be in favor with the market at any given moment. Some of these desks will hold positions for long periods whereas others will hold positions for seconds only (algorithmic trading desks, for example). There is no uniform way to say what kinds of profit a bank looks for since it varies between desks. There are many different ways to structure a desk, ranging from high-volume / low margin business to low-volume / high margin business. I would not classify any approach as inherently better than any other.

2. As for Goldman and the other banks closing down on the spreads, I have my doubts about that in the event this tax does go through. I could make an argument for the banks maintaining wide spreads in an effort to restore margins back to the days prior to decimalization (in the US) and the advent of ECNs. I think it is safe to say that however this turns out, it won’t be the banks that pay for it. In one manner or another, it will be the public that pays for it and they will have the populist politicians to thank for it.

To be continued...

Thomas Paine said...

3. Regarding your contention that the trades on a small time frame are artificial volume, I would disagree. I believe a healthy market requires a diversity of market participants and it is very difficult to draw a dividing line between volume that is “natural” and volume that is “artificial” (or, as the Professor puts it, volume that is “investing” versus “speculative”). Perhaps you meant “artificial” as a euphemism for “useless”. If that’s the case, let’s consider a simple thought experiment.

We’ll think about a simplified market for widgets (you can insert the name of your favorite product here). We’ll define two kinds of traders: micro and macro. The distinction between them is simply one of time scale. The micro-traders will provide liquidity in the manner that I indicated in my first post. The macro-traders will act as you suggested (i.e., taking positions for longer periods based on whatever informational edge they possess). Both participants operate in the market in a well-thought out capacity.

Now let’s consider a commercial participant (like a widget manufacturer) who needs to use the market to hedge. In a market where the micro-trader is active, the commercial participant will always be able to find a micro-trader to take the other side of his trade. The micro-trader does so because he knows he will be able to offset that trade in short order (i.e., a few seconds or minutes later). This ensures that the commercial user will have good liquidity when he needs it.

If this micro-trader is forced into extinction through the imposition of transaction taxes, then the only participants left to provide liquidity are the macro-traders. Like the micro-trader, the macro-trader will only take positions when he believes that he can offset the position at a profit to himself. However, the difference lies in the time frame of offset. The macro-trader will be looking to close out his positions over much longer time periods since this is where his informational edge lies.

This ensures that the commercial participant will get worse prices when dealing with a macro-trader than with a micro-trader. To make this completely clear, a micro-trader will deal with a commercial participant basically all of the time. The hedger will lose, on average, in these dealings but it might only amount to a few cents per share. The macro trader, on the other hand, will only deal with a commercial participant when he has a good inclination that he will make considerably more than that (i.e., dollars per share). The hedger will thus lose much more, on average, when dealing with a macro-trader than a micro-trader.

Furthermore, since the number of opportunities dwindles with increasingly larger time frames, this ensures that the macro-trader will not provide liquidity to anywhere near the same extent as the micro-trader would and that this liquidity will be available only when it is highly disadvantageous to the hedger.

A nice picturesque way to think about this is to ask yourself this question: Would you rather get in a swimming pool filled with remoras or with sharks?

Anyways, thanks for the comment. Take care.


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Gaurav Mehta said...

Hi Thomas, this was an excellent post which gives a lot of insight about the trading world and i for sure am not a trader. I liked the example you used of the widget manufacturer, the macro and the micro trader. In my earlier post i seemed to have completely missed the trading from the point of view of the micro trader. Though i do understand your prespective when you speak about algorithmn based trading and to point out companies like DE Shaw and other hedge funds do a lot of these algorithmn based tradings.

If this is the case then i don't think a financial tax will come into existence and if it came into existence it would be a much reformed version of the one doing the rounds presently.

Michael said...
This comment has been removed by the author.
Michael said...

In your post, you talked about the difficulty of making a distinction between "Speculators" and "Investors." However, I don't believe this is the right distinction, with regard to the tax. More appropriately would be to look at the difference between "Hedgers" (people who produce or consume the commodity) and "Speculators" (anyone who does not, which would include an Investor).

According to CFTC analysis of energy and agricultural Futures markets (May 20, 2008, pg16 e.g.), Hedgers generally lead market movements, and then Speculators amplify those initial movements, creating both liquidity and volatility. Therefore, given that we want to create liquidity without excess volatility, it seems *possible* that a tax on "non-hedging transactions" could allow regulators to achieve the optimal mix they desire.

(That is, if you tax too high, you restrict speculators, and the costs of hedging increase; if you tax too low, you risk excess volatility, which regulators prefer to minimize.)

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Sandman said...

Dead-bang-on-correct,sir. Unless said tax is universal,the activity will simply move where the tax is not. The result will be illiquidity where the tax is. And these transactions can be moved in a heartbeat. When the regulatory arm for US forex imposed new onerous regulations, virtually overnight the larger US brokers made accounts in Britain available to their clients to circumvent the regulation. If they hadn't done that, they'd have lost business to Switzerland, the Seychelles, or wherever. It's sad the US Government has spent its people into a hole, but yet another tax isn't the answer. Never will be either.

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