TARGET2-Securities, Financial Transaction Taxes and Europe as a Financial Backwater

A colleague recently pointed out that the industry was spending around a billion euros to introduce TARGET2-Securiites, which would save investors the odd hundred million a year in transaction fees, according to an early and optimistic ECB estimate. At the same time, 11 EU countries are talking of introducing a financial transaction tax that will cost the market, if their revenue raising assumptions are right, around €35 billion per annum.

A colleague recently pointed out that the industry was spending around a billion euros to introduce TARGET2-Securiites, which would save investors the odd hundred million a year in transaction fees, according to an early and optimistic ECB estimate. At the same time, 11 EU countries are talking of introducing a financial transaction tax that will cost the market, if their revenue raising assumptions are right, around €35 billion per annum.

In reality, neither sum is accurate. The savings from T2S will not arise because of T2S, but only if settlement volumes increase and the benefit is passed through to the originators of the trades. In fact, settlement costs have always declined as settlement volumes grew. T2S has perhaps other attributes, but cost saving really is not one of them. And the revenue assumptions of the FTT are also deeply flawed, for the tax will destroy markets, and the revenue take is likely to be less than the cost it creates for the EU economies.

In the real world we can assume that FTT will have the perhaps intended consequence of some in Europe of destroying several markets. The main one of concern should be the repo market.  Assuming a repo occurs each day of the year on a given instrument, and this is no absurd assumption for prime government securities, an added yield of around 0.15% per annum would accrue to the investor. If the transaction is subject to FTT, there will be an added daily charge of 0.1% each day or around 20-25% of face value of the transaction per annum. Thus the repo market is dead. The ramifications are multiple. An estimated €300 billion-plus of flows from U.S. money market funds alone into the EU banks will be eliminated and will require substitution, most likely from the ECB and other central banks. Government yields will come under pressure with an added 0.15% yield needed to retain their position against other repo-eligible government bonds.

Stock lending and borrowing will also be decimated by the tax, especially as it appears that, even on term lending, each collateral substitution would be subject to the tax. The result will be much lower liquidity in the major securities and thus greater market volatility.

Derivative transactions also will be decimated by their 0.01% proposed tax regime. It has to be remembered that derivatives will move more and more to swap execution facility (SEF) trading and central counterparty (CCP) clearance. But it is estimated that the change will create demand for more collateral. And FTT, over and above the tax rate on the transaction, will apparently also, as for stock lending, levy taxes on collateral, whether an original pledge or repo, substitution or other movement. Each derivative transaction thus will be hit by the tax at multiple touch points to the trade and on an ongoing basis throughout the transaction life cycle, creating a difficult-to-estimate cost of maintenance.

It is the FTT's effect on repo and collateral activities that is the most invidious. It will divert activity to the non-FTT world, which is after all around 70-80% of global capital markets. The U.K. challenge to the extraterritoriality provisions of the proposed FTT will be vital. Indeed, there is quiet talk in some of the capitals of Europe of hoping the challenge is effective. Having encouraged the proponents of the tax, especially those in the European Parliament, the ramifications are only now being understood. The problem is that nobody knows how to kill off the tax, or at least make it palatable, not only to the investment community but also governments and, of course, the now much-more-empowered European Parliament. Governments should be right to fear the tax could create a liquidity crunch in the EU, a massive increase in the ECB and NCB balance sheets and market instability. Paradoxically, it is also not clear whether the autocollateralization provisions of the ECB's T2S are exempt from the tax. It appears that could be hit, a step that would totally eradicate any possible benefit from that high-cost proposition.

Last October, I wrote a blog for this site titled "Assumptions Versus Realities of Financial Transaction Taxes." I pointed out then the challenges of collecting the tax and the potential nightmare that could become. Since then, the realization of the planned reach of the tax, its impact on each stage of a transaction, its effect on collateral management and the horror of extraterritoriality have made the target infrastructures assumed to be the major, but by no means the only, collectors realize the impossible burden the EU authorities expect them to assume. This is no simple tax. The U.K. stamp duty reserve tax is simple. This is a tax that will be the source of untold litigation and confusion if ever it comes to life.

Europe is in danger of becoming a financial backwater. There is a raft of regulation and change in progress, often driven by political rather than economic or prudential reasons. That is dangerous. By all means, raise a tax on financial transactions, but it would be less disruptive as well as faster to market, and possibly quite attractive for the different exchequers, if it followed the tried and tested structure of the much narrower scope of the U.K.'s stamp duty reserve tax. 

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