11 April 2013

Citigroup: European Financial Transaction Tax - No time to procrastinate

One of the salient arguments in favour of ‘Tobin taxes’ (taxes on financial transactions) is that they discourage the sort of short-term speculative flows that can be damaging when they reverse, as we saw in the Asian crisis. We suspect the distinction between these speculative flows and the vital repo market may not be entirely clear to many policymakers. However, it is an important distinction as the repo market, where funding is provided in exchange for collateral, is pivotal in the transmission of liquidity in the financial system. More than €1 trillion trades in the European overnight repo market; this would clearly collapse under the proposed tax, considering that the individual payments at each roll would cumulate to no less than 22 per cent on an annual basis. While it has been suggested that the repo market could migrate to some form of secured lending outside the scope of the FTT, in practice, the huge body of legal documentation underlying the market would make this extremely difficult.

The importance of the repo market extends far beyond just bank funding; it is central to market making and the provision of liquidity. In many asset classes, a trader usually won't be able to engage in back- to-back transactions that allow him/her to sell and buy back an instrument in the same day. Much more often, he/she will borrow on repo in order to sell it, and then cover the position when a willing seller is found a few days later. Without repo, traders will simply refuse to offer in the first place. If it becomes impossible to short, then many instruments will effectively end up trading 'by appointment only'.

In aggregate, liquidity across a broad swathe of financial instruments, especially low yielding, short-dated ones, would be significantly reduced, fund returns would suffer and bank earnings would be impacted...

The proposed FTT seems to run directly counter to the broader direction of recent regulatory initiatives aimed at promoting financial stability. It would make hedging more expensive; it would make asset prices ‘gappier’; it would discourage trades that require central clearing; it would encourage a shift back to the bank lending model in Europe; and it would make banks more dependent on fickle unsecured funding. It would also substantially add to illiquidity premia, including in corporate credit and in vulnerable markets like peripheral governments.

We do expect Member States will want to make significant changes before the proposal becomes final legislation. The scope may end up being narrower, there may be carve outs at least for certain transactions like hedges, and (hopefully) the repo market will be made exempt. Moreover, the complexity of the issues and the ongoing German election may force a later implementation date.

However, we think it would be a mistake to underestimate the political resolve behind the initiative and for market participants to assume that this will all just go away. The political push to ban naked short-selling on sovereign CDS was ignored for a long time, because market participants expected that 'common sense' (i.e. market logic) would water it down. However, in the end, a ban was enacted and the sovereign CDS market has been left a mere shadow of its former self.

The legislation that is enacted may yet compel corporates to issue debt from finance vehicles established outside the FTT zone. Funds that execute significant transactions outside the FTT zone will seek to relocate there. And fixed-income investors in the FTT zone may want to make sure that they are happy to hold them to maturity — or at least on a long-term basis. The time for procrastination is running out.

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