Category Archives: Economics Update

Financial Innovation

Recently I came across a couple of new peer-to-peer financial startups. With people feeling distrust towards mainstream banks in the wake of the financial crisis, it is likely that many of these financial startups will get a lot more attention in the near future. Here are two startups from my own home country, Estonia, which have been making headlines recently.

Transferwise

One such startup is Transferwise, the peer-to-peer online currency exchange from the creators of Skype and PayPal. The idea of this is to allow cheaper exchange of money between different currencies, by using the Reuters mid-market rate. It therefore offers a better rate then high street banks by taking the real currency value, in between the bid and offer price. At the same time, it is able to offer far lower service fees due to its limited overhead costs.

The way in which this works is as follows. For example, at any one time there might be one person who holds euros and wishes to purchase British pounds. At the same time, there is likely to be someone else who holds British pounds but wishes to purchase euros. Usually these two individuals would simply turn to a bank, buying at one rate, selling at another and incurring a transfer fee on top of the exchange rate loss. However, with Transferwise, the first individual holding pounds instead transfers these into the UK account of the second individual wishing to purchase pounds. The second individual holding euros then transfers these into the euro account of the first individual. The whole process is done via Transferwise accounts meaning that the money transfer is completed once both parties have sent their money in.

This process is best shown in Transferwise’s introductory video:

The only thing that now remains to be seen is whether this will be a knockout blow to high street banks or simply a “black eye”, as reffered to by The Economist.

isePankur

The second financial startup that I came across was isePankur. This is another peer-to-peer innovation that cuts out the spread used by banks to make money. In this case, it does so by cutting out the difference in interest rates for savings and loans.

The way in which it works is that people looking to borrow money post their loan requirements on the service’s website. isePankur then verifies all of the borrowers’ information, analyses their bank statements and performs various other checks, just as any commercial bank would do. Individuals looking to invest, then loan their money, spreading the investment between multiple applicants. The loan applicant is able to borrow at exactly the same rate as the investor gets in returns, unlike at a commercial high street bank where both receive different rates.

Again, this service has been praised by many, including one of The Economist editors, Edward Lucas. Read his article on his own experiences with isePankur here.

So what does this mean?

Essentially, this shows that with modern technological capabilities, financial innovation is able to take various creative new approaches. Such peer-to-peer services are likely to have an impact on commercial banking activities, but only if they gain the trust of their customers. The benefit of having a commercial high street bank, is that it is a physical place which people feel secure about, as opposed to an online service which takes place in a cloud and could easily disappear at any moment. It remains to be seen how much of an impact these companies will have, but initial responses have been positive and many consumers are already beginning to take advantage of such financial innovations.

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Celebrating The Greek Credit Event

Finally, the ISDA (International Swaps & Derivatives Association) has decided today that a restructuring credit event has occurred in Greece.

Has there not already been restructuring of Greek debt?

It is true that there have already been write-offs by holders of Greek debt, however, a restructuring credit event occurs when restructuring is involuntary. Surprisingly the debt write-offs were previously considered to be “voluntary”, even though this required a lot of convincing of private creditors. Today though, the Greek government announced that it will activate its Collective Action Clause on Greek bonds.

What does the Collective Action Clause (CAC) mean?

The CAC is an agreement that if a certain percentage of Greek debt holders agree to a write-off, the remaining debt holders can also be forced into writing off their part of the debt. Since this clause has now been activated, the restructuring is no longer voluntary, and so a credit event has occurred.

So why should we be happy about a credit event having occurred?

The good thing about the restructuring finally being considered a credit event, is that any insurance that was purchased by private sector creditors and governments would now be triggered. Many holders of Greek debt had purchased Credit Default Swaps (CDS) in case Greece were to experience a credit event, and now that one has occurred, the CDS have finally been triggered and creditors receive their payments.

What if the restructuring had not been considered a credit event?

If a credit event had not occurred and CDS payments had not been triggered, many private creditors would have possibly begun to wonder as to whether there was any use for CDS at all. After all, if Greece’s debt restructuring isn’t considered a credit event, then what is? As a result, CDS agreements would have been deemed worthless, causing both private creditors and governments who hold CDS, to write off their value and possibly land in even greater financial trouble.

So there you go, there’s a part of Greece’s failure that we can finally be happy about.

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Capital Gains vs. Ordinary Income – Is it as easy as we think to distinguish between the two?

Is distinguishing between capital gains and ordinary income really as easy as we think?

Apparently not, as is shown by the following example from Gregory Mankiw’s recent New York Times article.

What is a capital gain, and how can we distinguish it from ordinary income?

The answer seems simple. If you have a job, the money you are paid for your work is ordinary income. If you buy an asset at one time and sell it later for a higher price, the profit you made from holding it is a capital gain.

But is it really that easy? Consider five examples, and see if you can identify what is ordinary income and what is a capital gain:

• Abe buys a vacation home for his family for $800,000. Some years later, when his children have grown and left home, he sells it for $1 million. He makes $200,000.

• Bob is a real estate investor. After scouring the market for the best investment opportunities, he buys a house for $800,000 that he believes is undervalued. A few years later, he sells it at $1 million, for a profit of $200,000.

• Carl is a real estate investor and a carpenter. He buys a dilapidated house for $800,000. After spending his weekends fixing it up, he sells it a couple of years later for $1 million. Once again, the profit is $200,000.

• Dan is a real estate investor and a carpenter, but he is short of capital. He approaches his friend, Ms. Moneybags, and they become partners. Together, they buy a dilapidated house for $800,000 and sell it later for $1 million. She puts up the money, and he spends his weekends fixing up the house. They divide the $200,000 profit equally.

• Earl is a carpenter. Ms. Moneybags buys a dilapidated house for $800,000 and hires Earl to fix it up. After paying Earl $100,000 for his services, Ms. Moneybags sells the home for $1 million, for a profit of $100,000.

How much capital gains and ordinary income do we attribute to Abe, Bob, Carl, Dan and Earl? (To keep things simple, assume that Ms. Moneybags is untaxed. Think of her as running a pension fund or university endowment.)

Let’s take the easy cases first. It seems clear that Abe has a capital gain. His profit of $200,000 comes from simply holding an asset over time. And it seems equally clear that Earl’s $100,000 is ordinary income. He is being paid for providing his services.

But between these cases, the situation gets murky. Bob and Carl are being rewarded in part for the time they spend, but the tax law treats both as having earned entirely capital gains. The tax code does not count the time that Bob spent looking for investments as employment and his gain as taxable labor compensation, even though some of it arguably is. Nor does it try to tax Carl’s sweat equity as labor compensation.

This brings us to Dan and his partnership with Ms. Moneybags. The tax law treats this partnership as exactly equivalent to Carl’s situation. In this case, however, the $200,000 capital gain is divided into halves: some of it goes to Ms. Moneybags, who provided the cash, and some goes to Dan, who provided the sweat equity. Once again, nothing is treated as ordinary income.

In some ways, this treatment makes sense. After all, Dan is doing half of what Carl did, so why should he have to pay a higher tax rate than Carl did on that half of his income? On the other hand, it seems that Dan is getting off easy. Dan does not seem very different from Earl, because both are getting $100,000 for fixing up the house.

If these examples leave your head spinning, you are not alone. Economists and tax lawyers who study these issues are unsure about the best way to handle these situations in practice.

Here is where carried interest enters the picture. Carried interest from a private equity partnership is like the income that Dan earns from his real estate partnership. In this case, however, Dan is not a carpenter but a specialist in business turnarounds. The partnership does not buy dilapidated houses to fix up and sell; it buys troubled businesses to fix up and sell. And just as Dan the carpenter can treat his share of the partnership income as a capital gain, Dan the business specialist can do the same.

Critics of current law think it is unfair that these private equity partners are taxed at capital gains rates, whereas other high-income individuals like doctors and lawyers pay the much higher tax rates for ordinary income. It is a reasonable point, and some reform may well be appropriate. But as the tax situations of Abe through Earl illustrate, it is not obvious what the best approach would be. Not all problems have easy answers.

via Capital Gains vs. Ordinary Income – Economic View – NYTimes.com.

So should we even attempt to distinguish between capital gains and ordinary income?

Even this simplified example shows how difficult it can be to determine what should be taxed as capital gains and what should be taxed as ordinary income. Perhaps this is why some countries, such as my home country, Estonia (which incidentally is renowned for having a very simple tax system), do not distinguish between the two. Capital gains and ordinary income are both taxed at a flat rate of 21%. What are your thoughts on this issue? Should we distinguish between capital gains and ordinary income, or not?

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