Feasibility*of*taxing*derivatives*trading*

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Feasibility*of*taxing*derivatives*trading*

Rodney Schmidt

The North-South Institute rschmidt@nsi-ins.ca 24 September 2012

Feasibility*challenges*of*taxing*derivatives*trading*

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.

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The*difference*between*taxing*derivatives*and*taxing*equities*

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

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derivatives contracts (BIS, 2010).

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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?

New*regulations*governing*derivatives*trading*and*an*FTT*

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

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" There are three major derivative asset classes, and two minor ones. In order of importance they are (market share in

parentheses): interest rate contracts (78%) based on credit instruments; foreign exchange contracts (9%); credit default

swaps (6%); equity-linked contracts (3%); and commodity contracts (4%) (BIS, 2010).

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markets, and to permit the orderly unwinding of trades in the event of bankruptcy of a trader or general financial crisis. The derivatives industry, both traders and dealer / brokers, has lobbied hard against the new regulations, the former because of the added costs of margin and collateral requirements on exchanges with clearing, and the latter, as already noted, because of fears of loss of business due to greater industry competitiveness.

In Europe, though, part of the justification for the new provisions is indeed to make a tax on derivatives feasible:

We have obtained the guarantee that all meaningful information on derivatives contracts is reported and accessible to European and national authorities. Reporting obligations are as broad as possible. They cover all derivatives and all actors. This will give EU authorities a full picture of derivatives markets traded both on- and off-exchange. This is crucial to ensure that a financial transaction tax is actually collectable….records and accounts must be kept separately for each client…(Group of the Progressive Alliance of Socialists and Democrats in the European

Parliament, press release 10 February 2012).

Both Dodd-Frank and MiFID 2 / EMIR contain regulatory “extra-territoriality” provisions governing offshore trading that potentially implicate entities located in the regulated economy.

That is, regulators in the US would be able to regulate trading in derivatives that occurs offshore if those trades implicate the US financial system, and similarly for regulators in the EU. However, most important for feasibility of an FTT on derivatives are the provisions requiring trade reporting.

Two questions remain: First, how would a trade information repository for all individual trading in derivatives work? Second, would trade records be globally centralized, or at least globally

accessible to regulatory agencies?

Mechanics*of*derivatives*trading*

A trade, buy or sell, of a derivative, whether OTC or on-exchange, currently goes through a four- step process, and is supported by three key services (see the figure below). These processes and services were developed under several connected platforms by a group of the main dealers under guidance from central banks, especially the Federal Reserve Bank of New York.

First, two dealers or a dealer and a hedge or investment fund (a trader) agree to buy and sell,

respectively, a derivative instrument. In OTC markets this is usually done privately, but sometimes

is done through an electronic platform (dealers) or through a broker (hedge or investment funds,

where the broker is a dealer).

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Second, each of the two counterparties to a trade deal creates a record documenting the terms of the trade. The two records are compared and deemed matched once they are identical.

Third, the two counterparties to the trade verify the details of the trade, including terms and legal obligations. Then they create a final record of the trade.

Finally, the traders or, on an exchange, a central counterparty, make the payments associated with the trade. Note that payments may continue for up to two years, as in the case of interest rate swaps; hence the need for a kept record of the transaction.

Derivatives contracts may be standard or customized. The former, referred to as “plain vanilla”

and the majority (around 70 per cent), have simple and common terms and shorter maturities, and are suitable for electronic processing. The latter, referred to as “exotic” or “structured”, are more complicated or specialized, often have longer maturities, and may not permit electronically automated processing.

For vanilla derivatives, the last three steps of the trade process are facilitated by electronically standardized message templates, developed by the International Swaps and Derivatives Association (ISDA), and communications protocols, provided by SWIFTNet. More complex derivatives contracts can also be manually coded into the templates. The vast majority of inter- bank communications and clearing and settlement services across asset classes and products is

Agree"to"

deal"

Exchange"

payments"

Confirm"

trade"details"

Match"trade"

terms"

Processing*a*derivatives*trade*

Store"a"unique"trade"record"in"the"Global"Trade"Repository"

Electronically"automated"processing"

Electronically"standardized"communications"

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done over SWIFTNet. The rest use SWIFTNet syntax standards for financial messages (Financial product Markup Language – FpML) on other networks.

Once an agreement to trade is recorded electronically, it is matched, confirmed, and settled automatically.

The*Global*Trade*Information*Repository*

There are and will be numerous clearing houses set up for derivatives trading, especially once the new regulations are implemented (Financial Times, 11 September 2012). However, as of mid 2010, the Global Trade Repository in London is, by regulatory sanction, the unique global storehouse for trading information in all derivatives products. The new derivatives exchanges, as well as OTC traders, report the details of individual trades to the Global Trade Repository, as illustrated in the above figure.

For example, today MarkitSERV provides a single gateway for OTC derivatives processing globally. It matches and confirms more than 95 percent of global OTC credit default swaps and a significant and growing share of global interest rate swaps and equity and foreign exchange derivatives. MarkitSERV was launched in September 2009 by merging two previous platforms, Deriv/SERV, specializing in credit default swaps, and Markit Wire (formerly SwapsWire), specializing in interest rate swaps.

When a derivatives trade has been matched and confirmed, a final and legally binding record is stored in MarkitSERV’s Trade Information Warehouse, launched in 2006. The Warehouse maintains each contract and services it to maturity, which can be several years. It also houses manually recorded derivatives contracts that are too customized or complex for electronic processing. It accepts records from both in-house matching and confirmation services

(MarkitSERV) and other, third-party, services. MarkitSERV uses the records in the warehouse to settle derivatives contracts through links with large-value payments systems, including CLS Bank for foreign exchange derivatives.

The Warehouse is a key institution underpinning the derivatives industry:

A central trade information warehouse can serve as the repository for the most up-to- date record of each confirmed OTC derivatives contract. Information needed for the processing of payments and other post-trade events over the entire life cycle of a contract could be obtained from this centralized location of all trade records. With all market participants using the same trade record for post-trade operations, the

opportunity for payment or other processing problems would, in theory, be greatly diminished. In addition, others providing automated services in the various processing stages would be able to connect to the trade information warehouse and base their services on the warehouse’s trade records (Bank for International Settlements, March 2007, p. 15).

The Global Trade Repository – the London-based arm of the Trade Information Warehouse –

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services more than 1,700 global traders, 70 dealers, 50 inter-dealer brokers, and six on-exchange central counterparties (MarkitServ, 14 June 2012). It has been working with regulators and Congress since mid 2010 to become the single global trade information storehouse for all derivatives products, whether plain vanilla or customized (bespoke). To enhance market

transparency and facilitate management of systemic risk, Warehouse records are open to market participants, third-party service providers, and regulators. In this respect it already played a key role in processing or unwinding contracts affected by the bankruptcies or near-bankruptcies of Lehman Brothers, Washington Mutual, and Freddie Mac and Fannie Mae.

MarkitServ’s Trade Information Warehouse / Global Trade Repository is provided by the Depository Trust & Clearing Corporation (DTCC). In 2011 DTCC was selected by the

International Swaps and Derivatives Association (ISDA) and Association for Financial Markets in Europe (AFME) to be the “preferred service provider for building and managing global trade repositories for Interest Rates, Commodities and Foreign Exchange derivatives, adding to its already existing repositories for Credit and Equity derivatives” (DTCC, 14 June 2012). These repositories provide specialized services for reporting to regulators, such as to meet Dodd/Frank reporting requirements:

DTCC’s GTR service …provides regulators globally with access to data pursuant to supervisory authority or pursuant to industry commitments….The GTR service will support the mandatory reporting as regulations are finalized in each country, such as the US Dodd Frank Act, Europe’s European Market Infrastructure

Regulations (EMIR), … The GTR service supports a multitude of data submissions including real-time price reporting, transaction details, confirmation records, and valuation data...In establishing the Warehouse Trust Company as a regulated entity, our aim is to ensure that regulators, wherever they are located, have unfettered access to the information they need…(DTCC, 14 June 2012).

How*to*tax*derivatives*trading*

An FTT on derivatives, whether OTC or on-exchange, will be feasible as soon as new regulations requiring globally centralized trade reporting are in place. In the US and Europe this process will be complete within the next year. This is technically feasible because matching, confirming, storing, and settling contracts is standardized, centralized, and electronically automated. This came about through cooperative action of the largest dealers and under the lead and guidance of

regulators. Indeed, MarkitSERV and the Trade Information Warehouse / Global Trade Repository are part of the Federal Reserve System and approved by the UK Financial Services Authority.

Centralization of derivatives transaction records, globally, was completed by summer of 2010, as noted above. Standardization of complex or custom contracts for automatic record-making may take longer, and some may always need to be manually entered into electronic records. But the trend is clear, and the industry and regulators are committed to achieving nearly complete

automation, in order to improve market transparency and risk management. Ultimately, the intent

is to create one or a few CCPs for clearing and settling derivatives, and to electronically automate

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trading. Then trading, clearing, and settling derivatives will occur on a decentralized but automated dealer exchange, similar to the NASDAQ market for equities.

As long as there is a globally centralized trade information repository for derivatives, and the new regulations contain, as they do, “extra-territoriality” provisions, there will be no incentive for trading in derivatives to move offshore.

Clearing and settlement services such as MarkitSERV already charge a per transaction cost recovery fee that is equivalent in nature and mechanics to collecting an FTT. Hence, the FTT on derivatives could be collected through the clearing and settlement process, whether on exchanges or through the Global Trade Repository, just as the FTT is currently collected, in the UK and elsewhere, on trading in equities.

Sources*

Bank for International Settlements. December 2010. Global OTC derivatives market statistics.

Depository Trust & Clearing Corporation (DTCC). 14 June 2012. Available at:

http://www.dtcc.com/products/derivserv/

Depository Trust and Clearing Corporation (DTCC). An introduction to DTCC services and capabilities. June 2009. Available at:

http://www.dtcc.com/downloads/about/Introduction_to_DTCC.pdf .

Depository Trust and Clearing Corporation (DTCC). Deriv/SERV: Delivering automated solutions and risk management to OTC derivatives. March 2008. Available at:

http://www.dtcc.com/downloads/brochures/derivserv/DerivSERV%20Brochure.pdf . Depository Trust and Clearing Corporation (DTCC). Deriv/SERV today. Summer 2009 and

October 2009. Available at: http://www.dtcc.com/news/newsletters/dst/2009/2009_q3.pdf and http://www.dtcc.com/news/newsletters/dst/2009/2009_q4.pdf , respectively.

Financial Times. Battle for derivatives clearing heats up. 11 September 2012.

Global Trade Repository for Derivatives. Available at:

http://www.dtcc.com/products/derivserv/suite/global_trade_repository.php

Griffith-Jones, Stephany and Avinash Persaud. Financial Transaction Taxes. February 2012.

Available at:

http://policydialogue.org/files/publications/FINANCIAL_TRANSACTION_TAXES_Griff ith_Jones_and_Persaud_February_2012_REVISED.pdf

International Herald Tribune (IHT). Secret group keeps tight grip on derivatives trade. 13 December 2010: 17.

MarkitServ. 14 June 2012. Available at: http://www.markitserv.com/ms-en/

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