Reducing Financial Complexity: A Different Take on Transaction Taxes

I’m working on a project that involves, among other things, looking at taxes on financial transactions, and I’ve thought myself into an idea that I’d like to float to our skeptical readership. The short version: Tobin taxes, Keynes taxes, and other financial transaction taxes have been sold on the grounds they would reduce price volatility. There is some controversy about this, and the case is not at all clear. I think, however, that increasing transaction costs could have the effect of reducing the complexity of trading strategies, and that might be a very positive thing.

The original proponent of a transaction tax was Keynes, who wanted to apply it to the stock market. He thought that it would have the effect of penalizing speculative strategies with high turnover, while rewarding buy-to-hold strategies. His views on financial markets as casinos are well known, and the tax proposal fits like a glove. Tobin, writing after the collapse of Bretton Woods and its fixed exchange rates, zeroed in on foreign exchange transactions. He worried about excess volatility in currency markets and applied Keynes’ logic to that sphere.

The argument about “real” versus “speculative” motives for transactions is plausible but much too simple. In particular, it makes assumptions about hedging strategies that are unfounded. The simplest version of such a strategy is that you take a position in the forex markets that is the reverse of the one you take in your real (goods and services) transactions. This means that you would double the volume of real trade to get the real-plus-hedged component of forex transactions, and as we know the latter is a vast multiple of the former.

But hedges can be quite a bit more complicated. One can try to hedge a variety of risk factors, not only exchange rates but also interest rates, commodity prices, etc., and these risks may interact in nonobvious ways. Moreover, one can shade or fine-tune a hedge, or generate a package of hedges that have properties that a simple reverse-position transaction cannot emulate. Without knowing the deep microstructure of these markets, it is impossible to know a priori how much of the transaction volume is risk averting (hedging) rather than risk-seeking (speculation).

Empirically, there have been studies that claim that transaction costs (which a transaction tax would augment) have been positively associated with volatility in foreign exchange markets. These, to my knowledge, have not been refuted.

As I see it, the intellectual and political winds have therefore shifted on transaction taxes. Keynes and Tobin wanted a tax big enough to change behavior, because they thought markets needed to be checked. Contemporary proposals, which are gaining momentum, have much lower tax rates precisely to avoid altering the behavior of market players. We are now hearing about a tax of a basis point or less on the value of transactions, not enough to change the way markets work, positively or negatively.

But I think the fixation on the terms of contracts (short term vs long) misses the point. A transaction tax penalizes a trading strategy according to the volume of transactions it entails. Consider again the hedge. A reverse position is the simplest hedge, and it consists of just one transaction. Granted, it may be too simple to meet the needs of sophisticated players, but this is not an argument for unlimited complexity.

Complexity renders market positions opaque and creates potential for systemic faults that are invisible even to the well-trained eye. Note that transaction costs fall as one moves from simple/actual transactions (like spots and outright forwards) to more complex ones (derivatives). Apparently such costs were not sufficient to prevent the emergence of fantastically complex strategies that entailed taking conditional positions in a plethora of markets simultaneously—a complexification that culminated in collapse. The conclusion appears to be that these costs need to be raised.

In other words, it is not the term of the trade that should attract a tax, but the sheer number of such trades to support a single position-taking.

I have argued previously that there was a dialectical relationship between the complexity of trading strategies and the extent of leverage. More leverage justified putting resources into increasingly complex strategies that offered minuscule margins. The perception that such mini-margins could be attained as a sure thing (all risk offloaded) justified leveraging that would otherwise have been viewed as outré.

Hence there may well be a case for a large enough transaction tax to alter behavior, but with a different purpose. The issue is not how much volatility it discourages, but how much complexity and inducement to excess leverage..