Everyone and their dog are getting in their say on the Financial Transactions Tax (FTT). ISLA, the International Securities Lending Association, just released their analysis of the FTT and it is not good. At. All. Lets take a look at what they said.
The report quickly got to the heart of the matter. “…As currently drafted, the FTT would effectively close down the securities lending markets across the EU11 with considerable implications for long term investors and the mobility of collateral…” and “…Securities lending provides important liquidity to the secondary markets for both bonds and equities and in the year to May 2013 long term investors in the European markets generated incremental revenues of EUR3bn through securities lending…”
According to the authors, 65% of the securities lending markets would disappear and key markets like Germany and France would all but be decimated. Investors will forego EUR2 billion of revenue from securities lending.
Fails will shoot up as the cost to borrow paper to cover delivery frictions to make it uneconomic.“…Shorter dated transactions would be disproportionately impacted, increasing the risk of settlement fails by possibly as much as 100%…” This is an important point and one that we think tends to get glossed over – securities lending really does reduce fails, which improves system-wide stability.
Given the rule in its current form mandates both borrower and lenders to pay a 10bp fee, ISLA calculates that fees would have to rise by over 400% just to net the same revenue as before.
Looking at the cost of raising collateral – a topic near and dear to anyone collateralizing cleared swaps or managing an LCR-compliant book – it will shoot up. The result could be to shift investors from borrowing paper in order to use a collateral toward buying the underlying eligible collateral. This will hurt asset managers with lower returns earned from eligible paper that they would otherwise not owned. We have seen studies that said mandated central clearing will shave a substantial chunk from portfolio returns for insurance companies as they a) shift their AUM to include enough eligible assets or b) engage in expensive collateral transformation trades. The FTT will only make that worse. Repo dealers will price in the potential cost of borrowing or lending collateral , which will flow through to derivatives desk in the cost of their hedges. The combination of all these factors could push asset managers to avoid derivatives altogether. It doesn’t seem helpful or desirable.
“…Both the developing Basel III regime for banks and the drive towards central clearing and margining of derivative transactions (as being implemented in the EU through EMIR) place reliance upon the collateralization of financial transactions and exposures. Both will require a ready supply of eligible and appropriately priced collateral to enable the markets to function efficiently but without a functioning securities lending and repo market this will not be possible…”
Collateral velocity will fall as paper sits dead. The credit that velocity creates will also go by the wayside.
ISLA suggests that calmer heads, who in earlier FTTs in France and Italy exempted securities lending and repo, will again prevail. Regulators have not blinked yet but odds are suggesting they will. Let’s hope that the ISLA commentary is the worst case scenario and not anything realistic that we need to tackle at this time.
A link to the ISLA report is here.
A link to the ISLA impact analysis and data methodology is here.