Missing the mark on mark-to-market: the arguments against the Camp plan to require mark-to-market accounting for non-traded speculative derivatives.

Author:Stewart, Robert D.
Position::House Ways and Means Committee Chair Dave Camp
 
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  1. INTRODUCTION II. DERIVATIVES: SPECULATION, TAXATION, AND ARBITRAGE A. What Is a Derivative and What Is Its Purpose? 1. An Introduction to Derivatives 2. Naked CDSs: The Exemplary Speculative Derivative B. The Role of Derivatives in the Financial Crisis C. U.S. and IFRS Tax Regimes for Speculative Derivatives 1. Tax Treatment of Naked CDSs in the United States 2. Tax Treatment of Naked CDSs Under IFRS Accounting D. Arbitrage III. THE DRAFTS A. The Discussion Draft of January 2013 B. Suggested Changes to the Taxing of Speculative Derivatives C. A Lowered Risk of Arbitrage D. Mark-to-Market and Speculative Derivatives: Square Pegs in Round Holes IV. CONCLUSION I. INTRODUCTION

    On February 26, 2014, Representative Dave Camp (R-Mich.), Chairman of the House Ways and Means Committee, released a new discussion draft for tax-reform, entitled the "Tax Reform Act of 2014" (the "2014 Draft"). (1) This 193-page draft was the culmination of over a year of debate and revisions following the piecemeal release of discussion drafts in the early months of 2013. (2)

    One of the 2013 discussion drafts was entitled "Holding Wall Street Accountable And Protecting Taxpayers By Creating A Simpler, Fairer Tax Code: Financial Products Tax Reform" (the "2013 Draft"). (3) The stated purpose of the 2013 Draft, authored by Representative Camp and former Senator Max Baucus of Montana, was "to modernize tax rules to minimize Wall Street's ability to hide and disguise potentially significant risks through the abuse of derivatives and other novel financial products," (4) which the authors held to be a "contributing factor to the 2008 financial crisis" (5) (the "Financial Crisis"). This purpose has been carried over--with slightly different language--to the 2014 Draft. (6) In fact, much of the 2013 Draft has been incorporated into Section E of the 2014 discussion draft (the "2014 Draft")--but with some differences that will be discussed when relevant.

    To advance the goals stated above, the 2013 Draft and the 2014 Draft (collectively, the "Drafts") both proposed several changes to the taxation of "derivatives and novel financial products." (7) One of the more fundamental of these changes would require the "marking-to-market" of speculative derivatives, (8) a change intended to "provide a more accurate and consistent method of taxing these financial products and make them less susceptible to abuse...." (9)

    Furthermore, while not a stated goal of the Drafts, the changes could--depending on the implementing regulations--harmonize U.S. tax accounting of speculative derivatives with the International Financial Reporting Standards (IFRS) standards (10) used in Europe. This harmonization could in turn have the salutary effect of contributing to a reduction in regulatory or tax arbitrage between the two jurisdictions. (11) Indeed, this part of the reform nearly acts like the independent domestic implementation of an agreed international standard--a common methodology for enacting agreed standards without the force of hard law treaty agreements (12)--even if the mark-to-market standard being implemented is not part of any soft law agreement.

    In short, the goals and results of the proposed changes seem desirable, as they could quell bubbles and lower market risk while reducing room for arbitrage between the world's two major tax accounting systems. (13) This reduction in arbitrage could in turn prevent buildups of risky speculative investments in jurisdictions with looser standards or more favorable tax regimes. (14) If all of the above happens, it would support Representative Camp's stated purpose. (15)

    Still, despite the potential benefits, the Drafts' provision that would require the marking-to-market of speculative derivatives will be nearly impossible to regulate and administer as it currently stands in either of the Drafts. To implement properly and effectively, mark-to-market accounting requires access to current fair market values (FMVs). Unfortunately, FMVs are not easily accessible--or even practical--for some speculative derivatives such as naked credit default swaps (CDSs), as there is no suitable liquid market that can give useful insight into prices and values. (16) And while it is true that there are ways of computing rough approximations of FMVs, these can end up being speculative or subject to "gaming" as they depend on subjective as well as objective factors. (17) An accounting system that demands an input that is unavailable or relatively untrustworthy is not a suitable fulcrum around which harmonization should pivot.

    Therefore, as a next step to improved international financial regulation from a domestic-tax perspective, the authors of the next draft should focus on determining which speculative derivatives contribute the most to systemic risk. Following this initial consideration, the authors should then conclude which of these systemically risky derivatives are the most susceptible to changes in the U.S. tax code. This conclusion will depend in large part on whether it is possible--or even desirable--to find approximate FMVs for speculative derivatives whose true values depend on future events such as the default in a stream of payments on an underlying security.

    It is the goal of this Note to lay the groundwork for the above-described topics of consideration. To that end, Part II of this Note describes and explains derivatives and some of their more common uses; introduces the U.S. and IFRS tax regimes for speculative derivatives; examines the problems with using mark-to-market accounting for speculative derivatives under the new IFRS standards; and considers incentives for using gaps in these tax regimes. Part III introduces both Drafts; describes the derivatives taxation proposal in detail; notes the changes between the two Drafts; discusses the implications of these changes; and shows that while the mark-to-market proposal in the Drafts could lead to reduced chances for arbitrage, mark-to-market accounting is not well suited for use with certain speculative derivatives like naked CDSs and could prove quite difficult to implement.

  2. DERIVATIVES: SPECULATION, TAXATION, AND ARBITRAGE

    While this Note is not about derivatives per se, it is about the utility and practicality of a tax proposal that is intended, at least in part, to change the incentives for using derivatives. Thus, we must first examine the concept of derivatives and their function within the broader economic system. Because the drafters connected this issue to the Financial Crisis, we must also examine the role of speculative derivatives during those difficult months to understand what the drafters are hoping to fix.

    To these ends, Part II.A introduces derivatives and describes some of their more common uses. Part II.B outlines the role speculative derivatives played during the Financial Crisis, a history that is very much in the mind of policymakers as they attempt to reduce systemic risks in the domestic and global economies. Part II.C introduces the U.S. and IFRS tax regimes for speculative derivatives (in particular, naked CDSs as the exemplary speculative derivative for purposes of this Note) and notes some of the primary difficulties faced by IFRS with respect to mark-to-market accounting and FMV valuation for non-traded speculative derivatives. Finally, Part II.D describes how gaps between tax and regulatory systems can contribute to the possibility of arbitrage between different systems. Note that readers who are well-versed in derivatives and speculative derivatives as well as in the role played by derivatives in the Financial Crisis may wish to skim or skip over Parts II.A and II.B.

    1. What Is a Derivative and What Is Its Purpose?

      1. An Introduction to Derivatives

        At the simplest level of abstraction, a derivative "is a financial contract whose value is based on, or derived from, the level of some agreed-upon benchmark" (known as an "underlying"). (18) This benchmark is derived from the price of other financial instruments, including "stocks, bonds, commodities, currencies, government or corporate debt, home mortgages, interest rates, exchange rates, indexes that reflect the value of some bundle of financial products, or any combination of these." (19) Derivatives themselves are not connected to some tangible "thing" but to the value of another financial instrument, or even some other value entirely. (20) Confusingly, financial instruments that are not considered derivatives can resemble financial instruments that are usually thought to be derivatives, which means that a careful definition is essential to the principled treatment of derivatives. (21)

        Derivatives exist in large part to mitigate and manage risk. (22) Indeed, the history of derivative-like instruments being used for this purpose has been traced back at least as far as the days of Babylon and its famed creator of laws, Hammurabi. (23) Derivatives have also been used to hedge against speculative bubbles, such as the infamous "Tulip Bubble" in Holland in the seventeenth century, (24) and long periods of volatile prices led to the creation of swaps to hedge against the risks created by speculative bubbles as well as other foreseeable exogenous factors. (25) Today, derivatives are an indispensable part of the modern economy, used by numerous firms to manage and hedge against risks such as gas prices, currency prices, inflation, interest rates, and numerous other economic variables. (26)

        Of course, derivatives need not be used solely for risk management. For instance, investors can buy derivatives linked to the stock indices of a developing country, to individual sectors of developing countries, or to the price of a crop in a certain region. (27) Such purchases can diversify investors' positions, allow investors to reap gains from the growth of countries and sectors otherwise difficult to invest in directly (these positions may also serve a risk management purpose, as they may hedge...

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