The DeCarley Perspective...
The Commodity Markets have an Elephant in the Room: Financial Transaction Tax
As the election cycle heats up, like clockwork, talk of a financial transaction tax comes into the conversation. A decade ago, it was a fringe idea but in today’s environment, it is a mainstream solution to the government funding shortfall (I am using the term solution loosely). In other words, you could say things are starting to get serious.
Before an intelligent conversation can be had about the financial tax and the commodity industry, we would need to know the details. Obviously, those are few and far between. Thus, any preparation or guesses at the effects of the financial transaction tax are merely academic exercises at this point. The proposed rates range between 0.5% to 0.005% for stocks, bonds, and derivatives. Assuming a 0.1% rate for all financial transactions, investors buying $100,000 worth of stocks or bonds would pay a tax of $100 in addition to the traditional transaction costs. For a long-term investor, this would more annoying but probably not considered a deal-breaker. Although, a wonderful CNBC article was written by Greg Iacurci recently noting the Vanguard Group estimation that “every day Americans” could be forced to work an average of two and a half years longer to make up the shortfall caused by the tax in their retirement accounts. Nevertheless, if you apply the .1% tax to derivatives, namely options and futures, it is a game-changer (and that is an understatement). Let me explain.
If derivatives are charged based on face value, rather than margin requirement, the cost to hedge 1,000 barrels of crude oil could jump from under $10 to $80 to $100 (depending on the price of oil). Similarly, an investor wishing to sell and E-mini S&P 500 to hedge a portion of his stock portfolio could see costs skyrocket to $150 to $200 from under $10. Of course, this would slam the brakes on speculators as well as their costs also leap toward, or in excess of, triple digits. As a result, the futures market liquidity would dry up.
Obviously, there are those with the opinion that the derivative markets are unnecessary cesspools of speculation, greed, and corruption. I can attest to the existence of pockets of such, but as a whole, the derivatives industry is the oil (no pun intended) to the economic engine of the global economy. Specifically, the futures and options industry provides the most efficient and effective means of price hedging. Farmers, ranchers, portfolio managers, and multi-national corporations utilize commodity, financial, and currency derivatives to hedge their price risk exposure. As a result, end-users (the average Joe) enjoy a better experience and businesses of all sizes have a chance to manage operations in an economical manner. More importantly, the opportunity for producers to hedge reduces the odds of being forced out of business due to commodity market fluctuations. If producers are no longer able to go about daily operations without the undue stress of price uncertainty, it is feasible to assume supply and, eventually, upward pressure on prices of goods and services will become a real issue for the masses.
The bottom line is this: the futures market relies on exchange provided leverage to maintain liquidity supplied by speculators for use by hedgers. I anticipate the financial transaction tax, if applied to derivatives as has been suggested, would eliminate most speculators and liquidity would implode. While we wouldn’t know for certain until after the fact, conventional wisdom presumes market volatility would dramatically increase in a low liquidity environment. Thus, hedgers would likely have few reasonable strategies to curb price risk and consumers would ultimately pay the price.
The popularity of a financial transaction tax isn’t shocking; anything that appears to impact the minority is seen as a political “win” but in truth, the impact the tax has on the commodity markets would likely impact everyone. In addition to the obvious implications for savers; anybody using commodities in their every daily life could potentially see unusual price instability in products such as bread, milk, cheese, gasoline, natural gas, beef, pork, and even plastics. Further, a transaction tax could negatively impact price discovery in the currency markets, which has a profound impact on domestic consumers regardless of whether they ever step foot outside of the US border.
The real impact of the tax couldn’t possibly be known until after the fact. Government policies, regulations, and taxes commonly come with unintended consequences. One possibility could be, for instance, the US futures exchanges (Chicago Mercantile Group and Intercontinental Exchange) pack up and leave to countries that are more friendly to their business. This alone, would be a big hit to the economy. I once recall protestors in front of the Chicago Board of Trade building demanding a similar transaction tax; not unexpectedly, there was talk of moving the exchange to Houston to avoid the burden.
The financial tax would undoubtedly squash what is left of the futures and options brokerage industry. Brokers, software developers, educational content providers, etc. would be looking for a career change. Some might see this as a positive due to perceptions that speculators create volatility and I admit there is some short-sighted merit to this. However, it is ultimately supply and demand that determines market price; speculators are merely helping in the discovery of that price. It is a hairy process, but without liquidity, it would likely be even more so. In short, isn’t it better for price discovery to occur in the futures market rather than the end-user market (ie. grocery stores)? Further, if we want to blame speculators for pushing oil prices to $150.00, we must also give them credit for forcing crude oil to $26.00 in 2016. In other words, it goes both ways. The system might not be perfect, but many believe it to be the most efficient. The transaction tax is likely step in the other direction.
One last point to ponder. It is easy to create a law taxing each financial transaction, but it is a complicated and expensive process to calculate, collect, and remit those taxes to the government. Even if the commodity exchanges survive, the administrative costs will be like a weighted blanket. In a revenue tight environment, exchanges and brokerages will cut corners creating a less than stellar experience for market participants in which the impacts could trickle to everyday consumers.
In the spirit of full disclosure, my business and livelihood are like pennies on the track in the path of the financial tax freight train. My opinions are likely biased and are without a doubt emotionally invested. Yet, I’ve been in the commodity business since 2004 and I have an experienced perspective on how it all works. Despite short term budget improvements, it is difficult to imagine the long-term consequences to the general public, not just the wealthy, would justify putting this tax policy in place. Let’s hope it is all bark and no bite.
