November 29, 2023

High & Low Finance: A Tax That Could Change the Trading Game

To the dismay of the United States 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 American 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 American 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.

One objective, says Algirdas Semeta, the European Union commissioner in charge of tax policy, “is to reorient the financial system back to financing the real economy.”

But can Europe pull it off? Will trading simply migrate to other jurisdictions, such as the United States 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 an American 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.”

To get out of the tax, a financial institution would have to do more than simply move its headquarters out of the 11 countries that now plan to impose the tax. It would also have to forgo serving clients in any of those countries and trading in securities or derivatives from any of the countries. Officials are confident that no major institution will be willing to forsake such large markets as France, Germany, Italy and Spain.

The other countries that have at least preliminarily agreed to impose the tax are Belgium, Austria, Greece, Portugal, Slovakia, Slovenia and Estonia.

The scope of the tax is very broad. The proposal has exceptions for currency trading and the physical trading of commodities, but not for derivatives like currency or commodity futures contracts. When a company sold newly issued securities to investors, that transaction would not be taxed, but subsequent market trades would be. Over-the-counter trades would be subject to tax just as would transactions on a stock exchange, as long as a financial institution — a term that is also defined very broadly — was involved. You could sell your shares in Daimler to a friend without paying tax, but not if you got a broker involved.

Floyd Norris comments on finance and the economy at

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Off the Charts: In Europe, a Repeat of the Credit Crisis

In the euro area as a whole, the amount of credit outstanding has fallen to levels lower than they were a year ago, according to figures released last week by the European Central Bank. In some countries within the euro zone, including Italy and Spain, credit is falling at a faster rate now than it did during the first crisis.

The difficulty in obtaining credit seems likely to make it even harder for the countries that have been hurt the most to recover and begin to grow again. The figures show that while the E.C.B. has relieved the immediate financial pressures on both governments and banks by making it easy for them to borrow, it has not managed to extend that easy credit to those who need money the most.

The first of the accompanying charts shows 12-month changes in the amounts of loans outstanding in the 17 countries that make up the euro zone, and the lower charts show the state of lending in several of the countries. The bolder of the two lines in each chart shows the change in outstanding loans to nonfinancial companies, while the other line shows changes in total loans to households, a figure that includes both home mortgages and consumer loans.

In the middle of the last decade, loans were growing rapidly in many countries. Interest rates had fallen sharply as markets concluded there was no good reason for rates to be much higher in one euro zone country than another. After all, the currency risk was identical in all the countries.

In Ireland and Spain, the easy credit helped to finance large housing bubbles, which then burst during the crisis. In both of those countries, the amount of outstanding loans rose at a pace above 30 percent a year at the peak of the cycle.

A falling total of loans means that on a net basis, no new loans are being issued, although banks might be relending some of the money being repaid on old loans. In some cases, particularly in Ireland, the amount of loans outstanding has plunged not because loans are being repaid but because they are being written off.

Some countries seem unaffected. In Finland, which has been among the most vocal in demanding austerity in the troubled countries, the amount of loans outstanding continues to grow at a rate of more than 5 percent a year. In Austria and Germany, loan volume is also rising, although at a slower rate.

But in Portugal, the amount of corporate loans outstanding is now lower than it was in the spring of 2008, before the collapse of Lehman Brothers sent world credit markets tumbling. In Ireland, loan totals to both companies and households have fallen to 2005 levels.

Floyd Norris comments on finance and the economy at

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High & Low Finance: A Flaw in New Rules for Mortgages

That fact was central to the Obama administration’s proposals to fix the housing finance market a couple of months ago, but it seems to have been forgotten by a collection of regulators that proposed rules this week on when banks will not have to retain risks for loans they make.

Perhaps inadvertently, they gave Fannie Mae and Freddie Mac, the government-run housing finance agencies, another competitive advantage. That is exactly the opposite of what needs to be done.

The proposals are generally good. They force lenders to shoulder some of the risk when they securitize all but the safest mortgages. That is what the Dodd-Frank law required, and for good reason. One of the big problems we had leading up to the crisis was that many lenders believed they could profit by making loans while leaving others to suffer if the loans went bad.

But where is that risk to be retained? The law says it should be retained by lenders or securitizers; an unwieldy group of regulators is left to fill in the details. The regulators are also supposed to determine what constitutes a “qualified residential mortgage” — one that is so safe that the lender need not retain any of the risk.

It was those issues that the regulators addressed this week. They decided that “Q.R.M.’s,” as they are called, had to be very conservative, with 20 percent down payments and strict limits on leverage. That is good. If mortgage loans do not meet the highest standards, somebody involved in making the loans should be responsible if they blow up.

Much of the criticism of the proposed new rules seems to assume that no mortgage loans will be made at all if lenders have to keep some of the risk.

“By mandating a 20 percent down payment on qualified residential mortgages, the administration and federal regulators are excluding those without huge cash reserves — which constitutes most first-time home buyers and many middle-class households — from a chance to buy a home,” said Bob Nielsen, a home builder from Nevada and chairman of the National Association of Home Builders.

Regrettably, some consumer advocates have joined in that chorus.

What should happen, said Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation and one of the regulators involved in the proposal, is that “Q.R.M. loans will be a small part of the market,” and other loans will be made by lenders who do have “skin in the game.” The proposal asks for discussion of ways that can be accomplished without forcing banks to tie up excessive amounts of capital.

“Economic incentives,” she said, “are the best check against lax underwriting standards.”

Consider how absurd this debate would have seemed a few decades ago. Then you got a mortgage loan from a bank, which stood to profit if you made your payments and risked loss if you did not. Imagine arguing that no bank would lend if it had to take a risk. What business, people would have asked, did banks think they were in?

Over the decades, banks got out of the habit of actually owning loans. Instead, the loans were securitized, with investors putting up the money. Some loans went to Fannie Mae and Freddie Mac, so-called government-sponsored enterprises, whose securities were widely viewed as backed by the federal government. Others were securitized by Wall Street firms.

Investors should have monitored the quality of the loans — just as Fannie and Freddie should have — but they did not. Lower rungs of those securities would take losses if there were a lot of defaults, but senior tranches were deemed completely safe by bond rating agencies, who assumed that losses would never rise to those levels.

You know what happened. Easy money led to excessive lending and soaring home prices. That led to overbuilding. Mortgages were written on terms that lenders knew home buyers could not really afford. The borrower would pay less than the interest owed for a while, and then payments would soar. It was assumed that a homeowner facing those high payments would either sell the home or refinance the mortgage, creating more fees and more mortgages to securitize.

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