The North-South Institute email@example.com 24 September 2012
Applying a financial transaction tax to derivatives presents special challenges. These are not, however, insurmountable, given the new regulations underway to govern trading in derivatives.
The new regulations require moving trading of most derivatives from the “over-the-counter”
(OTC) or informal, non-centralized, market to exchanges with central clearing, and require
reporting of all trades, whether OTC or on exchanges. It is the trade reporting requirement, toward which the industry was already moving before 2008, that is crucial and necessary for fully feasible application of the FTT to derivatives trading. However, unqualified trade reporting would not be sufficient. The new regulations need to specify that trade reporting be globally centralized or, at least, globally accessible to regulatory agencies. This indeed seems to be the case.
Derivatives are financial contracts that allow traders to bet on future movements in either prices or interest rate payments associated with other financial instruments, such as shares (equities) or credit. Derivatives are often used, alone or as part of a complex trading strategy involving other instruments as well, to arbitrage differences in interest or exchange rates in different economies, or to hedge against or speculate on price movements in shares or interest rate changes in credit instruments.
Currently most derivatives are traded off exchanges, in the “over-the-counter” (OTC) market.
Traditionally, OTC markets are de-centralized, such that trading takes place privately between dealers or between dealers and large corporations and investment funds, including hedge funds.
Deals may be made by phone or fax, through a broker or the web, or on electronic bulletin boards.
By contrast, trading on exchanges is always between a dealer or other agent and a central counterparty (CCP) that takes one side of every deal.
Information on trading activity is less accessible in OTC markets than on exchanges. This non-
transparency plays into the hands of dealers and brokers since it confers a degree of monopoly
pricing, which largely explains why the industry opposes moving trading onto exchanges or
trading platforms (IHT 13 December 2010: 17). Trading on exchanges or platforms would be
much more competitive and would allow traders to engage directly with each other rather than
through dealers or brokers, as occurred in equity markets in the late 1990s and foreign exchange
markets since the mid-2000s.
Today there are many instances of an FTT being applied successfully to trading of equities (shares, stocks, securities). Perhaps the United Kingdom’s Stamp Duty Reserve Tax is the most well known. Equities are traded on exchanges with central clearing, so that individual trades are easily identified. Indeed, the Stamp Duty is collected automatically and electronically as equity trades are cleared and settled.
Exchanges have a geographic location and are therefore regulated within a recognized legal jurisdiction. What prevents trading of equities from moving to an offshore exchange, where there is no Stamp Duty? Evasion offshore is not significant because payment of the Duty is required for legal transfer of ownership in a resident entity:
Stamp taxes are paid by everyone, whether resident or non-resident on transfer of ownership of a resident security. Payment of the tax is a requirement for legal transfer of ownership and enforceability of ownership, including rights to receive dividends and to vote at shareholder meetings. Stamp taxes are collected at
settlement where the change in registered ownership takes place. They are a levy on transfer of legal ownership. For this to work, the register of owners has to be held in the taxing jurisdiction and hence the issuer of certificates of ownership, shares, needs to be locally incorporated. In case of UK, it is estimated that 40% of the Stamp Duty Reserve Tax on UK equities is paid by non-UK residents (Griffith- Jones and Persaud, February 2012: 9).
This feasibility mechanism is not available for taxing derivatives. Derivatives are contracts between traders specifying a stream of payments that depends on the price of a particular share or on interest obligations of a particular credit instrument, but does not depend on ownership of the share or debt. Derivatives contracts can be enforced between traders without reference to the underlying shares or debt on which they depend. There is no necessary connection between legal enforcement of derivatives contracts and the jurisdiction governing the entities whose shares or debt underlie the derivative. Since derivatives trading does not entail transfer of ownership in an enterprise or of a debt obligation, an FTT cannot be applied to them as a stamp duty, based on legal transfer of ownership, as it is to shares. The same is true of trading foreign exchange, the other great OTC market.
This not only poses a challenge to the feasibility of taxing trading in derivatives, but also implicates the feasibility of taxing equities. For hedgers or speculators, derivatives are to some extent substitutes for equities – one can hedge or take on open position in future price or interest rate movements either by appropriate purchases of equities or debt instruments or by entering into a derivative contract based on those equities or debt instruments. Potentially, then, an FTT on equities alone may lead to a shift in trading from equities to derivatives.
In practice, trading derivatives to evade an FTT on equities may not be an important concern, for
two reasons. First, currently equity-linked derivatives make up a very small share (3%) of all
derivatives contracts (BIS, 2010).1
Second, the degree of substitution between trading in derivatives and trading in shares is likely to be limited. As just mentioned, often derivatives trading is done as part of a complex hedging or speculative strategy involving numerous financial instruments, such as the carry trade involving debt, foreign exchange, and derivatives instruments, or use of derivatives to hedge against adverse price movements in equities. As long as the FTT rate is not too high, these multi-instrument strategies are likely to dominate, so that derivatives trading complements trading in other instruments, rather than substitutes for them (Griffith-Jones and Persaud, February 2012). This is consistent with the experience of the Stamp Duty on share trading in the UK.
However, in the absence of a globally coordinated tax on derivatives, trading on offshore exchanges (or in the OTC market where regulations to move trading on to exchanges are not in place) may be a strong substitute for trading in taxed jurisdictions. This is why globally centralized or accessible recording of all global trades in derivatives is both necessary and sufficient for taxing derivatives. How is this achieved?
The new regulations governing derivatives trading were initiated by the G20 communiqué in Pittsburgh in September 2009:
All standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest…OTC derivatives contracts should be reported to trade repositories….Non-centrally cleared contracts should be subject to higher capital requirements.
These new regulations are being globally coordinated, although details are spelled out in national legislation. In the US, the Securities and Exchange Commission last month complied with a Congressional directive under the Dodd-Frank Act to move trading of standardized derivatives contracts onto exchanges and to require reporting of all trades to a trade information repository. In Europe, the Markets in Financial Instruments Directive (MiFID) 2 will move derivatives onto registered trading exchanges while the European Markets Infrastructure Regulation (EMIR) makes it mandatory to report all derivatives contracts (OTC and non-OTC) to trade repositories. MiFID 2 is likely to be implemented later (possibly as late as 2015), but EMIR will be implemented next year. EMIR was adopted by the European Parliament on 29 March 2012. It will need to be adopted by the EU Council, although that is expected to be a formality.
These regulations are not being pursued primarily (or indeed at all in the case of the US) to facilitate an FTT on derivatives. They are included to ensure greater transparency in derivatives