OTC Derivatives Tax Plan Draws Fire

WASHINGTON - Market participants have been quick to criticize a bill proposed by Rep. John B. Larson, D-Conn., that would tax municipal and other over-the-counter derivatives, saying that the legislation could freeze the derivatives market by creating prohibitively high costs for such contracts.

The four-page bill, introduced July 9, would impose a 0.25% tax on the fair market value of the underlying "property" of the notional amount of a "covered" OTC derivative, which would include any non-exchange-traded option, forward, credit default swap, or similar financial instrument in notes, bonds, or "other evidence of indebtedness," as well as other swaps, commodities, currencies, and stocks.

The parties to the contracts would be individually and jointly liable for the tax. The parties may decide privately who will incur the tax.

"This legislation is about gathering the information we need to shed light on the dark, unregulated markets that contributed to the current economic crisis," Larson, a member of the Ways and Means Committee, said in a statement.

There are no official estimates on the tax revenues that could be derived from the bill. The Joint Tax Committee has not estimated the tax effects of the bill, according to a committee panel spokesperson. If approved, Larson's bill would only apply to contracts entered into after the measure was enacted into law.

But market participants, who doubt the bill will move forward, said the tax would generate significant revenues at the expense of issuers. While it appears the tax would not apply to municipalities, which do not pay federal taxes, it would apply to municipalities' bank or dealer counterparties and would make derivatives more costly as they take into account their portion of the tax, sources said.

The Securities Industry and Financial Markets Association opposes the bill, a spokesman said yesterday.

The bill also requires the Treasury secretary to provide to Congress an analysis of the scope and nature of the OTC derivatives markets, as well as the advisability of regulating those markets, based on the tax returns filed by the counterparties paying the tax. Currently, OTC derivative contracts are not publicly reported.

Industry groups tracking derivatives currently do not provide figures for how many contracts are entered into each year. Instead they show the aggregate notional amount or gross market value of all outstanding OTC derivatives, which was $33.9 trillion at the end of 2008, according to a May 19 release from the Bank for International Settlements.

The gross market value measures the cost of replacing all existing contracts and is a better measure of market risk than notional amounts outstanding, the BIS said.