American Express Tax and Business Services Recommends Definition for Dealers in Securities Futures Contracts

[2] Your request for comments, while asking commentators to try to equate dealers in securities futures contracts to equity options dealers, seemingly also acknowledges that those who do not traditionally fit the exact definition of equities options dealers might engage in the type of activity which in today's changing markets should obtain dealer treatment under the tax rules.

[3] We would like to propose a revised definition of who is a dealer for all purposes of Section 1256 related to options and futures activities. We have also suggested some guidelines for determining dealer status in a particular tax year when the nature of the activity engaged in by the taxpayer changes during the year to either flip the taxpayer into or out of dealer status.

THE NEED FOR A CHANGE IN DEFINING DEALER ACTIVITIES

[4] As stated in your request for comments, currently, the term EQUITY OPTIONS DEALER means a market maker or a specialist described in Section 1256(g)(8)(A) with respect to options that are described in Section 1256(g)(6) without regard to the requirement that indices be narrow based.

[5] However, Section 1256(g)(8)(B) gives the Secretary of the Treasury the authority to broaden the definition of the term OPTIONS DEALER, not only to address persons trading in other markets (such as the new market for securities futures contracts), but also to include as an OPTIONS DEALER any person whom the Secretary determines performs functions similar to the persons described in Section 1256(g)(8)(A).

[6] Thus, now seems to be the time not only to deal with the new securities futures markets through regulations, but also to address the changing nature of the options markets.

THE TRANSFORMATION OF THE SECURITIES MARKETS

[7] Several factors have conspired to reduce the need and desirability for taxpayers to attain broker/dealer or market maker status with respect to specific options and futures. The decrease in commissions in the last two decades is one of the factors that has made it less attractive to actually attain or retain broker/dealer status, particularly on a small scale.

[8] Furthermore, consolidation is dramatically reducing the number of market makers and floor specialists; e.g., CMJ Partners (formerly Adler Coleman & Co.) combined with Wagner Stott, with whom Mercator had already combined, and now Bear Hunter Partners (an affiliation between Bear Stearns and Hunter Specialists) has purchased Wagner Stott. As a result of this combination, the new Wagner Stott Bear will be the specialist for 359 issues, including 4 of the Dow Jones Industrials, 73 of the S&P 500 Index, and 40 of the 250 most active issues on the NYSE. This unit will account for over 18% of the dollar volume and 16% of the share volume on the NYSE.

[9] Along the same lines, Goldman Sachs has acquired Spear Leeds & Kellogg (SLK). SLK is a specialist in more than 400 NYSE-listed stocks and more than 200 stocks listed on the AMEX. Additionally, its SLK Capital Markets division makes a market for approximately 7000 Nasdaq and OTC stocks. Merrill Lynch acquired Herzog Heine Geduld, an operation that makes markets in over 11,000 securities, including every Nasdaq initial public offering and secondary issue.

[10] This type of consolidation will dramatically reduce the competitiveness in the realm of market makers and floor specialists.

[11] Furthermore, older forms of market making are giving way to highly computerized market making functions. Newer entities such as Knight Trading Group now control vast segments of the market making arena. Knight is currently the leading market maker in the U.S., with approximately 18% of the Nasdaq volume in March, 2001.

[12] The function of these market makers and specialists is to help maintain liquidity and stability in jittery markets when individual investors may get skittish and run to the sidelines. With the diminution in number of market makers, other market participants are likely to become much more important in providing liquidity and depth in the equities, options and futures markets. In seriously tumultuous markets, it is always a good idea to have as many participants as possible.

OTHER MARKET PARTICIPANTS WHO PERFORM A FUNCTION SIMILAR TO TRADITIONAL DEALERS

[13] Aside from dealers, market-makers and specialists (all of whom are dwindling in numbers as the consolidation noted above takes place), there is a growing cadre of active traders in specific securities or in certain classes of securities. These traders would, in earlier times, likely have been dealers, market-makers or specialists in the securities in which they trade. At that time the world of dealers, etc. had a much broader population than it does after the recent consolidations. It also would have been necessary in earlier times to be a dealer (or to use one as a middleman) in order to gain immediate access to the trading floor. Now this access can be achieved electronically.

[14] These traders can be distinguished from the more casual trader -- even from the day trader who earns his entire livelihood from trading. The trading that these active traders engage in generally takes place within the framework of a broker/dealer, thus mandating that the trader, through the broker dealer, meet licensing and capital requirements. Furthermore, a substantial majority of the income generated by the broker/dealer comes from such activity.

[15] Because the activity takes place in a segregated proprietary account of the broker/dealer, it does not meet the requirements that it be a dealer activity under the rules as they currently are drafted for equity options. This is due to the fact that the activity is not part of the dealer activity of buying and selling directly from and to customers. However, the activity is vital to the liquidity of the markets as well as to maintaining stability in those markets.

[16] First, substantial capital is committed to the activity by the broker/dealer. Since the activity generally constitutes the substantial majority of the income of the broker/dealer, it often consumes the substantial majority of the capital of the broker/dealer, generally in the multiple millions of dollars.

[17] Furthermore, these traders do not simply speculate in the market. They are constantly monitoring the markets in particular equity options and other products (generally by electronic means), looking for disequilibrium. (This is exactly what market makers on the floor do.) These traders act to bring the market back to a steady state by taking positions contrary to market aberrations that they pinpoint. At the same time, they are quick to hedge their positions to take the perceived risk out of the net positions that they hold.

[18] This activity is virtually the same as that of the "upstairs dealer," a function that is nowhere clearly addressed in the rules governing the taxation of such activities.

IMPACT OF ELECTRONIC COMMUNICATIONS NETWORKS

[19] The trading of Nasdaq-listed stocks is spread over many market centers. The two principal types of market centers are markets makers and electronic communication networks (ECNs).

[20] ECNs, such as Instinet and Island, are growing in dominance and may eventually result in the establishment of one or more new exchanges. ECNs currently differ from exchanges in that they are broker-dealers regulated by NASD that match public orders and do not act as principals. There are no designated market makers on the ECNs. As a result, customer orders can be directly crossed with one another. This feature is especially attractive to liquidity traders.

[21] As more and more transactions are taking place through ECNs, it will be less and less necessary to maintain market maker status. However, the type of liquidity traders that use the ECNs for much of their trading activities are absolutely vital to maintaining maximum liquidity in the market.

THE GOAL SHOULD BE CONSISTENCY IN TAX TREATMENT

[22] It is desirable that trade or business status yield the same tax results as dealer status -- with the understandable exception of the rules specifically designed to prohibit all but dealers from deducting their losses for tax purposes on an unlimited basis and on treating those losses as ordinary, rather than capital, in nature.

[23] Thus, the definition of dealer status should be expanded for purposes of Section 1256 to encompass the class of active trader discussed above. These active traders provide substantial liquidity in the equity options markets and are sure to do the same, particularly with appropriate tax treatment, in the single stock futures contract markets. They are also virtually indistinguishable in their activities from registered market makers -- a category of taxpayer that is dwindling with electronic access to the securities markets and with consolidation in the market maker ranks.

[24] This category of active trader can be distinguished in the regulations from other traders by the fact that the activity is conducted within a licensed broker/dealer. The regulations can also mandate certain minimum capital requirements -- perhaps $25 million. These requirements are verifiable as part of the certified audit of the broker/dealer. Additionally, the regulations should focus on the fact that the activity undertaken by these traders is not simply speculative in nature. It is engaged in to profit from bringing a market for a particular equity option (and soon a particular single stock futures contract) back to a state of equilibrium and to attempt to eliminate the spikes in the market prices. Another distinguishing characteristic of this type of trading activity is the fact that the substantial majority of the income of the broker/dealer comes from the trading activity rather than from direct transactions with customers.

[25] All such trading activity segregated into a separate proprietary trading account of the broker/dealer should receive mark- to-market, 60% long-term, 40% short-term capital gains treatment.

[26] The regulations may want to specify that in order to qualify for dealer treatment, the active trader cannot be engaging primarily in speculative transactions. There has to be a purpose of taking advantage of aberrations in the market to bring it back into equilibrium and also of reducing the risk in the positions taken by the active trader. This type of trading should be distinguished from purely speculative trading (such as that in which most day traders engage). Speculative trading and the "herd mentality" often lead to increased market chaos.

[1] This expansion of dealer treatment will also remove the preference that may result from 60/40 mark-to-market treatment for regulated futures contracts and nonequity options. Continued preferential treatment of these products could easily result in distortion of the various product markets if funneling capital to certain products, such as broad-based indices (which are not all that broad under the new definitions) results in more favorable tax treatment than placing capital in other product markets, such as equity options and the new single stock futures contracts. Maximum liquidity in all of these markets is extremely desirable.

CHANGE IN DEALER STATUS

[28] There is yet another issue that needs to be addressed in regulations. Under current rules, when a taxpayer establishes itself as a dealer in certain stock or securities (other than equity options), and has not specifically identified its other positions as investment securities on the date that they were purchased, the taxpayer will receive mark-to-market treatment with respect to those other holdings. However, unlike its gain or loss in dealer securities (which will be ordinary in nature), the mark-to-market gain or loss on the nondealer securities will be capital in nature and, to the extent that gain or loss is accrued after the first year of holding the security, it will be long-term capital gain or loss.

[29] A rule that would be more in keeping with taxpayer expectations would be that any taxpayer who becomes a dealer (and who had previously engaged in investment activities) is treated as holding all positions acquired prior to attaining dealer status for investment purposes (unless some other election had been made). Thus, the taxpayer's prior holdings would become a segregated investment account upon the date dealer status is operable. The taxpayer, by dent of his original investment activity, would be deemed to have designated all purchases prior to becoming a dealer as allocable to a segregated investment account.

[30] On the other hand, where a taxpayer ceases to be a dealer in securities for which he previously had such status, that status should continue in existence until all the positions acquired as a dealer are unwound. Such a rule should treat as dealer equities any other positions acquired to minimize risk in the unwinding of all the old dealer positions.

[31] We would be happy to discuss these issues with you further. If you have questions, please do not hesitate to contact me at 212-372-1209.

Sincerely,