Note: This response is authored by CPEG’s Bill Barclay in response to a February 16th Editorial in the Chicago Sun-Times regarding the potential for a “LaSalle Street Tax”, a very small tax on the trading of financial assets. You can download a full Q&A on the Lasalle Street Tax here.
First they ignore you, then they laugh at you, then they fight you…
…and then you win.
The gathering momentum behind the LaSalle Street Tax (LST) is moving us through Gandhi’s stages faster than we expected. The most recent evidence that this momentum can no longer be ignored comes from the Sun Times February 16th editorial, which endorses such a tax in principle. While attacking the proposed level of the LST, the editorial says “a very small Chicago tax might make sense.”
Of course, the Sun Times would limit the revenue collected to tens of millions of dollars, while LST advocates are talking billions. As they say in finance, it’s a wide market – but that’s what negotiations are for. So, let the negotiations for an LST begin.
Condescendingly, the Sun Times considers the expectations for the proposed LST akin to belief in “pixie dust.” The paper is suggesting that LST proponent’s arguments ignore reality. However the editorial reveals that the Sun Times is itself well stocked with pixie dust.
The Sun Times endorses the notion that more trading is always better, worrying that the LST would drive trading volume down and/or away from Chicago. There is a huge amount of trading occurring on the Chicago derivative markets: more than $900 trillion in underlying value in 2014. Bear in mind, world GDP is $70 trillion and the US GDP is about $17 trillion. It is obvious that most of this trading is of the “socially useless” type described by Andrew Haldane, the leading UK regulator during the Great Recession. Further, there is evidence that such misdirection of resources hampers growth in the real economy.
But for now, we’ll accept the “more trading is always better” mantra. Before proceeding, let’s also be clear that the exchanges – the CME and the CBOE – would not pay any of the LST. The tax is levied on trading, that is the traders, not the exchanges. So, who are these traders, and how would they be impacted by a $1 and $2 LST?
Would a farm family hedging the soybean crop with contracts worth between $30,000 to $50,000 risk falling prices before harvest because of an additional $1 to hedge 5000 bushels? Would the pension fund manager using S&P 500 futures to quickly invest new inflows of money be deterred by the $2 LST on a contract worth more than $100,000? The LST would still leave the commissions charged for the trade well below where they were only a decade ago. What about the speculator who may take the other side of the trade with the farmer or the pension fund? And here I’ll reference myself: as I told the Sun Times, I have traded and still at times trade on these markets. The addition of the LST would make absolutely no difference in my behavior. I – if I were trading for a $1 per contract profit, I would look for another line of work. For probably obvious reasons, the paper chose not to report that part of our conversation.
Another interesting way of thinking about the LST is to compare it to actual prices available for trading in these markets, the bid/ask spread. The bid/ask spread is the amount you would lose if you bought one of the contracts subject to the proposed LST and instantly turned around and sold the same contract (or if you sold and then instantly bought the same contract). In grain futures that difference is $12.50 vs. the LST of $1. In various financial futures that difference can get as high as $25. Obviously the LST is a much smaller amount.
There is a category of traders who would be adversely impacted by the LST: high frequency trading (HFT) firms would definitely not like the LST. Who are these entities and what do they do? One example is Citadel Trading, founded by CEO Ken Griffin, a major contributor to the campaigns of Rahm Emanuel and Bruce Rauner. Citadel has made huge profits by extremely high speed submission, cancellation and trading of the products available for trading on the Chicago markets and elsewhere. Extremely high speed means hundreds of bids and offers in as little as a second.
When HFT activity first appeared in large amounts, the argument was advanced that this activity helped make the markets more liquid, allowing the farmer, the pension fund manager or the traditional speculator to buy and sell more quickly and at better prices. This claim has increasingly been challenged, and it faces a particular obstacle in derivative markets such as Chicago’s. There is no new wealth created in the trading of derivatives; wealth is simply transferred from one participant to another. The money I make on a trade, you lose (and vice versa). So, if HFT firms are profitable – and many are – those profits are coming at the expense of someone else. Perhaps the farmer? Perhaps your pension fund?
The Sun Times also argues that, if we adopt the LST, traders will move to lower cost markets. But, exactly….where?
Products traded on the Chicago derivative markets that would be subject to the LST are not traded anywhere else. Of course, the Sun Times might argue, another exchange could set itself up outside of Illinois, get permission from the industry regulator to trade products not exclusively licensed to the CME or CBOE and compete with lower trading costs since there would be no LST in effect on the new, competing exchange.
It is an interesting scenario – and we actually have a real world experiment testing the proposition that a difference in trading costs at the rates proposed by the LST would shift volume. In 2010-2012 the Electronic Liquidity Exchange (ELX) began trading several products available on the CME. The product specifications were identical. There was, however, one difference: the transaction, clearing and settlement fees charged by the ELX would be anywhere from $1.25 to $2 less than on the CME. The difference in trading costs was thus very similar to the level of the proposed LST. In addition, the ELX had the backing of JP Morgan Chase, Morgan Stanley and Goldman Sachs. You haven’t heard of ELX because, in their very best days, their total monthly trading volume almost equaled the daily trading volume in these same products on the CME. This experience reinforces the long time pattern of liquidity monopolies in derivative markets: when two (or more) exchanges compete in the same product, one captures all or almost all the trading. After trading moves to one market, it is extremely difficult to shift. It would undoubtedly have been economically rational for all participants in the CME products that were offered at lower cost on the ELX to move – at the same time. It was not economically rational for one or a few to move from the liquid to the illiquid market – at least for the small savings of $1 or $2 per contract.
The Sun Times implies the LST might be illegal (they give no reference to support this implication). In the past several sessions of Congress, several bills have been proposed that would levy such a tax nationally. Several of these bills have been assessed by the Congressional Budget Office (CBO) and other agencies with no questions raised concerning their legality.
The state of New York has had a tax on the trading of stocks since the early 1900s. Until the early 1980s, the tax was collected as an accepted part of the NYS budget. No one claimed the tax violated state or federal law. Since the early 1980s, New York has collected the tax but has rebated it to the brokerage firms – note, not to their customers. Governor Cuomo sought to eliminate the tax but found too much resistance and abandoned the effort. No one claimed New York was prohibited from collecting the tax.
So, what would result from an LST in Chicago? Probably some reduction in trading – we don’t really know how much. As the Sun Times notes, 30 or so countries already have some form of this tax and their markets seem to be functioning quite well. Most importantly, there is no evidence that markets with a tax on trading are less active than those without such a tax. The most extensive experience a tax on trading is with stock markets. Such a tax exists on several of the largest ones in the world, including the UK (the 4th largest in the world), Switzerland (the 10th largest in the world), and South Korea (the 9th largest by trading value in the world). Also worth noting: these taxes are levied at a considerably higher rate than the proposed LST.
Most of the decline in socially useless trading activity would occur as a result of the LST would be among those HFT entities that have turned Chicago’s financial markets into electronic sandboxes for people with more dollars than sense.
What are we waiting for?