Volume, Liquidity . . . and Taxes?

I recently spoke at the annual Tax Day hosted by the Committee of Banking Institutions on Taxation (the “CBIT”).  Prior to my presentation there was a panel that analyzed one of the discussion drafts released this year by Rep. David Camp, Chairman of the House Ways and Means Committee.  The panel focused on the discussion draft in which the Chairman proposed that all financial derivatives be marked-to-market on an annual basis and subject to ordinary income tax rates.  However, unlike other discussions I’ve seen on the subject this one focused not on the myriad tax problems that may occur if enacted as proposed but rather the market and trading issues.

The gist of the analysis was that by employing mark-to-market and the ordinary income tax rate (as opposed to the lower capital gains rate), the tax would drive investors to trade physical securities or not at all.  The knock-on effect would be that volumes would be driven lower and liquidity would decrease.  The panel made the case that taxation would hurt the market overall through these unintended consequences.

As a tax policy matter it is unclear what ill the Chairman is trying to cure with this proposal.  There was some suggestion that derivatives are causing distortions in certain markets, that they played a significant role in the financial crisis and that the tax electivity associated with derivatives is unhelpful and unwarranted.  This last point is the only one that makes any sense and has any hope of being alleviated by the proposal.

Personally, I found the arguments that trading would be severely impacted by the tax change somewhat specious.  Will institutional investors stop trading because the effective tax rate has increased?  I would tend to think not.  Perhaps they might trade in physical form rather than derivative form but that would not necessarily impact volumes or liquidity.  I suppose it is arguable that derivatives cause an increase in volumes and hence liquidity as compared to comparable physical trading.  Generally, when an investor trades a derivative with a financial institution the institution will delta hedge the position if the delta is less than one.  The periodic trading necessary to delta hedge will, over time, cause a greater total volume than if the investor had just executed a cash trade.

Nevertheless, there are good arguments that this will not happen.  First, many derivatives are already marked to market for tax purposes.  Exchange traded futures, broad based index options, and other so-called “1256 contracts” already get marked (albeit at a tax rate significantly lower than what is called for under the Camp proposal).  Second, those who trade derivatives normally do so to express a particular economic view which would be difficult and / or expensive to execute in physical form.  Finally, it is hard to imagine that a higher tax rate might cause investors to stop trading.  Perhaps the trading may be done in a more thoughtful manner but it would continue.

The Camp proposal does contain one provision that will hurt trading.  The proposal calls for built-in gain (but not loss) in a particular position to be subject to immediate taxation if the investor hedges the position (that can occur with call overwriting as well as downside protection).  This part of the market would surely be impacted in the short term.

The key takeaway for me however was that tax reform is moving forward and there will surely be non-tax effects.  We should all be cognizant of how tax reform will impact our individual industries.  Sweeping tax changes will surely create problems for some businesses but it will just as surely create opportunities.  If you would like to discuss how tax reform might impact you or your business please contact your regular WithumSmith+Brown partner.

Tony Tuths


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