European Traders May Face Financial Transaction Tax

Earlier this week, eleven European countries were given the green light to implement a financial transaction tax according to an article from the Associated Press (AP). The story was subsequently picked up by the Wall Street Journal (WSJ).

According to the AP, the European Commission proposed "that trades in bonds and shares be taxed at 0.1 percent and trades in derivatives at 0.01 percent." Since these taxes will be based upon notional values for derivatives, the tax could be a large increase in the transaction costs associated with these instruments. For a similarly structured proposal within the United States, see the HR4191 bill introduced in the US Congress in December 2009.

The logic is that a small transaction tax would discourage risky bets and, as an ancillary benefit, fund the rescue of banks. Algirdas Semeta hailed the agreement as "a milestone in global tax history." The tax is estimated to raise upwards of €57 billion per year if it were applied across the European Union.

Oliver Wyman conducted a study in January 2012 on the impact of the financial transaction tax on FX markets and concludes that such a tax would "increase transaction cost for all transactions by 3-7x and by up to 18x for the most liquid part of the market."

One problem with implementing such a tax is that it needs to be implemented universally or else the transactions will likely just take place elsewhere. In fact, according to the Wyman report the implementation will "cause a relocation of volumes that could reduce liquidity and thereby increase indirect transaction costs by up to a further 110%."

The relocation problem has been addressed by imposing the transaction tax "on both the buyer and the seller of a financial instrument, as long as either of the two parties is based in one of the participating countries or acting on behalf of someone based in one of those countries," according to WSJ article.

It is possible that such a tax would be a significant hindrance to high frequency traders if a suitable relocation scheme is not possible. These traders typically have the largest volume of trades and some of the slimmest margins (frequently limited by the tick size of the asset). It seems unlikely that such a tax will discourage low-frequency risky bets and more likely that the costs will simply end up increasing costs associated with pension funds and retirement accounts. We'll be watching this story closely as it develops.