A just published report “The impact of a Financial transaction tax on corporate and Sovereign Debt”, written by London Economics on behalf of the Regulatory Strategy Group (IRSG) and sponsored by the City of London, caught our eye. Not surprisingly, they don’t like the FTT. Not at all.
The report gets to the point immediately,
“…it is important to note that the EC proposal for an FTT does not exempt intermediaries in debt security transactions from the tax. As such, the sale and purchase of a debt security liable for the tax would be charged at multiple stages of the chain of settlement, creating a “cascade effect” such that the effective tax rate would be in the order of 100 bps (or, 1%) rather than 10bps. This would cripple activity on debt securities markets…”
The authors assume that a bond turns over 10 times during its life and since intermediaries are not exempted in the EC proposal, each leg would be charged — hence the 10x multiplier. The rates proposed for financial institutions, according to the paper, were 10bp for securities and 1bp for derivatives.
The EC proposals “…includes all financial markets and transactions, as well as any close substitutes. Hence, both transactions on regulated markets and over-the-counter transactions will trigger the taxation…” and that it will only impact secondary market transactions.
The EC will levy the tax based on the “residence principal”, which “…entitles the jurisdiction to levy the tax on every financial transaction involving entities that are considered to be residents in this jurisdiction, regardless of where the transaction takes place…” So no place to hide.
The repo market is holding its breath on the FTT. They realize that a 10bp fee on every turn of paper will be devastating. The paper outlined how repo might be impacted,
“Potential impact on the repo market may well be severe, as the FTT cost may be higher than financial-intermediary fees that those intermediaries receive for arranging transactions. One stakeholder suggested that the average fee for a repurchase agreement was in the order of 5 basis points (bps). A minimum FTT of 10bps on each counterparty to a transaction may well therefore result in a substantial reduction in activity in the repo market.
Further, repo markets would be impacted as the rise in debt security yields due to the FTT would reduce the amount that repo sellers could borrow, and increase the margins they have to pay (as collateral in the form of debt securities would be worth less).
The consequent reduction in repo market activity may have impacts on the real economy, as the likes of banks use repo markets for short-term funding that may relate to the amount they lend to the real economy. Moreover, other market participants may be unable to manage risks (through short positions) and foster enterprise (through taking leveraged positions) as they may wish to.
In addition, if an FTT on repos were to be brought into force as planned, it would place too high a burden on repo transactions compared to other financial instruments (namely, secured loans) because the former are liable for the tax and the latter are not (secured loans are indeed not liable for the tax) despite being economically similar.”
Tri-party trades could be hit hard. The authors said, “…the tri-party segment of the repo market would be negatively impacted insofar as intermediaries’ inventory management transactions would be affected by the FTT. Intermediation in the tri-party repo market would therefore only take place at a significant premium…”. It also begs the question about how bond substitution within a tri-party repo (or for that matter, any repo with substitution rights) could be treated.
The differential between the rates on securities and derivatives may give rise to regulatory arbitrage and product substitution. Total Return Swaps, which would be taxed as a derivative but act like (long or short) bond position + financing might be one such substitute. On the other hand, the hedges for a TRS, especially the financing of the position, won’t be exempt. One could imagine that since the tax is based on the turnover that repo markets would skew away from short term trades toward long term locked in funding (a trend already in place thanks to the LCR).
The FTT introduces friction into the system and, if enacted as proposed, will change market behavior dramatically. Turnover will fall and, along with it, liquidity. Costs will be passed along in one shape or form. The unintended consequence of the rules may very well be no different from a tightening of monetary policy just when those markets can least afford it.
We are expecting similar comments from the ICMA at their April 8 2013 press conference as well.
A link to the report is here.