Against liquidity

By Felix Salmon
November 27, 2009
Paul Krugman today argues in favor of a financial-transactions tax on the grounds that it would discourage over-reliance on ultra-short-term repo markets, among other reasons. In other words, reliance on repos is a bad thing, and it's a good idea for government policy to "nudge" financial institutions away from it.

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Paul Krugman today argues in favor of a financial-transactions tax on the grounds that it would discourage over-reliance on ultra-short-term repo markets, among other reasons. In other words, reliance on repos is a bad thing, and it’s a good idea for government policy to “nudge” financial institutions away from it.

That’s something that opponents of the Miller-Moore amendment should bear in mind, when they complain that it could hit the repo market hard. Here’s Agnes Crane:

The repurchase agreement, or repo, market is a critical source of financing for dealers, hedge funds and others who use leverage to finance short-term trading positions. It’s a source of extra income for those holding virtually risk-free securities since they can squeeze out extra return by lending them out.

Such financing makes for a deeper and more liquid market that gives investors confidence that if they buy a Treasury note, for example, they can quickly sell it if they want to.

The problem is that we don’t want to encourage the use of leverage to finance short-term trading positions. Indeed, from a public-policy point of view, we’d ideally want to discourage it.

Would a less liquid repo market mean, in turn, a less liquid Treasury market? I daresay it would. But that’s no bad thing: the more liquid the Treasury market, the more that investors flock to it in times of crisis, exacerbating the systemic downside of the flight-to-quality trade, and reducing the amount of liquidity elsewhere in the markets, especially among credit instruments.

There are serious systemic consequences to living in a world where a Treasury bond — or any asset, for that matter — is considered a safe haven from all possible harm. Investing shouldn’t be about safety: it should be about calculated risk. Excess demand for triple-A-rated risk-free assets, as we’ve seen over the past couple of years, can be much more systemically damaging than excess demand for risky assets like dot-com stocks. So yes, let’s throw some sand into the wheels of the repo market, either through a Tobin tax or through the Miller-Moore amendment or both. Because liquidity is not ever and always a good thing.


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It’s obvious you have no experience in financial markets, nor does mr. krugman. Discouraging liquidity is never a good thing. But with that said, there will never be a financial transaction tax, because when analyzed it fails every time.

Posted by Dogma | Report as abusive

Felix,I think the debate about short term trading is currently lacking balanced views. I’m not sure why “short term” is being equated with “more speculative.” In my mind, short term transactions are often some of the least speculative transactions out there — they are frequently for very small sizes, and done a huge number of times. If you are succeeding at short terms transactions over a large sample set, then most statistics will demonstrate that it is not the result of luck. Whereas if your sample set is a single large transaction, then it is much harder to analyze success.For instance, most people don’t view running supermarkets as a particularly speculative business, even though its holdings are very “short term.” In a way, the short term nature of the business helps a supermarket to assess its results. You can start by purchasing small quantities of item, and if they sell quickly, then gradually start purchasing more, limiting your risk along the way, since you’re constantly getting new data points about demand in the market. However, if an East Coast supermarket chain decided to engage in a massive plan to build tens or hundreds of new stores on the West Coast at an unfront cost of hunreds of millions of dollars, then I would argue there is much more reason to call that speculative.Now suppose we implemented a transaction tax on food. There’s little reason to suggest it would impact the latter behavior of “real speculation.” But it there are lots of reasons to think it would affect real prices to the consumer, since the supermarket has to by it from a farmer, which in turn has to sell it to a customer, so the tax would ultimately be charged three times to the customer. The farmer would have to add the taxes he pays into the prices he sells food for, the supermarket would have to add it to the prices they sell for, and the customer would also have to pay it. The number grows even more if you include companies like Coca-Cola which act as a middle man between producers and supermarkets, or if you consider the fact that restaurants may by from supermarkets. But just because Coca-Cola and Supermarkets are middle men, it doesn’t mean that they don’t provide social value. It is very convenient for me (and I’m sure tons of other people) that I can buy Milk the same place that I buy toothpaste. In fact, by enacting a tax like this, you’re granting scale to large conglomerates, like a combined Farming/Soda/Supermarket company that operates all in-house.I think its the same way in financial markets. The credit default swaps AIG sold were part of a long term transaction. Citigroup created a massive, ill-managed entity through years of long term M+A deals. The repos that got people in trouble weren’t those done for treasuries. Treasuries are extremely easy to liquidate for cash, and thus in many ways could be considered more as a short term holding. They are liquid enough that whomever is holding them SHOULD mark them to market. Furthermore, they were rallying throughout the crisis, so it wasn’t write-downs on treasury holdings that killed firms. Rather, it was when Bear Stearns was holding illiquid mortage securities and using repos to finance them that we saw problems. Again, these are long term securities that aren’t easy to move!I have no problem with raising the taxes on Wall Street firms, but I don’t think a transaction tax is the right way to do it. A tax on earnings would result in more economic efficiencies. Or if you want to discourage speculation, then a tax on concentration might be best. If you’re risking a very small percentage of your firm’s capital, then no problem. But if you’re risking a large percentage of your firm’s capital, then you deserve to pay more.As an example of how a transaction tax could harm individual investors, look at the ETF on the Dollar Index, UUP. When the fund ran out of new shares to issue, it immediately surged over 1%, without any corresponding move in the dollar itself. Why was that? It was because market makers could sell the ETF, and buy its underlying consituents if prices ever got too high. Once the fund couldn’t issue new shares, this opportunity disappeared.Now consider what would happen under a transaction tax. First off, the investor would have to pay the tax, unless a de minimis exemption was granted to him. Second, the market maker would have to pay the tax on the UUP shares. Third, he would have to hedge with the holding of UUP, which in this case are Dollar Index Futures listed on ICE Futures exchange, so he would have to pay the tax on these. Then, if the market maker doesn’t want to hold his position forever (and pay its associated margin / financing costs), he would have to tender his shares to the agent running the UUP trust. He probably have to pay a fourth tax on receiving the UUP shares to cover his short, then pay a fifth tax on delivering the futures to the agent. Assuming the agent has to pay these taxes as well, then market maker would probably have to reimburse the agent as well, mean that in the end, 7 times the notional amount was taxed! In the end of course, the market maker is going to factor these into his spreads, which is going to pass onto the investor. So even a tax for a very small amount like 0.25% can grow very rapidly? In the end, this also encourages consolidation. The economics would be in favor of the ETF agent not acting as a complete fidicuary, but rather it would encourage the creation of ETF agents who function as market makers as well. It would also encourage the creation of assets to “game” the metrics of notional value on which a tax would probably be based — undoubtedly there is risk this could drive volume away from transparent public exchanges, and towards opaque, bank led markets.

Posted by Graham | Report as abusive

Felix — I am totally in agreement with you Krugman on this. Why not mandate say 0.25 % of every purchase or sale of a stock or bond or other fancy financial instrument?If you are a serious investor you are looking at mispricings not of 0.25 % but of 10% or 30% or 100% etc. Those who believe that they find intrinsic values to within a precision of a few percent or less are fools.Real investing serves a social function and it takes many months or years. Those who invested and held oil or drillers starting 5 or 10 years ago did a useful thing and saw great profits as a result. Those funds encouraged and helped finance more drilling and searching for oil 5 and 10 years ago. Looking back, that (now) found energy is terribly important in this world of energy tightness and more should have done. To the extent that oil price increases five years ago have pushed energy breakthroughs in autos, etc. today and going forward, even better.And guess how many transactions you would have needed to do this? Just one or two. A single purchase of oil driller or two or an oil index. Over the last 10 years you would be sitting on a several hundred percent gain. You would have paid the transaction fee just once, barely noticable.To take a less mundane example, John Paulson’s greatest trade in history just involved a handful of positions held for a few years from the height of the housing bubble to its bitter low. A transaction fee would barely have registered. He served the useful role of leaning against a horrible housing bubble, almost alone. The world would be a better place right now if more people had bet against housing, fighting the bubble.

Posted by Dan | Report as abusive

A transaction tax is not significantly different from any other transaction cost. Historical markets functioned perfectly reasonably in the presence of much greater transaction costs. A small transaction tax is not the end of the world.Consider the regulated brokerage commissions of the past (which typically induced small investors to buy-and-hold and kept brokerages occupied with re-selling existing stocks rather than building crazy new securities). These investors’ costs existed along with more expensive costs for brokers with no real harm to the underlying capitalist system.Consider the past fractional pricing of stocks and consequent wider spreads. We did fine under this regime. Of course it’s nice to get penny spreads and low-cost transactions these days, but there’s no real reason that we need to absolutely minimize transaction costs so that HFT can arbitrage away fractions of cents differentials between various assets. No one is harmed when you can buy slightly different forms of the same asset at prices .5% apart and transaction costs make the arbitrage impossible – buy the cheaper one if you want to be long the underlying, sell the more expensive one if you want to be short the underlying, and don’t worry about the tiny sliver of irrationality that will probably dissipate in a fairly short time under normal buying and selling pressure even without cheap arbitrage. For instance, closed-end funds are very hard to arb and no one cares – sometimes idiots lose out buying them at a premium and sometimes those who don’t mind taking liquidity risk do well buying at a discount and holding. I don’t have a problem with either of these situations.The talk we should be having is what level of transaction charges appropriately bill the investing community for the benefits that government regulation confers on it and fund the government more efficiently than other sources of revenue. Given that there’s no compelling social benefit from rapid-fire trading and obvious harm done by those who rely on the ability to enter/exit/hedge risky positions rapidly and expect bailouts when they fail, why not penalize those who trade heavily rather than raise income taxes on the more sedate? The alternative is not the utopia of frictionless, tax-free investing where we all become effortlessly rich due to the magic of the unfettered market, but the world we actually live in. If you make investing too easy all you get is lots of morons flooding into risky assets at the top of markets and flowing back out at the bottom. A little bit of friction can help to encourage people to think about what they’re doing and make decisions carefully about where to direct capital and how much risk to take.

Posted by najdorf | Report as abusive

Najdorf (love the chess reference by the way),I agree with you that the world won’t come to an end if every asset trades like a closed-end fund, but that doesn’t mean it is particularly desirable. I’m trying to point out how there is value in middle men and short-term holdings. Sure, we could outlaw supermarkets and you could go to a Farmer to buy your produce and a Colgate factor to buy your toothpaste — the world would go own. Of course, what might happen is that a black market could emerge for produce and toothpaste could develop (read McMafia you will get a right explanation about the trials and travels Cigarette smugglers go through, and how it has encouraged Crime in Eastern Europe). Similarly, banks might go to to the same steps to “game the notional value” metric of a transaction tax or take their business oversees. The notional on a triple leveraged ETF is 1/3 right, so it’s cheaper for a tax point of view, right? Options would be a cheaper version of trading the underlying right? Unless Congress implemented a “VAR based” transaction tax, you probably going to be helping to promote the employment of thousands of swap lawyers coming up with interesting new structures, the end result being that little guys are worse off.This is a lot of work to go to unless you are convinced that short term holding is really what caused the crisis, and again, I would argue that it is excess concentration of a firm’s capital in a trade (or set of related trades) that cause our problems, not whether or not the trade was short or long term in time horizon. None of the financial insitutions that failed or were bailed out were relying on the ability to “exit risk positions rapidly,” they were instead relying on their belief that they NEVER had to exit risky positions. Do you think AIG decides against selling CDS out of control because of a small tax? Or that Citigroup stops its series of mega mergers?My point is that you’re imposing additional costs without exacting any benefits, and in fact encouraging the use of fancy derivatives and TBTF banks. If you want to prevent another economic crisis, tax excessive bonuses, excess concentration risk, transactions not marked to market [this allows the flexibility of not immediately crushing the capital of banks, but encouraging future mark to market], or transactions done away from public exchanges — almost none of the financial instruments that caused the crisis were traded on public exchanges were there is price transparency.I agree that the world won’t come to end if everything trades like a closed end fund, but that’s not the same as saying it was the cause of the crisis. The arguments you make about “fractions of a cent” don’t hold water by the way, in the UUP example I gave, I illustrated how there could be a total of 7 transactions. At a price of $22 per share, with a charge of 0.25% per transaction, that works out to $0.385 to the end investor. Again, it’s not going to cause Armageddon, but it’s passing on costs that he shouldn’t have to pay, and the end result is going to be much lower volumes on public exchanges (where there is open price compeition), minimizing the actual revenue collection of the tax, while migrating volumes to non-price competitive private derivatives transactions specifically designed to circumvent the tax.And to your argue of “buy the cheaper, sell the more expensive one,” that obviously doesn’t work if you’re trying to exit your position and don’t want to hold assets on your books and tie-up capital until the end of time. Even Warren Buffett has liquidated some positions last time that I checked. For instance, Buffett got out of positions in railroads Union Pacific and Norfolk Southern when he acquired Burlington. If Warren’s sales in UNP and NSC can help an individual investor planning for retirement using an indexing strategy in the S&P 500 buy more cheaply, and Warren sell at a better price, where’s the harm in that? There certainly are some benefits. But make no mistake, if under a transaction tax, SPY was trading at premium, there’s no way Warren would sell SPY, and buy the other 498 components, because he’d get killed on the financing of wearing a zillion open positions on his books.-Graham

Posted by Graham | Report as abusive

Dan,As someone who committed the majority of his liquid net worth to starting a business during the middle of the financial crisis, providing many people with jobs and without any expectation of getting this money back for several years, I completely agree with you that real investment requires a timespan of years and that 0.25% percent is largely irrelevant to real investment.However, that doesn’t mean that all financial transactions that serve a social purpose are the same as “real investments.”For instance, you receive a paycheck from your employer. That money gets transferred first from the customers of your employer to your employer, then to a payroll company like ADP, then to your bank account, where perhaps they are transferred to a money market fund, which may purchase short term debt of a highly rated company. Now let’s say 6 months later, you and your wife decide to put a down payment on a house, because you think it would be a great place to raise a child. The money market fund liquidates its position in the debt by selling to another money market fund, the money is wired to your account at a bank, which is then transferred to an escrow account at the seller’s bank, and ultimately to the account of the seller.How many financial transactions are involved there? My point is that unless you come up with a very rigorous definition for “valid transaction” versus a “invalid transaction,” then you’re going to be taxing all sorts of transactions that serve a useful purpose, or exposing the tax code to manipulation through the creation of all sorts of financial instruments based on evading it.To go back to your example of oil companies, oil companies commit vast amount of capital to pull oil out of the ground, and thus have a huge expose to the price they are ultimately able to sell it for. As a result, they engage in all sorts of financial transactions with many different counterparties and stages along the way –examples could be constructed with just as many examples of capital transfer.And one of John Paulson’s biggest holdings currently is Bank of America. I am not a big supporter of the banks, but needless to say, they engage in all sorts of financial transactions.-Graham

Posted by Graham | Report as abusive

Graham –Fine points, well said. You are likely right that is could cause a lot of unintended consequences.Still, I hate that microarbitrageurs present a hidden tax that doesn’t even go into the public coffers. You can bet that every time an oil company or a teacher’s pension fund engages in market transactions, a Goldmanite is front-running that action through high frequency trading.In any case, this hat’s off to you for your personal role adding to this economy.

Posted by Dan | Report as abusive

Treasury bonds are not riskless. T-bills maybe, not bonds.

Posted by lance | Report as abusive

I am amazed that economists/politicians (one group advises the other) are unable to focus on the singular problem faced by the western world. The overall level of indebtedness 3.7x GDP in the US. A financial transactions tax does nothing to address this issue and for economists/politicians to decide that short term trading is socially useless is subjective and such strategies had no bearing whatsoever on this crisis. I exclude High Frequency Equity trading as there are possible legal issues surrounding such strategies but they are being slowly addressed. That aside, a financial transactions tax is a blunt instrument that will lead to a significant fall in liquidity as other short term liquidity provisioning strategies become unprofitable. Signals would have to be lengthened to adjust for the tax and transaction frequency would collapse. The US is justified in its decision to spurn such a move as it will deepen US markets at the expense of European competitors.

Posted by James Arnold | Report as abusive

I’m not sure why anyone would want to discourage the use of leverage in short-term transactions specifically — that’s the only kind of transaction in which leverage is prudent, after all — it’s ok to buy 10y treasuries at 10-20x leverage, because they can be sold in an instant if necessary. It’s not ok to use leverage in long-term investments that cannot be converted into cash — that’s a sure recipe for bankruptcy, as this crisis has only revealed too well.Further, repos are not just used to lever up treasury holdings — a bank has to park its excess capital somewhere, and the most common and prudent choice is risk-free securities like governments (t-bills, notes or bonds). When some of that needs to be accessed for cashflow, it’s easiest to convert into cash by doing a repo transaction, rather than constantly selling and buying back the securities themselves (which would mean also constantly rehedging interest rate risk).

Posted by nivedita | Report as abusive