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WSJ: Options Market Fights Tax Plan

FEBRUARY 10, 2010
By TENNILLE TRACY

The options industry is gearing up for another fight over taxes.

For the second year in a row, the Obama administration has proposed to raise taxes on options market makers by more than 70% and to eliminate the special tax treatment they have enjoyed for decades. The move would raise $2.6 billion in new tax revenue over the next 10 years, according to Treasury Department estimates.

But given the important role that market makers play in options, ensuring liquidity by taking the other side of investors' orders to buy and sell options, the industry is trying actively to kill the administration's proposal.

The industry fears that the tax—which is garnering more interest given the government's need to raise more tax revenue to finance heavy spending—could drive some market makers away and make buying and selling options more expensive for investors.

"This is an idea that's been out there for a while," said Susan Milligan, senior vice president of government relations for the Options Industry Council. "But when it's in the president's budget, you have to take it seriously."

After trying unsuccessfully to increase taxes on market makers in last year's budget, the Obama administration made another attempt on Feb. 1, when it released its budget for 2011.

Specifically, the administration seeks to eliminate a tax rule, called the 60/40 Rule, that was adopted in 1984 as part of a compromise over mark-to-market accounting. Rather than impose traditional income taxes, the 60/40 Rule requires options market makers to pay long-term capital gains on 60% of their profits and short-term capital gains on 40% of their profits.

A repeal of the 60/40 Rule would require market makers to pay regular income taxes on all trading profits, resulting in a rate that's 72% higher than what they currently pay. While the blended rate currently amounts to taxes of about 23%, the regular income tax would be as high as 39.6% in 2011.

"All income from dealing in securities is active business income that should be treated as such, and not as capital gains," said a Treasury Department spokeswoman.

While many Americans could face higher taxes next year—in part because the administration wants to allow tax cuts for people making more than $250,000 to expire—the repeal could have broader implications for the options market, the OIC says.

The fear is that market makers could simply abandon their current roles if the risks of the job start to outweigh the rewards. If that were to happen, investors would find less liquidity in the options market, making it far more difficult to buy and sell their contracts.

Even if market makers stuck around, they would probably pass along the costs of higher taxes to investors by widening the spreads between bids and offers, which are the prices at which they're willing to buy and sell the contracts.

"Market makers are obligated to make two-sided markets in thousands of [options] and we're concerned about losing liquidity," said William Brodsky, chief executive of the Chicago Board Options Exchange. "So my response to people is that there are unintended consequences here."

The tax battle is part of a broader effort by the options industry to preserve the advantages that market-makers enjoy over other types of traders and investors.

Since market makers shoulder a lot of responsibility in options, the OIC and the options exchanges want to make sure that market makers find their jobs lucrative enough to stick around, rather than use their knowledge of options to trade as normal customers.

Just last year, for example, several options exchanges developed new rules to strip away some of the perks enjoyed by high-frequency traders, who often compete with market makers, hoping to level the playing field between the two large players.

The repeal of the 60/40 Rule has surfaced before. In 2003, the Senate Finance Committee tried unsuccessfully to eliminate it and President Clinton also made a go at it during his time in the White House.

Because of the way Congress changes tax policies, lawmakers could conceivably repeal the 60/40 Rule at any time, particularly if they're looking for ways to reduce the federal deficit or to raise revenue to pay for new spending measures, such as a new health-care plan.

But the administration's decision to include it in the budget proposal for a second year raises the odds of that happening.

"I think we'll go back and touch base with [lawmakers] on the Ways & Means Committee and remind them of our concerns here," Ms. Milligan said. "The stakes are higher as Congress looks for ways to pay for popular tax breaks and to combat the budget deficit."

Write to Tennille Tracy at [e-mail]

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