Financial markets, to borrow from the film The Big Lebowski, could be about to enter a world of pain. That is, if the past is any guide to the future and if plans for a broad-based European financial transaction tax (FTT) continue to make headway. Industry figures say the tax, as mooted, could push bid-offer spreads in many markets much wider, siphon off liquidity and drive up volatility for a range of assets or instruments. In a twist of irony, the levy could end up punishing, rather than helping, a number of shaky sovereign bond markets with potentially disastrous results for the global financial system.
The process for agreeing the tax is somewhat opaque and fraught with uncertainties due to a complex political backdrop and a cacophony of views. So the uncertainties are large and numerous. But while there are plenty of questions about the scope, scale and timing of the tax, there does seems to be little doubt that the political will is there and many industry figures believe that some kind of a cross-border FTT will emerge, albeit one that is potentially not as draconian as what is currently being discussed.
International Swaps and Derivatives Association
How worried are the members of the International Swaps and Derivatives Association?
Richard Metcalfe, deputy regional director and senior regulatory advisor for the association, summed it up in one word:
An FTT for the whole European Union is out of the question, with countries such as Britain and Sweden firmly against the idea. But under a procedure known as "enhanced cooperation", the tax can be agreed for some EU countries as long as at least nine sign up. The euro itself was created through enhanced cooperation.
Mention the FTT, however, and the word "cooperation" is not the first thing that springs to mind for many in the market.
"Contrary to what some of the proponents of the tax are saying, the FTT clearly hits investors," said Keith Lawson, senior counsel for the Investment Company Institute, which represents US buy side companies. "Any FTT that's paid by a mutual fund is paid by its shareholders through a lower return."
But before delving into the implications of the tax, it helps to understand the background and the basics of what falls in the scope of the current proposal.
In September 2011, the European Commission issued an initial proposal for a wide-ranging FTT, having explored the idea of how to make the financial sector bear more of the cost for the fallout of the 2008 global financial crisis. Then, in October of last year, the Commission proposed that enhanced cooperation be allowed for an FTT. This had the backing of 11 countries and was supported by the European Parliament. Those countries, representing more than 90% of the euro zone economy, were: Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain.
Finally, in February of this year, the Commission put forward a plan for the so-called EU-11. The tax would be for 10 basis points of the nominal amount transacted. It would be both issuance-based and residence-based. Issuance-based meant it would apply to any security issued in one of the participating countries, regardless of where the trading took place. Residence-based meant it would apply to any transaction that involved a firm deemed to be in the EU-11. It would cover equities, fixed income and derivatives.
Meanwhile, while all of this had been going on, two prominent EU countries - France and Italy - had already been implementing their own national FTTs. The idea was that these would be replaced by the EU-11 version once it was introduced.
Then, in late May, signs emerged that the Commission was scaling back its ambitions. This was hailed by market participants as a victory for common sense. Brussels had been besieged by industry representatives who sought to show the harm that could come from a tax of that size and scale. The Commission, it emerged in a Reuters report, was said to be looking at a much smaller tax of one basis point, one that initially would only apply to stocks and only later (if at all) to fixed income and derivatives.
Algirdas Šemeta, the European Commissioner for Taxation and Customs Union, who has been spearheading efforts to enact the tax. Soon after the Reuters report, Šemeta was quoted as saying it was premature to say what the final outcome would be, although he has since suggested the Commission could consider lower rates for some market segments.
Stealing from the rich?
These taxes are often called Tobin taxes, named after Nobel laureate James Tobin who proposed the idea of taxing financial transactions. They're also known as Robin Hood taxes, and the idea of taxing the rich to help the poor has generated massive popular support in many European countries in the wake of the global financial crisis.
Leaving aside for the moment the fiscal policy arguments and whether such taxes are fair, the nature of the tax could make it far costlier than other FTT examples, and the complexities of collecting it could create a whole new set of headaches for financial firms and venues, at a time when they are already reeling under the weight of an avalanche of regulation.
Industry figures say the revenues generated by the tax will inevitably be less than what the European Commission estimates and that ultimately it could cost more in economic terms than it generates in revenues collected. They cite France's disappointingly low collection levels from its own tax. Most of all they cite Sweden, which had a disastrous FTT in the 1980s.
Swedes have not been shy about trying to get Europe to understand the problems with FTTs. Magnus Wiberg, a former economist at the Swedish finance ministry and at the Riksbank, recently wrote an article in the Financial Times with the headline: 'We tried a Tobin tax and it didn't work'.
Sweden began with a 0.5% tax on stock transactions in 1984. After the rate was doubled to 1.0%, volume on the Stockholm bourse fell 30% during the second half of 1986 and throughout 1987.
But an even bigger shockwave came when the tax was broadened to include bonds in 1989. "This, in turn, led to an 85% reduction in bond-trading volume and a 98% reduction of trading volume in bond derivatives," Wiberg said. "The increase in tax revenues resulting from the broadening was less than 5% of what had been expected."
What's notable is the size of the fixed income tax in Sweden. It had introduced a tax of 0.002% on securities with a maturity of 90 days or fewer, rising to as much as 0.003% for bonds of five years or more. Yet despite the extremely small size of the tax, the effect on the market was much more dramatic.
Investors simply stopped trading in Sweden. France and Italy are also experiencing volume declines following the implementation of their taxes.
According to data from Thomson Reuters Equity Market Share Reporter, French equity volumes across all types of venues lit and dark during the first five months of this year were down 27% from the year-earlier total, which was before the tax had taken effect. To put that in perspective, equity volumes across all venues in the 27 EU members have actually risen 8% in the same five months from the year-earlier period, highlighting a dramatic underperformance for France. Similarly, Italian volumes in the months after the March 1, 2013 introduction slid by more than 50% from the levels just beforehand.
Lessons not learned
So why does the Commission not give due consideration to history when it comes to FTTs?
It seems that European tax officials have in fact been paying attention to history. But they have drawn very different conclusions from what the financial community did. The view from Brussels, it seems, is that the problem with Sweden's FTT was simply that it didn't apply to a wide enough area. National taxes are too easily avoided, so the focus this time around has been on casting as wide a geographical net as possible.
That is one reason why the continuing push for an FTT, regardless of the size of the levy, remains so frightening for many in the industry. In seeking to ensure that tax avoidance did not undermine the whole project, European officials came up with proposals that would catch all kinds of fish in the trawling net.
"One of the big issues is the extra-territorial nature of the tax," said Lawson of ICI.
Keith Lawson, ICI
"That's what makes the proposal so extraordinary in the extra-territorial application. For example, if a US fund had as an investor, a person who was resident in the United States, but had a permanent address in Germany, the US fund would be deemed to be German for purposes of the redemption by the shareholder, even though the investor is a tax resident of the United States," Lawson said.
For those that are not categorised as an EU-11 firm, fairly or not, there is the possibility of trading with an EU-11 firm unwittingly. "From our perspective, this residence principle is really very difficult," Lawson added. "Often you don't know who your counterparty is."
The tax also does not exempt market makers. It is meant to apply to each party in the chain of a given transaction, not just the end-users. This "cascading effect" is unusual. For instance, the French transaction tax, which is issuance based, exempts market makers so any assets that are bought and sold on the same day are not taxed.
"It's a big, big deal, that cumulative effect," Metcalfe of ISDA said.
Customers will end up paying not just for the immediate transaction but all the costs associated with hedging transactions that go with it," he said. "If I'm a market maker I'm going to have to price in my need to hedge that transaction," Metcalfe added, noting that for some trades that need was continuous.
"If you take on a position in relation to interest rate risk, through an interest rate swap, as market prices change over time you could be rebalancing that hedge on a daily basis. Every time you'd be getting taxed," he said.
"Even at the reduced rate of one basis point, that alone could amount to some 2.5% of the notional size of the trade per year, assuming 250 business days a year. The other point here is, you tax the notional. Well, the notional doesn't change hands, certainly not on an interest rate swap," Metcalfe said. "Even for one party to a single trade, the tax can amount to a significant multiple of the bid-offer spread."
Then there is the issuance principle, which creates its own set of issues.
John Chown, a co-founder of the Institute for Fiscal Studies in the UK, took issue with the idea that a British and an American firm, trading with each other, could be taxed by a European country, simply because they were buying or selling a share in a German company.
"There is still a great deal of confusion as to how the proposed tax will actually work. But what is clear is that, despite the UK having vetoed the previous proposals, economic activity in the UK will be taxed," Chown wrote in a paper. "But the UK Government will not receive any of the revenues which will instead be paid to the FTT-zone tax authorities."
The UK filed a challenge to the FTT in the European Court of Justice in April.
One prospect of all this, Chown told Automated Trader, would be increased use of synthetic trades to avoid the tax. "You can deal in depositary receipts or you can deal in something which is not a euro but is something that derives 99.9 percent of its value from the euro," he said.
Metcalfe of ISDA said the use of synthetics would depend on whether the tax covered related derivatives. But he noted the popularity of contracts for differences in Britain in order to avoid paying the UK's stamp duty on stock trades.
One aspect that is unclear is whether the location of the matching engine will matter. A venue based in the tax area in theory could move its matching engine to a location outside the area and argue that trading was not taking place inside the country. Nonetheless, as commentator have noted, the issuance and residence principles - if they both make it to the final version of any tax - would still address a lot of transactions regardless of where the trading takes place.
In the firing line
There is a view that the real target of the FTT is high-frequency trading. Regardless of whether HFT benefits markets or not, there are scores of politicians and EU bureaucrats who are extremely antagonistic towards HFT.
In fact, in the proposal document in September 2011, the Commission highlighted the potential impact on HFT: "Automated Trading in financial markets could be affected by a tax induced increase in transaction costs, so that these costs would erode the marginal profit. This would especially hold for the business model of high-frequency trading physically closely linked to the trading platforms on which financial institutions undertake numerous high-volume but low margin transactions."
The reference to HFT was dropped in the proposal document issued this year, although it was discussed in some length in the Commission's accompanying impact assessment.
If the tax really is about dealing a blow to that segment of the market, it would suggest that the levy ultimately might be limited to equities and some derivatives. Taxes on currency trades would contravene EU rules and fixed income does not attract the same degree of HFT activity as equity markets.
Such an outcome would also help a number of European countries that have begun to take on board the implications for their sovereign bond markets.
In fact, Sweden's experience on the fixed income side may be one factor that is introducing more caution. Debt-strapped European countries are extremely sensitive to financing costs after years of over-borrowing. Lawson noted that both Italy and Spain - two countries with huge amounts of debt - are both in the EU-11.
"Because of the impact secondary market trading has on cost of capital for the countries, it's hard to see how they support a tax that they don't like. And so it's hard to see how the EU proposal that's on the table gets enacted," Lawson said. "If it did get enacted, you would think it would get unwound very quickly because of the impact on those governments as they try to issue debt to deal with their deficit issues."
There is also the risk, Lawson said, of the repo market coming to a complete halt if the tax went through as initially described.
"And so you couldn't see a tax like that being around very long at all. But if it is something that looks a lot more like the UK stamp duty, or looks a lot more like the French tax, then it will depend more on what the rate is, how it's structured, how many countries are in, and whether or not the revenue that's raised justifies the effort," he said.
"My impression is that the tax policy people are trying to figure out what could be done be done while doing minimal damage to the country. Nobody yet is talking about it, but I'm sure there are people in Brussels who have a very clear idea of what that deal could be," Lawson added.
Metcalfe said that even the Commission's own original impact assessment said there could be a decline of between 60% and 90% in the volume of derivatives from the tax.
"What's harder to measure is the knock-on effect," he added. "There's a knock-on effect in terms of financial activity more generally, there's a knock-on effect in terms of the economy. If people don't use the derivatives, the FX and interest rate and commodity risks don't go away so they have to absorb those."
Planning for the future is difficult because of the highly politicised nature of the discussion. There are 27 countries in the EU and the vast majority of them are coalition-dominated, which means dozens of political parties are constantly weighing into the debate. Just ask Angela Merkel. The moment it was reported that the European Commission was easing its stance, Merkel came in for domestic political heat as someone who would not stand up to evil bankers.
Lawson said France likes its tax and wants the European model to be based on that, which would mean applying the issuance principle but not the residence principle.
"Here's the political rub," Lawson said. "If you look at the 11 countries, several of them have very, very small capital markets - which means they don't get very much out of the issuance principle. So a lot of the smaller countries need the residence principle to make this attractive. So without the residence principle, you don't have the nine minimum required to do enhanced cooperation, at least as the tax currently is structured."
Germany, meanwhile, is thought unlikely to take a firm view about what kind of tax it will favour until after elections in September. But Germany also presents another complicating factor.
"There is a constitutional law requirement in Germany, that a tax be enforceable in order for it to be valid. And if you can't enforce this tax in Singapore, for example, and I don't know how you do, then it's not valid in Germany," Lawson said.
To address the varying political requirements, a number of possibilities for structuring the tax are being mooted. In addition to whether the issuance or residence principle is applied, there is the question of which asset classes it will cover, what types of transactions will fall in scope (for instance, taxing repos becomes extremely problematic for banks) and whether any groups of people are given exemptions, such as companies engaged in routine corporate business.
Lawson said there was some speculation that a much narrower tax, based on the issuance principle, could ultimately get the support of some 20 countries if the Commission came up with ways to allocate some tax revenues towards smaller countries that otherwise would not benefit. But different countries had their pet peeves. One example: Lawson noted that not having a carve-out for pension funds would be a deal-breaker for the Netherlands.
Niki Beattie, Market Structure Partners
Niki Beattie, chief executive of Market Structure Partners, said Britain's experience showed that a national transaction tax can work without the market going haywire, but this tax has evolved over hundreds of years and implementing a wide-ranging tax across Europe in a hurry is a much more difficult proposition.
"The UK has a stamp tax and the market's functioned perfectly well for many years," Beattie said. "I think that the biggest problem in this is that people are trying to do it on a pan-European basis and at speed. It's a massive undertaking and if not well-thought-out may have far reaching negative consequences."
She also noted that problems that can occur, for instance, with securities that have listings both inside and outside of the EU-11 countries. "You've got some quite significant issues if you start putting in taxes that can't be implemented on a global level," Beattie said.
She added: "There's a cost to the administrative burden. Someone's got to pick up the taxes and pass on the cost for picking that up."
France, working to a very tight timetable, chose Euroclear France to collect the tax for it. The French are relying on voluntary declarations by market participants. That may sound market-friendly, but it presents some challenges.
The way it works is reasonably straight-forward.
The law calls for the tax to be paid in the early days of the month following the transfer of ownership. Each month, Euroclear France collects the monies and the report from the liable parties and, as remuneration, holds the monies collected and collects interest for approximately 20 days before it pays the government.
"The tax applies to a wide scope of trades on a cross-border basis, so we are not in position to check, for example, that what we received is consistent with what happened in the financial markets," said Dan Toledano, director, product management at Euroclear France. "However, we provide several reports to the tax authorities which analyse them and may decide to audit the liable parties."
Dan Toledano, Euroclear, France
Toledano said the process now was smooth. "Of course when we had to implement the FTT itself, there were several issues which arose, one of the major ones being the very short time frame to implement the tax."
The tax law had been published at the end of February 2012 and it became chargeable in August of that year, with a three-month grace period for firms to start paying. But there were changes in the law right up until the August start.
"One of the things which was the most complex to implement for the participants was the calculation of the 'net buying position'. The tax does not apply necessarily to each and every gross trade," Toledano said, referring to cases where a market participant has sold some securities on the same day they were bought.
Toledano said Euroclear France has not been speaking directly to the European Commission about the practical experiences it has had, but that its input was being collected through trade organisations which were speaking to the Commission. He said that the European version, by including both issuance-based and residence-based provisions, could be more complex to implement than the French version which only considers the issuance.
One way or another, it requires more systems to be added for financial firms.
"More than the payment and reporting mechanism to the tax authorities, I would say the most complex thing for the financial firms is the impact on their internal system: how to identify the taxable and exempted transactions in all their activities," Toledano said. "Also, they may decide to recharge this tax to their underlying clients, so they have to implement mechanisms to confirm the tax amount and collect the tax."
Initially, with the political winds blowing strongly at their backs, the tax appeared to be on a fast track and was meant to be in place by 2014. But the prospect of a significant movement during the remainder of 2013 is diminished by a couple of factors. For a start, little happens in July and much of August due to the summer holidays and a large chunk of December is lost for the same reason. Also, Lithuania has the EU presidency in the second half of the year and it is not among the EU-11, so it may not prioritise the issue as much as some of the more pro-FTT countries.
"None of this means that we're any less concerned or being any less vocal about our views," Lawson said. "You know, we're still very concerned about this proposal, and will work actively to protect investors"
Beattie said it appeared at least that European officials had come to the view that a slower, more careful approach was called for.
"I think people have really sort of taken a step back and are now starting to think this is having wider implications than we thought," she said. "Introducing it in incrementally smaller rates, and maybe adding a stage for bonds once they've understood how it's impacted their equity market, I think it's entirely sensible."
She added: "My view is it really takes two to three years to assess the damage of what these things are doing and we need to look at that in conjunction with all the other regulation that is being implemented."
But none of that means the desire to establish a tax has lessened.
"I think people still have an appetite to put some sort of tax through," Beattie said.
Metcalfe shared the view that a multi-country FTT in one form or another would be introduced. But he said he remained hopeful that some of the more market-damaging elements being talked about could be avoided.
European proposal at a glance
- FTT would apply to a broad swathe of assets and derivatives
- Wide-ranging nature would prevent use of derivatives (eg CFDs) to avoid the tax
- Tax would be both issuance-based and residence-based
- Tax would be 10 basis points for most assets, one bp for derivatives
- Derivatives tax would be based on notional amounts
- European Commission reportedly looking at scaled-back, phased version
- Official estimates: tax revenues could be about 31 billion euros per year
- September 2011: European Commission proposes a wide-ranging FTT
- October 2012: Use of 'enhanced cooperation' proposed for 11 countries
- February 2013: Detailed proposal for the EU-11
- July 2013: Lithuanian EU Presidency begins
- September 2013: German elections
Current and historical examples
- Began for shares on March 1, 2013
- Average trading volumes in first three months down 55% from average from first two months of the year (data from Thomson Reuters Equity Market Share Reporter)
- Tax is primarily issuance based but for derivatives is residence based
- Rates vary, with OTC trades as high as 22 basis points and trades on regulated markets at 12 basis points.
- Sets special regime for HFT (defined as cases where the issue, modification or cancellation of orders is within 500 milliseconds), with two bp tax on orders that are modified or cancelled on a daily basis.
- Began in August 2012, with an initial three-month grace period on payments
- Average trading volumes in first five months of the year down 27% from year-earlier levels (data from Thomson Reuters Equity Market Share Reporter)
- Tax is issuance based and is 20 bp
- Scope includes French equities, HFT transactions and purchases of credit default swaps in European sovereign debt
- Began for stocks in 1984, initially at 0.5% and later doubled to 1.0%
- Volumes fell 30% on Stockholm bourse in aftermath of 1.0% rate
- Small tax on bonds began in 1989, leading to 85% fall in cash bond volume and 98% collapse in bond derivatives
- Increase in revenues from tax broadening less than 5% of expectations
- By 1990, more than half of all Swedish trading estimated to have moved to London
- Taxes on bonds abolished in 1990, tax on equities abolished in 1991
- Sweden's finance minister in 2011 estimated 90-99% of traders in bonds, equities and derivatives had moved from Stockholm to London due to the tax
(Sources: BBC, European Commission, Euroclear France, Financial Times, Freshfields Bruckhaus Deringer, ISDA, London Stock Exchange Group, Thomson Reuters)