The Financial Transaction Tax (FTT)
According to some, it’s a done deal. Trade processing vendors are already updating their systems to process the Financial Transaction Tax, which was only proposed by Brussels in February and not yet even ratified. If adopted by the EU member states, the tax would begin in January 2014. The European FTT as it’s called, it’s also called the Tobin Tax, is a tax of 10 basis points (0.10%) on securities transactions and a tax of 1 basis point (.01%) on derivatives transactions. The tax is expected to bring in $35 billion to $40 billion a year in tax revenue, which sounds impressive, but it’s really to punish banks and bankers for the financial crisis.
The key part about any FTT type of tax is that it only works if everyone agrees to participate. So far, the British government has refused, and even threatened to sue the EU, figuring the tax is really a backdoor way to tax London’s financial markets. The unique part about this tax is that, unlike other taxes, it is collected no matter where the financial transaction takes place. It applies to any transaction that takes place anywhere in the world, so the only way to escape the tax is to cease all financial services in the 11 countries of the EU.
The Swedish FTT
This isn’t the first time a FTT was implemented. Sweden* imposed a 0.50% tax on stock trades in 1984 and increased the tax to 1.0% in 1986, expanding it to include other types of equities. At the time, Sweden had currency controls which slowed down the negative consequences of the tax. But even with the controls, the average volume of stock trading fell by 30% on the Stockholm exchange and for the 11 most traded stocks, volume fell by 60%. Still, the Swedish government liked the tax so much, it expanded it to include bonds in 1989 and effectively crashed the Swedish bond market, causing a 85% reduction in Swedish bond trading and a 98% reduction in derivatives trading. Where did all the trading go? Once Sweden abolished their exchange controls in 1989, it all moved London. But there’s a good ending to the Swedish story: once the FTT was removed in December 1991, much of the trading volume moved back to the Swedish market.
Other Transaction Taxes
Some European governments have already imposed their own FTT earlier this year. Hungry initiated a transaction tax of 0.10%, and so far, raised only half the revenue that was expected. Italy launched a FTT in March and the TMF Group estimates the tax has cut trading volumes by 38%. France, imposed the highest FTT of them all, expecting tax revenue to be €530 million to date on the 0.20% tax, and so far again, only €200 million was raised, far below the estimate. In the United States, although the White House has officially opposed a FTT, two Democrats introduced a FTT of .03% back in November 2011, claiming it would generate about $35 billion a year in tax revenue.
Waking Up To The Implications
From past experiences, it’s clear the FTT is unlikely to generate the tax revenue that’s promised. Trades move to other locations and smart institutions find ways of avoiding the tax. Luckily, some European officials realize the consequences. Maya Atig, the head of the French DMO (French Treasury) stated that the Tax could drain European market liquidity by 15%. The Director General of the Italian treasury, Maria Cannata, stated that policy makers must be mindful of “the importance of not damaging the government bond markets.” Wait a second, where were these people when the tax was being discussed in February? Any European treasury that issues bonds should be very concerned. If the tax damages their bond market, it will make it harder for them to borrow money in the future.
The tax could actually be much higher than it appears on the surface. The International Regulatory Strategy Group (IRSG) estimates the effective rate of the tax is actually 100 basis points, or 1%, rather than 10 basis points. Assuming a bond is traded about 10 times in its life then the tax would be applied 10 times. If true, it would have a significant impact on European bond market trading.
Effects On The European Repo Market
Gabriele Frediani, the head of the electronic fixed income markets at MTS, said the tax would cause trading in the European Repo market to fall by 99%, “The Repo market would disappear overnight.” For me, that sounds like the worst case scenario. But here’s one shred of good news: Repo trades will be treated as a single transaction under the tax instead of two trades. At one point, it was understood that Repo was being treated as a buy and a sell transaction, creating two tax events for every one Repo trade. After market participants raised serious concerns, it was decided that Repo trades will be treated as a single transaction instead of two. In addition, all Repo trades with a central bank will be exempt from the tax, demonstrating that governments still know how to take care of themselves.
Still, the Repo market will bear the largest burden of the tax, it will reduce Repo market activity in many ways, making hedging more costly, increasing the costs of secured financing, and eliminating financial intermediation (market making) in the Repo market. Quite possibly, the FTT will speed up a trend which is already transforming the financing markets.
Effects on Dealer Intermediation
As proposed right now, the FTT adds a 10 basis point tax on every Repo trade. Now remember, for a market maker, that’s a 10 basis point tax on both sides of the transaction. The costs for a market maker really just widened by 20 basis points. Borrow securities from one client and lending them to another client just became economically unprofitable. And when businesses are unprofitable, what happens to them? They disappear. The Repo and securities financing markets are already commoditized and margins are thin, so here’s what could happen after the tax is implemented:
- Spreads could widen to account for the increase in costs, making bid/offer spreads in securities finance about 25 basis points.
- No more securities finance intermediation by dealers. Instead, dealers will only offer their own long positions and cover their own short positions. Basically, they would exit the Repo market making business, and fewer market makers it means less liquidity and a less efficient market.
- A “direct” Repo market would evolve.
“Direct Lending” is already a hot topic in the Repo market. Instead of hedge funds going through a dealer to cover their shorts and that dealer covering the position through a Securities Lending group, the hedge fund would borrow directly from the Securities Lending group. Of course, in order for this to work, the beneficial owners (pension funds, municipalities, etc.) must accept leveraged investment funds as counterparties. Direct Lending makes a lot of sense. Leveraged funds are the ultimate borrowers of many securities, including stocks, Treasurys, corporates and emerging markets securities, and “eliminating the middle man” has been a good business strategy for hundreds of years.
That brings us back to the FTT. Securities dealers and market makers are already under stress in the securities financing markets. Dodd-Frank, Basel III, increased capital requirements, and limited balance sheets are reducing market activity anyway. The FTT will speed up this process, moving the securities finance markets away from market making intermediation and into a Direct Lending market. The tax will speed up the transformation of the European Repo markets from a dealer-based market into a marketplace where the end-borrowers of securities go directly to the end-suppliers of securities.
* "We tried a Tobin tax and it didn't work"; Financial Times; 4/16/2013