Kirsten Wegner, CEO of the Modern Markets Initiative, writes that news from the US came earlier this year that the New York Stock Exchange is preparing to hand human traders a bigger role making markets for exchange traded funds (ETFs).
Here, we witnessed yet another milestone in the rapid ascent of these trading vehicles into mainstream American investing. Over the past decade, demand for ETFs has grown markedly as investors – both institutional and retail—increasingly turn to them as investment options. In fact, the most popular ETF, the SPDR S&P 500 (SPY), routinely trades over 100 million shares a day. According to the Investment Company Institute, share issuance of ETFs over the past decade has totaled USD2.1 trillion in equities, bonds, commodities and currencies. It’s been an exciting area of growth for retail investors, and an opportunity for investors to hedge their risk amongst a variety of assets in a basket by “theme.”
There are many examples of types of ETFs, and many different investment strategies, but essentially many ETFs have offered a way for individual average investors to hedge the risk of investing in a single stock, and to invest across asset classes.
But overlooked in the current discussions of ETFs is legislation introduced by Sen. Bernie Sanders (I-VT) and others that seeks to tax ETF transactions.
Recent proposals of the financial transaction tax (FTT), show that a 10-basis point FTT would actually have a 20 to 30-basis point impact on the ETF industry. This is because the FTT would not just tax the underlying transaction and increase the ‘spread’ on the cost to buy and sell a stock but would also tax the underlying structure of the ETF.
In many cases, there is more than one transaction in order for a market maker to provide liquidity for an ETF. The business model of an ETF often includes not just the transaction on the ETF, but also a hedge transaction on the underlying investments.
In short, for a 10-bps retirement tax on cash equity transactions, one would expect that market makers would need to widen spreads in US equity ETFs by approximately 10-bps x 2 = 20-bps in order to cover the increased costs. The factor of 2 is driven by the tax being incurred both on the ETF transaction and the hedge in the basket of equities that the ETF tracks.
This means that the increased round-trip cost to a long-term investor wanting to trade a domestic equity ETF would be 30-bps (10-bps of their own transaction tax plus the 20-bps of wider bid-offer spread), assuming they purchased the ETF at the offer and then later sold at the bid.
While many in the political class in Washington are framing their FTT push as a revenue-generating movement that will only impact the wealthiest Americans and financial institutions, the truth is that they are misguided. The tax would have a staggeringly negative effect on the average investment portfolio. At the end of the day, those bearing the cost of the FTT on ETFs would be mom and pop investors, pension funds, and other investors who rely on ETFs as a vehicle to advance their secure retirement while hedging the risk.
Kirsten Wegner is the CEO of the Modern Markets Initiative, an education and advocacy organisation devoted to the role of technological innovation in creating the world’s best markets.
