Consider it a warning sign when legislation coming off Capitol Hill includes language – even before it is enacted – indicating a federal agency will need to simplify its related rules. As former Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) Commissioners, we know too well the complexities in implementing rules to carry out legislative intent. Even more concerning is when legislation will negatively impact the functioning of the derivatives and equities markets, as well as the millions of retail investors who invest in them.
Unfortunately, the Modernization of Derivatives (MODA) Tax Act features both worrisome elements: it includes a provision that pre-emptively gives the Treasury Department the authority to simplify some of the bill’s requirements, and it will impede markets’ functioning and harm retail and institutional investors alike. Plus, its name is a misnomer – the “derivatives” affected by the bill are not just complex structured products used only by institutions, but straightforward options that are essential for the stock markets to function properly. Investors use options to hedge or reduce risk in their portfolios.
On paper, the bill will raise $16 billion over 10 years by assessing taxes on derivatives’ unrealized gains or losses annually, regardless of whether the asset is actually sold. This means investors could pay taxes on income that they have not actually received. We do not have to commission a poll to say that most Americans would not support paying a phantom tax. According to a recent study, this change would “have an immediate, chilling impact on the options (and equities) markets” by driving liquidity and volume down across both.
The tax would have a chilling effect on investing – who wants to be taxed for what amounts to estimated hypotheticals? – that will cause investors to pull back from the options and stock markets, damaging liquidity in the marketplace in the process. High cost and high harm.
Proponents of changing derivatives taxation say they are only punishing derivatives traders. That tunnel vision oversimplifies how markets operate and misses the global picture. The derivatives and equities markets, while very different in the way they operate and are regulated, are deeply interconnected. For example, many retail and institutional stock market investors utilize the options markets to hedge and manage risk, which in turn provides liquidity in the stock markets. Drying up liquidity in the options or stock markets will widen spreads and increase volatility. We also find it sadly ironic that this proposal is being considered at the same time members of Congress and regulators are expressing concerns about the hidden tax investors pay when widening spreads increase the cost for retail trading of equities and options.
The scope of the potential impact of mark-to-market taxation to investors is massive. According to industry data, today there are more than a dozen equity options U.S. exchanges that list more than 1 million options contracts on more than 5,000 underlying stocks. Options markets are standardized; the options contracts are listed on exchanges, cleared, and heavily regulated with a fast-growing retail investor base. Meanwhile, more than half of U.S. households are invested in the stock markets through retirement accounts, mutual funds, ETFs, and other means. Given the interconnected nature of the markets, this tax would harm investors across income brackets and asset classes.
There is a reason this proposal has existed in some form for more than a decade, yet never gets enacted. It creates cascading problems that harm derivatives and equities markets and investors of all income levels, and it will not deliver expected tax revenue. On behalf of the options and equities markets we once oversaw and the investors who rely on them, we urge Congress to continue to oppose any form of this legislation.
Paul Atkins is a former SEC Republican Commissioner; Fred Hatfield is a former CFTC Democratic Commissioner; Jill Sommers is a former CFTC Republican Commissioner.
This op-ed originally appeared in RealClearMarkets on September 27 and can be found here.