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| The Dodd-Frank Bill signed into law earlier this summer by President Obama is a move toward the US Administration having, in due course, the administrative power to reorganize failing financial institutions deemed to be "too large to fail" and to protect consumers from obviously unconscienable, whether deliberately dishonest or sociopathic, actions by financial intermediaries. That's progress. But many people had been hoping that this anxiously-awaited major overhaul of regulatory powers over US banks and other financial institutions would address more directly a principal cause of the 2008-9 collapse of credit markets. John Taylor, president & CEO of the US National Community Reinvestment Coalition, says the new law is “a boon to Wall Street lobbyists, who will now be working behind the scenes to influence the regulators”. In Europe, the French and German governments are leading efforts, very broadly supported in the Eurozone, to impose a financial transactions tax (FTT) in order to build up a fund to insure against bank failures in the future. In North America and elsewhere that proposal is being criticized as introducing a moral hazard on the part of financial institution executives whom some say may be tempted to bet that their institution is too large for governments to let fail. Worldwide, bank leaders are naturally, of course, against any financial transaction tax. And at the level of central banks, the mathematical models of central banking naturally suggest to financial superintendents that increases in commercial/investment reserves such as those proposed by Basel III is the logical way to protect economies against failures of large financial institutions. Beefing up bank buffer capital will place an extra demand on private capital markets, however. Moreover this strategy may not work for long -- because innovation in derivatives, whether of products or markets, is today much more likely than in the past fifteen years to be motivated by the desire of those driving them to escape from the consequences of unwise speculative positions in which they are mired than by the aim of serving the real needs for future pricing certainty of principals in the real economy. Real economy principals want pricing and capital availability certainties in order to optimize extraction, production, distribution/retailing and event staging operations, and to complete socially valuable creative endeavours. Given that, why does the total of outstanding derivative contracts now amount to approximately ten times world GDP? In this context, is it not reasonable to suppose that regulators worldwide, especially those with an eye on getting trader jobs themselves, will to some degree be disposed in their hearts, whatever else they may profess, to prefer more work for regulators rather than a tax on the industry on which their livelihoods depend? An informal analysis by a former JP Morgan Managing Director and representative on the board supervising Long Term Capital's dissolution confirms what really happens to motivate the floating of derivative products. 2000+ pages of Dodd-Frank legislation plus bank capital buffering guidelines that make sovereign debt loans five times more profitable (and more bonus-supporting for bank executives) than loans to the small/medium enterprises that are typically directed to the development of a more sustainable and fairer economy may only be diverting us from rationally clear focus on the root issues. These appear to me to be (1) seriously conflicted interests in market-making and (2) improvident and/or rent-seeking in derivative contracts. Who can't think of a way these latter problems have imposed largely unrecognized externalities on the world financial system? But these two issues are now at last -- in journalistic, academic, and some central bank and major international NGO circles, at least -- beginning to be recognized as primary sources of the financial tsunami from which we all are now having laboriously and painfully to dig out. So perhaps now we can begin to face rationally the reality that, although regulation and buffer capital strategies may help avoid another tsunami in the short-term, true progress in balancing the real and derivative economies will not be made until serious action is taken to address these two primary sources of costly externalities. Are the G20 leaders clear about that? Do they and their staffs and political colleagues know they must urgently address the dysfunctional activities of derivative market principals? If so, a solution that does so with reasonable simplicity is likely to gain political attention. In this context, the word "dysfunctional" can be applied in two sets of circumstances. ONE was the speculative activity that led to such "crazy" price volatility as we saw in North American retail markets in the summer of 2009 in oil products: if it was not actively dysfunctional in exacerbating necessary price changes, was it as functional, productive, and healthy for the economy as a whole as such a vast amount of capital as was absorbed in that speculative activity might have been had it been productively employed by rational, as opposed to merely mathematically logical, speculative activity? The overall function in an economy of derivative trading is not to bail out improvident or ethically questionable financial principals, but to smooth necessary price adjustments so that extraction, production, distribution, and cultural event staging plans can be optimized by competent real-economy principals. And make no mistake about the reality that much trading in derivatives is done solely to bail out improvident financial principals. No less fierce a proponent of derivative markets than former Federal Reserve Chairman, Alan Greenspan, advised the Senate Banking Committee in 2003 as follows: “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so." That philosophy evidently sounded very innocuous to the US senators of seven years ago. But what we now can see actually happened in the next five years leading up to the 2008 Lehman failure was that risk was being transferred by increasingly complex derivatives to people who, if they thought (contemplating their prospective bonuses?) they had the capability to take it on, in actuality -- when the moment of truth arrived -- didn't. Worst of all, no one with executive responsibility at the top of the central banking, commercial banking, investment banking, trading, insurance, or regulation communities was acknowledging that was happening. On the contrary, the chief high priest of finance of that period, the Fed Chairman, was fascinated -- aided and abetted by thousands upon thousands of adoring worshippers of free markets -- by such simplicities as "the invisible hand always does best". What few understood in those heady days is that the necessary concomitant of free markets is diligent application of the intelligent human principle of either fully costing and charging for externalities or making them illegal. Was Greenspan thinking of the "players" in the derivative market as members of a self-entitled illuminati? Reading his remark, above, to US Senators of the Bush era, one wonders about that. The OTHER set of circumstances was the memetic presumptions by traders of never-ending increases in real estate prices -- a mania that presented market-makers having a cooler view of the end to such a boom with a conflict of interest. Those presumptions and indulgences in conflicts of interest were certainly dysfunctional because they fed inordinate bubbles of prices and investments that were bound, sooner or later, to burst. IF, therefore, speculative contracts can rationally be identified -- prospectively, from the perspective of the economy as a whole, as either functional or very likely to be dysfunctional, then a tax levied at the writing or exchange of a very- likely-to-be-dysfunctional derivative contract would usefully inhibit dysfunctional trading without throwing the "good speculation baby out with the bath water". But is such a prospective differentiation between functional and dysfunctional speculation both rationally and practically possible? Many say not. Yet close examination of the two poles in the spectrum of risk entailed in different derivative contracts suggests otherwise. One of the poles of risk is formed by derivative contracts that shift prices at a rate that correlates with the time horizon needed for intelligent planning of the supply of the real "good" at pricing issue. Such forms of speculation provide the utility to extraction, production, distribution, and event planners of an active market for assessments of uncertain future prices, and are therefore functional contributions to the economy as a whole. The other pole is formed by speculative contracts that, in contrast, change prices primarily because traders and market-makers want, even imagine they need, to trade and think they can either make a "killing" (and be bailed out when they make monstrous knaves of themselves!) or escape from shouldering the consequences of improvidently taken speculative positions. Such forms of speculation are oblivious to the reality that good quality planning by competent real-economy actors is rendered futile by the risk of disappearance of institutions such as Lehman or by wild price volatility such as occurred in crude oil futures over the summer of 2009 or by the flash NYSE market crash of May 2010. Engendering either workaholism or despair, and eventually cynicism and outrage, all of which attack social coherence, such forms of speculation require active and presently intelligent intervention. "Wall Street likes to characterize the proliferation of frenzied financial games as a sophisticated pro-social activity, facilitating the fine-tuning of a complex economy. But the truth is otherwise. Short-term transactions frequently act as an invisible foot, kicking society in the shin." -- Warren Buffett, quoted in an article by William Hanley in Canada's National Post of 100821 That the spectrum of different speculative contracts has this bi-polarity offers a means to distinguish the "good" speculation from the "bad". This is because, in general, the lengths of contracts that have effects more of the first character described above, i.e. are functional for the economy as a whole, are different from the lengths of contract sought only by financial intermediaries motivated strictly by making money in derivative markets -- without regard to honesty in the sense of the discipline of avoiding either falsehood or deception and of being reciprocally open about intents and evolving intentions in derivative markets. Therefore a tax on speculative contracts deemed, and we'll discuss this term in detail later in this paper, to be of the second character would render them prospectively less profitable, and would therefore be consistent with the mixed-economy free-market principles with which most people are philosophically and practically comfortable today. In sum, a tax on contracts identifiable prospectively as inordinately risk-laden, and we'll discuss that term also later in this paper, would diminish the incidence of the price volatility that renders any form of extraction, production, distribution, or event planning futile. Without inhibiting functional speculation, a tax on contracts deemed to likely to be of zero or negative functional contribution to the real economy would have the net effect of diminishing the high-frequency trading that has led to the derivative market growing out of all reasonable proportion to the real economy, and also the trading that amounts to "intra financial club externalization of the costs of prior unwisdom". The key word in this scheme is, of course, "deemed". It raises the question of who would do the deeming and, just as important, the practical question of how? To answer those questions, please consider a possible scenario. In it, three parameters that are common to all derivative contract are assessed automatically by computers to determine whether any particular derivative contract trade was aimed at meeting the needs for short or long term project capital of real economy actors or at spreading the risk of an already sunk capital investment, which de facto would then be considered a "bad" investment, and any attempt at resale of which can then only be considered a shortcoming in honesty, i.e. corrupt:
The fee contemplated in this scenario might be called a "differentiated speculative Financial Contracting Fee (dsFCF)". By contrast with this aim, a plain vanilla FTT would tax all derivatives as well as all other financial transactions. That blanket approach, while it can, if the tax rate is low enough, have some benefits in stabilizing derivative markets (as Stephen Schulmeister's November 2010 paper makes clear), also introduces unnecessarily devitalizing effects in financial transactions which clearly benefit the economy outside the "bankster insiders". In other words, the key criterion by which we can distinguish between a vitalizing dsFCF and a devitalizing FTT will be the accuracy and cost- efficiency of a dsFCF proposal in discriminating between intra-financial-institutional self-dealing (which primarily benefit "socially ruthless insider club members", aka "banksters"), and other financial transactions which benefit the economy as a whole. While not a cure-all, a dsFCF is likely to be more apt for the need and times than the blanket financial transaction taxes so far proposed as preventatives of another financial-economic collapse, and so we might call it alternatively call it a smart FTT. Here's why: 1. It's NOT the "Robin Hood" tax. The undifferentiated FTT, often called the "Robin Hood" tax by marketers who may have been too clever in evoking animosity from the speculator segment of the financial establishment, was first proposed, I understand, by Maynard Keynes in the 1930s to control foreign currency speculation. It went nowhere. Then in the 1990s James Tobin resurrected the idea and it took on with some academics, but never affected the thinking of any leading politicians. An undifferentiated tax would apply to all financial transactions, whether functional or dysfunctional from the perspective of the economy as a whole, and it would be unlikely to deter such people as the SocGen trader who lost his employer $7 billion euros or the Goldman Sachs Abacus mortgage players now under indictment by the United States Securities Exchange Commission 2. A differentiated speculative financial contracting tax levied at the moment of initiation (dsFCF) addresses the ROOT problem of derivative contracts being incoherent with the needs of the real economy. A dsFCF does NOT tax responsible trading conscientiously observant of conflicts of interest in derivatives (or, of course, the roughly 50% of stock or bond trades that are undertaken without the herding exploitation of high-frequency trading). Indeed, by refraining from doing so, it explicitly recognizes the issues of brokers, traders, and managers/sponsors/insurers of traders as they relate to making a contribution functional to the WHOLE economy. Such recognition will be reassuring to politicians, many of whom must necessarily be more inclined to believe the orthodox experts, i.e. senior private-sector bankers and central bankers, than to acquire the insights necessary to distinguish between the logical orthodoxies that are now ignoring of externalities and the creative rationality required to address current dysfunctions practically 3. Institution of a dsFCF will obviate much legal delay and cost. Legal processes continue, even with the descent of bankers to the position of society's most hated professionals, to be the object of much frustration and anger by both investors and investment fund managers and by the public at large. This is because, once a matter becomes legally controversial, progress tends to be slow, animosity rises, and the trauma of a lose/win result is always experienced. But the dsFCT's action would be transparent and final and thus would not afford any scope for legal processes 4. A dsFCF is calibrateable, democratically, to changing conditions. Regulators will not initially be very accurate in making the distinction between functional and dysfunctional speculation but, with some experience facilitated by a formal committee structure involving executives from both the real and derivative sectors of the economy, we can expect them to become much more accurate. In that light, let’s recognize that a learning curve must be climbed and also that such learning will only occur in the minds of people demonstrably committed to learning across the divides of conventional left-right politicized economics 5. A dsFCF would minimize, and perhaps obviate entirely, the additions of capital proposed by the Basel Committee on Banking Supervision. Because a dsFCF would directly attack the main problem, namely crazily speculative activities, rather than merely protect against them, a dsFCF would be a much more economic solution than the Basel proposals for beefed up reserved capital buffering, whether by contingent embedded capital or by any other form of capital 6. Lastly, the dsFCF concept meets all the criticisms of an FTT levelled by the IMF's June 2010 Report to the Toronto G20 Summit leaders. A detailed elaboration of this point is available by emailing the writer. A differentiated speculative Financial Contracting Tax (dsFCF) has not, to my knowledge, ever before been proposed. However, materials relating to how the ideas in this paper might be applied in practice are now in the hands of staffers at the White House, the German Chancellery, Downing Street, the IMF, the Committee for Global Financial Stability of the Bank for International Settlements in Basel, the Commodities and Futures Trading Commission in Washington, a private list of journalists at The Economist, the Financial Times, the Wall Street Journal, and the New York Times, and of influential associates of mine. At the last UN Conference to assess progress on the Millennium Development Goals (MDG), both French President Sarkozy, a conservative, and Spanish PM Zapateros, a socialist, urged world leaders to implement an FTT to fund flagging MDG progress. Later, French Foreign Minister Bernard Kouchner was vehement on the subject: "But this is not about replacing public funding - that's the message that the world must get through," he told reporters on 100921, speaking in French. "It's not a technical problem, it's a political problem. We need to have strong political will." Asked about possible opposition from other countries to the tax, the former founder of Doctors without Borders, clearly exasperated, switched to English and declared: "I know that they are not all in agreement. But it was the case when we founded Doctors Without Borders. It was impossible so we did it. Yes, it will be impossible, so we will do it," he said. The political context in which a dsFCT would be implemented is characterized currently by the G20 leaders facing not only rising current account deficits but also rising and now long-standing anger from voters whose contributions to their local economies were seriously jeopardized, and in some cases largely or completely wiped out, by the collective actions of banks in a "free market" ideological climate that by no means had all economists' or even bankers' approval. As of the last day of September, even Mark Carney, the Governor of the Bank of Canada, whose passage through the two years of credit crunch elapsing since the fall of Lehman has, until very recently, been markedly better than that of other, larger Western economies, is beginning to show concern. Given the rapid dissemination over the internet of the FTT idea known as the "Robin Hood" tax, either a dsFCF or, failing that a plain vanilla FTT is very likely sooner or later to become a tempting political possibility -- even a necessary action. Now borrowing 41 cents of every dollar spent, the United States particularly needs a new source of revenue -- one that helps adjust its economy to new ecological, economic, financial, and military realities. To illustrate this reality, consider what would have happened had a dsFCF been in place earlier this year when Wall Street was hiring traders in expectation of higher derivative trading volume. Clearly, the projected profitability of new hires would have been lower, and so fewer would have been hired, or re-hired. That would have been better than what became the case in the summer when derivative trading volume fell sharply and Wall Street leaders would have been wondering what to do with surplus staff. (Derivative trading volume is now rising). So, when all is said and done about the theory of a dsFCF, what we can conclude is that, IF a dsFCF had been in place earlier this year, Wall Street would now be better off, the US national deficit, now at a critical level, would have been lower, and at least some of the more flexible thinkers among derivative traders would now be re-employed in more useful activities outside an occupation that was instrumental in precipitating the 2007-8 crises in credit markets. Jean-Claude Trichet, the president of the European Central Bank, has warned that an FTT can only be implemented world-wide. Any less than global implementation by, say the Eurozone, would run the risk of losing local employment. But what if only the dysfunctional transactions were to be lost to a rogue trading jurisdiction? Wouldn't that not only make the Eurozone a stabler financial environment but also enhance the reputation, among the more ethically serious real economy principals, of the Eurozone's leading financial institutions? But, as Julie Dickson, the head of Canada's top banking regulator, said in a speech in Montreal on October 27: "There's no silver bullet to address the weakness that led to the crisis, and we cannot over-sell one element versus another." .. |
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| After Seoul: a Plain Vanilla or a Smart FTT? Why a "Calibrateable dsFCF" Makes Sense (c) 2010-11 by Angus Cunningham Principal, Authentix Coaches |
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| The author of this paper operates an executive coaching practice in Toronto with clients who include a manager of trading with a major Canadian bank. Educated at Cambridge and Wharton, and a McKinsey management consulting alumnus, Angus began his enterprise by leading a team that delivered the world's first electronic trading system built with open-system components -- to a Toronto-based bond trading house. In this paper he points out, after getting worldwide feedback from financial journalists, traders, investment bankers, lawyers, and a television producer, what remains unaddressed, or at least unfocused, in current regulatory initiatives, and proposes a differentiated speculative financial contracting fee (dsFCF). The dsFCF is a "smart" FTT in that it facilitates healthy and calibrateable coherence between the instincts of speculative "players" and the needs of the "real" economy. A blog facility is available for comment. |
| At the UN Conference on Millennium Development Goals French and Spanish delegations pushed strongly for a financial transactions tax (FTT). In most countries, options for addressing government deficits are running out because opposition to austerity measures are turning into voter anger that a declining number of G20 leaders will be able to face down and get re-elected. At the same time the battle for currency advantage is straining the IMF's abilities to get international collaboration. In the US Senator Crapo told attendees at the annual Security Traders Association in Washington on 100922: "A transaction tax is not off the table. You are advised to keep alert and vigilant." Stephen Harper, the G20 leader most vehemently opposed to any bank taxes, attended La Francophonie, where he no doubt met strong proponents of an FTT. And on 101106, the French President, the FTT's strongest proponent, reported that China will support France's plans for international financial reform when France takes over the G20 presidency in 2011. Then, at the Seoul G20 Summit, nothing was announced about an FTT. |