One of the key drivers behind the rise in derivatives markets was the move by regulators to increase transparency in corporate bonds. In 2001, the Securities and Exchange Commission approved a proprosal by the national Association of Securities Dealers to report corporate bonds on an electronic system called TRACE.
This plan worked brilliantly. Regulators could monitor market activity. Market participants had much better pricing data. Corporate borrowers could check the state of markets to time their own issuances.
But Wall Street hated it. It made attempting to accumulate a position difficult because within a few minutes after you made a trade, your purchases were broadcast to everyone else. Credit traders immediately understood that it was far better to build positions synthetically in the derivatives market, which still traded just like the cash bond market did back in the days of darkness.
The lesson of this is pretty simple: financial markets are great at creating substitute products to avoid regulations.
And that's likely going to be exactly what will happen if Europe gets serious about its financial transaction tax. The tax will apply to stocks, bonds and derivatives. But it won't apply to currency trading, apparently because EU rules about the free flow of capital prohibit taxing currency trades.
Tim Worstall at Forbes points out that this is going to lead to the entirely predictable consequence of increased FX speculation.
So, if the tax is brought in we’ll just see all the speculation moving over to synthetics which include FX. And the tax will raise virtually nothing. Just as the current FTT on stocks in London raises not all that much as the speculation is done by contracts for differences, which aren’t subject to the tax.
Not being able to include FX in the FTT leaves a barn door wide open through which the markets will drive the whole coach and horses.
Quite simply, the tax will never work and yet that probably won’t stop them trying.
If something is this obviously predictable, can we even call it an unintended consequence?
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