Loopholes in securities transfer tax must be closed to level playing field
16 October 2012
Posted by: SAIT Technical
By Stuart Theobald (Business Day)
Executive summary (SAIT Technical)
Stuart Theobald discusses some objections against the growth of algorithmic trading ("algos") in the market. Algos need to have the lowest possible tradings costs which means avoiding Securities Transfer Tax. Brokers are allowed to transact exempt from securities transfer tax, an exemption that has existed since 1995. However, the exemption has led to widespread abuse.
RECENT estimates put the proportion of equity market volume driven by high frequency trading (HFT) at 60% in the US and at 35% in UK.
There aren't any reliable numbers for the proportion in South Africa, but some brokers I've spoken to think as much as 50% of volume comes from HFT or algorithmic trading. Such trading is driven by computer programmes.
As a result, the phenomenon of the "flash crash” has emerged in which programmes get into a trading war with each other, causing prices to spiral downwards until someone hits the off switch.
The JSE has now opened up space for traders to place their computers physically next to its own servers in order to shave milliseconds off the time between broker orders and the market. Most of the larger brokers are in on the game, hiring whizz kids to design the software to drive the trades. Profits are not large — the focus of HFT is to exploit very brief moments of mispricing, going for small profits on a large volume of trades.
There are, however, some serious objections to the growth of "algos” in the market. For "real” investors who are trying to build a position in a stock, algos can be an expensive annoyance. As a real investor posts a bid, algos flock around it, posting bids a cent different to try and force prices one way or another. Algos can use the fact that they can be milliseconds faster than a real trader to run circles around them. This has led to a fair bit of annoyance among traditional stock brokers. But algos can also be a force for good — they can be used by real investors to implement a trade, saving a little money by averaging into the market in a way not obvious to other algos.
There is one problem with the way algo trading happens in South Africa, as some of it looks to be illegal. For an algo strategy to work it has to have the lowest trading costs possible in order for it to generate a profit from tiny price discrepancies and rapid trades. That means algos need to avoid SA's securities transfer tax – the stamp duty of 0.25% that is levied on every share trade. Brokers themselves are allowed to transact exempt from securities transfer tax, an exemption that stems back to 1995. It was granted on the premise it would support brokers' role as market markers, which in turn improves liquidity leading to a net increase in volumes and securities transfer tax receipts. Last year, the tax raised R2.9bn.
However, the exemption has led to widespread abuse. One area is where banks use their internal broker to undertake basic hedging business for the rest of the banks' activities. The bank is in effect the principal and the broker the agent, which means these trades should not be seen as the brokers' own work. But when it comes to algos, there is another abuse of brokers renting out their exempt status to software programmers.
I have been told of a few large international brokers in South Africa doing exactly this. If third -party programmers are using a broker's systems to trade, it cannot be the case that the broker is the principal, which is critical determination of whether exempt status should apply. Usually, I am told, this form of trading works on a profit share basis — the broker charges no commission, but gets a slice of the profits.
Also, exempt accounts don't have the same capital requirements as normal ones, lowering the costs further for the algos. Amendments to the legislation governing securities transfer tax are working their way through Parliament but these are focused on the bank-broker relationship rather than the broker-algo provider relationship. The amendments specify that for the exemption to apply a broker "must own the shares and have the full ability to acquire and dispose of the shares without being subject to the direct or indirect approval of another person”.
A broker may be able to contort its relationship with an algo provider to fit this by making sure the software is technically owned by the broker and making sure that any human interventions can be undertaken by the broker. But even then it looks like the form and substance of the relationship is that of an algo provider generating profits by using the brokers' exempt status.
I'm not sure if HFT is a good thing. There are good and bad aspects to it. But if we are going to have a securities transfer tax, it should be applied consistently.
A better solution to the abuses would have been to widen its application, but reduce it substantially. Done cleverly this would leave the fiscus's take unchanged, eliminate the incentive to dress up algo-broker relationships into something they are not and remove the unfair advantage that brokers have over their clients.