What does the FTT mean for investors and the financial markets?

Where we’ve come from . . . The FTT was first proposed by European Commission president Jose Barroso in September 2011. The European Parliament voted in favour of it in May 2012, despite strong opposition from a number of Member States. The proposal was then passed to ECOFIN, the European Council body responsible for deciding tax matters.

In October 2012, after a lack of unanimity in ECOFIN, 11 countries agreed to proceed with the FTT under the “enhanced cooperation” procedure, which is open to a minimum of nine Member States. The 11 are: Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovenia, Slovakia and Spain (the FTT Zone). The Commission subsequently issued substantive proposals in February 2013 that are being negotiated and eventually implemented by the 11. Although the European Parliament’s role in the enhanced cooperation procedure is minimal, it supported the proposal, with suggested amendments, in July this year.

Separately, France and Italy have both introduced an FTT on equities. These taxes came into effect on 1 August 2012 in France and on 1 March 2013 in Italy. On 1 September, Italy extended the tax to equity derivatives.

. . . and where we are nowThe situation remains fluid. In April 2013, the British government filed a legal challenge to the decision authorising the use of enhanced cooperation with the European Court of Justice. In June, the Commission tacitly admitted that the January 2014 launch date was no longer realistic but the FTT could still enter into force towards the middle of 2014. Tax commissioner Algirdas Semeta subsequently said the Commission was prepared to consider lower tax rates in certain market segments, including government bonds and pension funds.1

Impact on the marketsThe European Commission expects the FTT to reduce trading in derivatives by 75% and in cash equities and bonds by 15%.2 This is supported by trends in French and Italian equity turnover since the two countries introduced their own FTTs. Based on monthly figures from Thomson Reuters, Tabb Group says France’s share of European market volumes fell from 17.1% to 13.1% in the 11 months following the introduction of the FTT. Thomson Reuters figures point to a 45% fall in Italy’s share of the Eurozone market in three months of FTT. While European equity turnover rose 14% in the first half of 2013, French and Italian turnover has declined by 10%.3

So Europe’s proposed financial transaction tax (FTT) has been widely analysed within the financial community. But its implications are less widely understood by investors, corporates and consumers. Here we look at what the impact may be, what the final proposals may look like and how clients can prepare.

Securities and Fund Services

Citi’s Hans Lorenzen, Head of European Investment Grade Credit Product Strategy, says the proposed tax has big implications for liquidity. The impact is likely to be “particularly pronounced in fixed income, reflecting higher transaction costs relative to likely volatility.”4 Short duration products are expected to be most affected. Bank of America Merrill Lynch argues that “the FTT as currently constructed would render a whole range of current financial products and practices uneconomic.”5

Prime among them is repo, a EUR1 trillion market. Lorenzen says: “The proposals would have an enormous impact on repo markets, where overnight rolling costs would amount to no less than 22% annually. In all probability, all repos would have to be re-documented as some form of loan transaction, which is not straightforward as it creates a host of other problems associated with the transfer of ultimate ownership.” The International Capital Markets Association has warned that the Commission’s proposals put the “economic viability of the industry at risk.”6

There are concerns, too, about the securities lending market. According to the International Securities Lending Association, this generated incremental revenues of EUR3 billion for long-term investors in Europe in the year to May 2013. ISLA predicts that applying the FTT as envisaged would reduce the market to about a third of its current size. “Securities lending fee levels would need to increase by over 400% just to maintain current revenue streams,” it says.7

Operational and infrastructure issuesThe FTT has wide operational implications. ISLA suggests the tax could result in the removal of close on EUR500 billion of government bonds from the lending/collateral markets. “The growing demand to borrow high-quality collateral for the purposes of collateralising centrally cleared and other derivative transactions will be substantially undermined by the FTT with pools of potentially eligible collateral effectively left immobilised by the tax”, it says.8

Entities other than those party to the transactions (such as CCPs, CSDs, ICSDs and, by default, their members) under Article 10 of the proposal, they could be held jointly and severally liable for collection of the FTT. Clearing members have a principal relationship with a CCP and as such central clearing will also incur an FTT charge. At present, they and a CCP only take counterparty risk on each other. However, the introduction of joint and several liability for the payment of the tax on all participants in a transaction chain — as envisaged in the Commission proposal — could introduce anonymous counterparty risk.

Costs to market participantsGoldman Sachs has estimated the impact on Europe’s top 42 banks, on a 2012 pro forma basis, at EUR170 billion, and

this assumes no move to mitigate the tax by, for instance, exiting affected businesses. The FTT would also reduce the profitability of Europe’s exchanges and inter-dealer brokers, it suggests, by around a fifth on average. Derivatives exchanges would be more severely affected.9

The consultancy Oliver Wyman says: “Non-bank financial institutions such as pension funds, insurers and asset managers are hit as they bear a direct tax levy as well as any portion passed through by the dealer, potentially doubling the tax burden for these users.”10

Under the Commission proposal, asset managers will incur the FTT at two levels: on transactions undertaken at the portfolio level and in the trading of fund units. Goldman estimates that Europe’s fund managers could find themselves contributing around EUR17 billion a year in FTT: “Our top-down analysis implies that investors based in FTT countries could face an annual tax of 17-23 bps on their equity and bond portfolios”.11

Wider implicationsThe proposed FTT has implications at government, corporate and individual levels.

The Commission expects the economic impact to be either slightly negative or slightly positive, depending on how the tax revenues are used. The original impact assessment suggested a very significant impact on GDP.12 One uncertainty is the extent to which the FTT will increase government bond yields. Lorenzen has pointed to a number of factors — the cost of “cascading”, wider bid-offer spreads and a probable decline in the number of primary dealers — that would not only lead investors to demand higher yields but oblige sovereign issuers to syndicate their issuance, at a higher cost. “This likelihood is reflected in the comparatively outspoken comments against the FTT made by several national debt management agencies,” he says.13 Another impact may be the disappearance of some contracts or products altogether, not an increase in spreads, if the effect is too great.

The Commission expects trading in government debt to raise EUR6.5 billion in tax annually. This would more than offset an estimated EUR2 billion increase in debt funding costs. By contrast, Bank of America Merrill Lynch puts the added funding cost for just Germany, Italy and France at a minimum of EUR6.5 billion in the first year.14

Higher debt costs are also predicted for corporate issuers. Business Europe, an umbrella organisation representing industry associations across Europe, claims “the tax will raise the cost of financing for firms and hence undermine investment.” It also warns that by making essential risk management activities more difficult, it will damage European companies’ competitiveness.15

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End-investors will most likely bear a lot of the added cost, says Oliver Wyman: “Prior studies have shown that as much as 90% of the additional tax burden on financial institutions is generally passed on to end-users.”16

Where next?There are signs — both from the Council Working Group and from the European Parliament (which only has a consultative role) — that some of the difficulties are now recognised.

Among the Parliament’s suggested amendments in July were a reduced rate (0.01%) on repos and lower, transitional rates on government bonds (0.05%) and transactions involving pension funds (0.05% for equities and 0.005% for derivatives). They also suggested a limited exemption for market makers. These amendments appear to chime with the remarks of Commissioner Semeta, mentioned above, and recent calls for a scaling-back of the proposal from Pierre Moscovici, the French finance minister.17 Reuters has reported that some countries want all fixed income exempted, leaving a tax that would primarily affect equities and derivatives.18

Another key compromise may be a focus on either the issuance or the residence principle, but not to require both. This debate is causing division among the EU11. The European Commission and/or Member States may undertake further impact assessment on this aspect. However, the legality of the “establishment” principle is currently being considered by the EU. Under the current draft Directive, the principle impacts (through the imposition of the EU FTT) financial institutions resident outside of the EU11 dealing with any EU11 customer. The issue of legality could see the treaty rights of non-participating Member States being infringed.

Some reduction in scope therefore looks likely. Widely reported debate19 between the 11 over the final shape of the tax makes it highly probable the start date will be formally postponed. The final decision to go forward rests with the EU11 and requires their unanimous agreement to do so, that is, all must agree on the final text. It is also worth noting there is currently no method in place for the collection of the tax and systems would need to be reconfigured to identify the “establishment” of counterparties.

How can financial institutions prepare?Clients should plan on the basis that some variant of the Commission’s proposal will take effect. It is widely thought the German election in September will be an important determinant of the course of the current proposal and, if the current coalition remains, there is expected to be a narrower FTT. Institutions need to monitor developments in Brussels and assess the potential impact of the tax on their operations.

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Outline of the Commission’s proposals

All markets, all instruments, all actors!

The proposal is intended to capture the vast majority of financial instruments and financial transactions, including all securities (equity and debt), all derivatives, repos, stock lending, all types of fund units, money market instruments, structured products, swaps and possibly collateral. Key exclusions are loans, spot FX transactions, spot commodities, new issues and transactions with the European Central Bank.

The FTT is payable by financial institutions. However, the definition of “financial institution” is broad and includes investment firms, credit institutions, insurers, regulated markets, SPVs, UCITS/AIF funds and their managers, retail investment funds and pension funds. It is also likely to include the treasury entities set up by many corporate.

The proposed FTT would apply to all transactions globally where at least one party is a financial institution “established” in one of the FTT Zone countries. “Establishment” is widely defined (and does not follow usual tax residence rules). The establishment of such a financial institution would deem the same establishment on a non-FTT Zone counterparty that is itself a financial institution, making both parties liable for tax.

To deter relocation of business, the FTT will also apply to transactions by financial institutions “established” outside the FTT zone if:

• FTT Zone instrument: the instrument is issued within the FTT zone, regardless of where their counterparties are established.

• FTT Zone counterparty: the instrument is issued outside the FTT zone but their counterparty is “established” in the FTT Zone.

While the headline rates sound less than threatening (0.1% on securities and 0.01% on derivatives), the effective rates will be much higher. Because the tax will be applied at every leg of a transaction to which a financial institution is party, with only CCPs, CSDs and ICSDs exempt, the tax will be multiplied many times over. This has been called the “cascade effect”. For a transaction involving executing brokers and a clearing member on both sides, the tax paid could be multiplied eight-fold.

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Current actions we are taking

Citi has been working through financial and industry bodies to communicate widely held concerns. “We have also been encouraging real-economy companies and associations to look at the potential impact the proposals will have on them,” says Lorenzen. “In fact,” he continues, “we are trying to get as broad a population of people as possible to get engaged in this debate.”

What did our clients ask us?

Would all collateral substitutions in a repo be subject to FTT? This has not been dealt with clearly to date. But any change of ownership or material modification, such as moving assets internally within a corporation or modifying a derivative, are caught in the scope of the tax.

Would the London branch of an FTT Zone bank dealing in non-EU securities be liable for FTT? Yes, though if it were a subsidiary, it could possibly be exempt (but only if its customer is not “established” in the FTT Zone). Changing from one to the other may be viewed as an avoidance measure.

What is your best bet for the final outcome? Repo and government bonds will most likely be exempted, while the lending of equity securities is taxed. Given the disagreements between Member States, it is possible that the FTT will start with a narrow scope and more markets — such as securities lending — will be brought in later.

It is possible that an FTT on an issuance basis only will be considered a more readily achievable objective, although such a compromise does not appear to have been reached as yet.

What is clear is that the impact of the FTT will be widely felt. Firms need to assess the fallout on two levels. First, what is the impact on each business line? There may be some areas of trading or investment where the very viability of an operation is called into question. Second, what is the impact on the business model as a whole? Does the FTT require a change in strategy, a shift of resources or investment in new businesses, activities or geographies?

While the final shape of the FTT remains uncertain, that planning needs to be sooner rather than later.

More detailsFor more information about this or any related topic, please contact your Citi representative.

1 Speech to European Parliament, Jul 2, 2013.2 European Commission Staff Working Document Impact Assessment,

February 2, 2013.3 Tabb Group European Equities Market: 2013 Mid-Year review, September 3, 20134 Citi Research, April 10, 2013.5 Financial Transaction Tax – toll or roadblock? Bank of America Merrill

Lynch, March 25, 2013.International Capital Markets Association press release, March 11, 2013.

6 International Securities Lending Association, Impact of the Financial Transaction Tax on Europe’s Securities Lending Market, June 3, 2013.

7 Ibid.8 Goldman Sachs Equity Research, Europe: Financial Services, Financial

Transfer Tax: How severe?, May 1, 2013.9 Proposed European Commission Financial Transaction Tax Impact

Analysis on Foreign Exchange Markets, Oliver Wyman, January 201210 Goldman Sachs Equity Research, Europe: Financial Services, Financial

Transfer Tax: How severe?, May 1, 2013.11 European Commission Executive Summary of the Impact Assessment,

September 28, 2011.12 Citi Research, April 10, 2013.13 Financial Transaction Tax – toll or roadblock? Bank of America Merrill

Lynch, March 25, 2013.14 Letter from Business Europe Director General, Markus J Beyrer, May 6, 2013.15 Proposed European Commission Financial Transaction Tax Impact.

.Analysis on Foreign Exchange Markets, Oliver Wyman, January 2012.16 Reuters report, July 11, 2013.17 Reuters report, May 30, 2013.18 Ibid.19 Reuters report, September 10, 2013.