ANALYSIS-Transaction taxes, liquidity and patience
By Mike Dolan
LONDON, Sept 8 (Reuters) – The case for a tax on global financial transactions may have been perversely boosted by the relative success of foreign exchange markets through the past three years of world banking turmoil.
As markets in credit, interbank and securities lending malfunctioned and stock markets lurched violently, currency markets, for the most part, appeared to have a “good crisis”.
There was greater volatility for sure and some big shifts in foreign exchange rates as scared money barrelled across borders. But the world’s biggest market seemed to operate efficiently in the face of high stress and huge volumes, and liquidity and settlement held up without major disasters.
What is more, the world’s central banking overseer, the Bank for International Settlements, last week reported that worldwide foreign exchange turnover jumped by a fifth over the past three years to $4 trillion every day, roughly equal to the entire annual economic output of Europe’s largest economy Germany.
That means daily trading has more than trebled since 2001.
In a pretty bleak period for the financial industry at large, such a badge of success and its attendant profits would normally be welcomed with open arms and not a little pride.
But with the public and political mood gunning to reclaim some of the costs to taxpayers of serial bailouts of financial firms – some 2.7 percent of the Group of 20’s collective gross domestic product according to the International Monetary Fund – this may not be best time to crow about size.
* BIS report: http://www.bis.org/publ/rpfx10.pdf?noframes=1
* IMF view on bank levies: http://blog-imfdirect.imf.org/2010/04/25/fair-and-substantial%e2%80%94taxing-the-financial-sector/
* BoE paper on “Patience and Finance”: http://www.bankofengland.co.uk/publications/speeches/2010/speech445.pdf
Last year’s G20 summit in Pittsburgh asked the IMF to study the feasibility of bank levies and taxes to help fund any future banking rescues.
Interim reports show the IMF warming to value-added style taxes on bank profits but leaning against transactions levies like a Tobin tax, named after Nobel laureate James Tobin’s 1970s idea of levying 0.5 percent or less on all forex transactions as a way of smoothing currency volatility.
IMF Fiscal Affairs Director Carlo Cottarelli argued this would not be the most efficient way to address systemic risk issues and costs would likely just be passed to the consumer. But he did not rule out such a tax in other contexts.
Poverty relief campaigners, for example, advocate the tax as a way of raising funds to aid the world’s poorest.
What’s more, some form of transactions tax remains popular among major European governments such as Germany and France.
PATIENCE A VIRTUE?
But for all the debate about the purpose or efficacy of such a tax, and many agree it would be workable so long as it was global, an arguably bigger issue is whether there is too much trading in financial assets, and that such “over-trading” has no wider benefit beyond the industry itself.
The breakdown of the BIS data shows that only 13 percent of the $4 trillion turned over in an average day is with “non-financial customers” — essentially firms needing to change currency for real trade reasons and related hedging activity.
A whopping 39 percent of turnover is simply traded back and forth between the major dealing banks — of which about 20 mega insititutions are dominant. Almost half of dealing is conducted with other financial institutions — pension funds, insurers, hedge funds and the like.
The blizzard of cross-border holdings of stocks, bonds and their derivatives and ever-shorter holding periods of these securities is one factor. The inexorable rise of rapid-fire, computer-driven, or algorithmic, trading is another.
But the key counter-argument against staunching this flow is that the resultant liquidity, by acting as a shock absorber so that huge transactions do not cause destabilising price dislocations, is good for global trade and growth in itself.
Yet, is ever-increasing liquidity automatically beneficial?
An intriguing new paper by Bank of England director Andrew Haldane on “Patience and Finance” addresses this issue.
Haldane examined the dual human traits of patience and impatience and how it affects financial behaviour. He pitched momentum traders — those who impatiently rely on market timing to buy when the price is rising or sell when it’s falling — against longer-term value investors who buy when the price is “too low” or vice versa.
One suggested conclusion was the latter are being increasingly dominated and influenced by the former, whose trading performance has proved superior over the decades to all except truly-patient buy-and-hold investors like Warren Buffet.
The net result may be greater liquidity, he showed, but there’s ample evidence over 20 years to show a vast increase in securities trading and a drop in average holding periods; more volatility of prices compared to shifts in fundamentals; and much greater deviation of prices from measures of fair value.
“Liquidity unlocks the impatience gene. Investors whose judgment is wrong, but whose timing is right, can lock immediate gains,” Haldane wrote. But, “like information, liquidity can be too much of a good thing.”