Article11 Apr 2013

European Financial Transaction Tax: No Time to Procrastinate

Citi GPS Opinion Article
11 April 2013 – Procrastination is part of human nature. We put off things we'd rather not deal with – the visit to the dentist, writing that birthday card to your least favorite aunt, clearing out the shed. It seems to be in the nature of markets too.

To date at least, there has been precious little reaction to the EU Commission's proposal for a Financial Transactions Tax (FTT) in 11 EU Member States (1). Yet we believe it holds the potential to rock European financial markets to the core. And with an implementation date of 1 January 2014 planned, it is becoming harder and harder to ignore.

We cannot emphasize strongly enough that the FTT envisaged by the EU Commission is very different to existing transaction tax schemes on equities in the UK, France and Italy.

First, it impacts fixed income much harder. The Commission envisages a flat rate tax (10 cents of notional on cash instruments, 1 cent on derivatives). In fixed income, where people trade on basis points – or even quarter basis points – 10 cents of notional matters much more than in a volatile asset class like equities, where the cost can be recouped much quicker, if the view on the stock is correct. In corporate credit, for instance, just one tax payment can wipe out several months of carry.

Second, the proposal explicitly targets nearly all financial institutions. Normally, market makers are made exempt, but in seeking compensation for the cost of the financial crisis, the Commission has to date resisted calls to leave them outside the scope. Moreover, because the tax would apply to both sides of a transaction (buying/selling) there would be a cascading of tax payments, implying that the true level of taxation ends up far higher than the headline numbers suggest. For instance, a simple transaction from one investor through a broker dealer, a clearing house, a broker dealer on the other side to another investor would end up incurring no less than six payments of the tax. Corporate treasurers may also be alarmed to find that there is an explicit provision which seems aimed at including treasury functions under the definition of a financial institution.

Third, in an attempt to limit the scope for avoidance, the Commission's proposal has some rather unusual extraterritorial properties — a US bank and a Japanese asset manager trading Bunds in New York would both have to pay the tax. Similarly, a German insurer trading US Treasuries with a UK bank would also incur a payment on both sides. Financial institutions based in the FTT zone will be at a disadvantage to their peers outside.

But, arguably, the most concerning aspect of the proposal is also the most obscure: its affect on the repurchase agreement, or repo, market. One of the salient arguments in favour of ‘Tobin taxes’ (taxes on financial transactions) is that they discourage the sort of short-term speculative flows that can be damaging when they reverse, as we saw in the Asian crisis. We suspect the distinction between these speculative flows and the vital repo market may not be entirely clear to many policymakers. However, it is an important distinction as the repo market, where funding is provided in exchange for collateral, is pivotal in the transmission of liquidity in the financial system. More than €1tn trades in the European overnight repo market; this would clearly collapse under the proposed tax, considering that the individual payments at each roll would cumulate to no less than 22% on an annual basis. While it has been suggested that the repo market could migrate to some form of secured lending outside the scope of the FTT, in practice, the huge body of legal documentation underlying the market would make this extremely difficult.

The importance of the repo market extends far beyond just bank funding; it is central to market making and the provision of liquidity. In many asset classes, a trader usually won't be able to engage in back- to-back transactions that allow him/her to sell and buy back an instrument in the same day. Much more often, he/she will borrow on repo in order to sell it, and then cover the position when a willing seller is found a few days later. Without repo, traders will simply refuse to offer in the first place. If it becomes impossible to short, then many instruments will effectively end up trading 'by appointment only'.

In aggregate, liquidity across a broad swathe of financial instruments, especially low yielding, short-dated ones, would be significantly reduced, fund returns would suffer and bank earnings would be impacted.

Now, before you reach for the tissues, it is important to stress that the FTT remains a proposal. It will still need approval by the 11 Member States participating under the so-called 'enhanced cooperation' procedure. And there are very good arguments for amending the proposal.

The principal objective of the FTT is to raise revenues — to ensure that financial institutions make a 'fair and substantial contribution' to the cost of the financial crisis. The Commission estimates that the proposed tax would generate annual revenues of €30-35bn, equivalent to 0.4% of the GDP of the 11 participating countries. At a time when sources of revenue are in short supply, that's a substantial amount. However, we suspect if enacted as written, this estimated revenue would be almost eliminated by second-order effects — substitution to other markets, higher funding costs for sovereigns themselves and the impact of lower GDP on tax revenues.

But, more importantly perhaps, the proposed FTT seems to run directly counter to the broader direction of recent regulatory initiatives aimed at promoting financial stability. It would make hedging more expensive; it would make asset prices ‘gappier’; it would discourage trades that require central clearing; it would encourage a shift back to the bank lending model in Europe; and it would make banks more dependent on fickle unsecured funding. It would also substantially add to illiquidity premia, including in corporate credit and in vulnerable markets like peripheral governments.

We do expect Member States will want to make significant changes before the proposal becomes final legislation. The scope may end up being narrower, there may be carve outs at least for certain transactions like hedges, and (hopefully) the repo market will be made exempt. Moreover, the complexity of the issues and the ongoing German election may force a later implementation date.

However, we think it would be a mistake to underestimate the political resolve behind the initiative and for market participants to assume that this will all just go away. The political push to ban naked short-selling on sovereign CDS was ignored for a long time, because market participants expected that 'common sense' (i.e. market logic) would water it down. However, in the end, a ban was enacted and the sovereign CDS market has been left a mere shadow of its former self.

The legislation that is enacted may yet compel corporates to issue debt from finance vehicles established outside the FTT zone. Funds that execute significant transactions outside the FTT zone will seek to relocate there. And fixed-income investors in the FTT zone may want to make sure that they are happy to hold them to maturity — or at least on a long-term basis. The time for procrastination is running out.

(1) Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain.


Subscribe to Citi GPS

Keep up to date with our latest insights.