An academic argument that could turn volatile

European regulators seem convinced a financial transaction tax would curb speculation and reduce volatility but the market is doubtful, fearing that it could increase costs for long-term investors.
By None

So who thought up this transaction tax idea in the first place and what's the whole point?

It was back in 1978 that economics Nobel Prize Laureate and namesake of the tax – James Tobin – first proposed to “throw some sand in the wheels of our excessively efficient international money markets”, by levying a tax on FX transactions to penalise short-term speculators but not long-term investors. From the outset, the idea of a financial transactions tax (FTT) was aimed at discouraging speculative behaviour and providing stability of the markets.

In this vein, the European Commission (EC) last week proposed a Europe-wide financial transaction tax on the exchange of shares and bonds at a rate of 0.1% and derivative contracts at a rate of 0.01%, which could cost the industry about €57 billion a year.

But would a transaction tax inhibit speculation-driven volatility or instead dry up liquidity, making volatility worse?

Well that's the €57 billion question. While some analysts believe the equity market is probably well placed to handle a financial transaction tax, others argue that products such as spot FX or exchange-traded interest rate derivatives have lower margins than cash equities, meaning liquidity in these markets could be more severely affected by a tax. At any rate, objections to the FTT can be found for all asset classes.

The greatest burden of the tax will likely fall on high frequency trading (HFT), which accounts for around 40% of European volumes.

However, most market participants strongly disagree the tax will curb speculation, Worse, it would increase costs for long-term investors and decrease market efficiency by acting as a disincentive for market makers to provide liquidity.

Well, the people who would have to pay the tax would say that, right? Where do these arguments come from? HFT firms and those with a vested interest?

That's a little cynical. Equally, you could legitimately argue Brussels simply sees the tax as a way to maintain its coffers after member states threatened to decrease the EU's budget. But the argument that an FTT would not curb speculative trading and would increase volatility has merit. And the sources of these arguments might surprise you.

Branding the FTT as a “blunt-edged tool with multiple adverse effects”, Barclays Capital points to empirical studies cited by the International Monetary Fund, suggesting FTTs reduce asset prices, suppress investor returns and raise the cost of capital. In turn, the IMF says by depressing trading volumes and liquidity FTTs create market distortions and interfere with the price discovery process.

Last month, US Treasury secretary Tim Geithner told Bloomberg that history had not proved the measure effective in containing the risks of large swings in asset prices and that most evidence suggested FTTs probably damage liquidity and undermine depth in markets.

So, case dismissed? Tobin was wrong?

Well, trying to put a number on the possible risk to volumes is very difficult and, ahem, speculative. Generally, models do show a FTT should theoretically diminish volatility by lessening the number of speculators. But if the tax is too large, reductions in market trading and liquidity can result in an increase in volatility.

Of course, financial markets in the real world don't often behave the way theoretical models predict. The Institute of Development Studies has found most analysis of the link between transaction costs and volatility finds higher transaction costs lead to more – rather than less – volatility. A 2002 study of stocks moving from Nasdaq to the New York Stock Exchange (now NYSE Euronext) found strong evidence that stocks migrating to a lower trading cost environment also experienced decreased volatility of daily returns. Similarly, a study of French stocks found that a 20% increase in transaction costs generated an increase in volatility of about 30%.

As Europe's transaction tax proposal passes on to the European Council and European Parliament, where the EC hopes it will be processed by the end of 2012, all industry eyes are on Brussels. But with strong opinions on both sides, the concerned parties aren't likely to hold their collective breath and wait for a decision. Brussels may have a fight on its hands over this one.

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