Financial Transaction Tax (FTT) – another profit cutting regulation to cope with

MC_FTT

Directives, regulations, technical standards on thousands of pages have already been written in a direct reaction to the financial crisis of 2008. Today most of these legislations are still in implementing stages and financial institutions are struggling to keep up with the regulatory tsunami of EMIR, CRD IV, MiFID II, AiFMD, UCITS, MAR, etc.

Right in the middle of this already challenging situation, the European Commission tabled yet another legislative proposal – this time for a Financial Transaction Tax (FTT). It is planned to enter into force by January 1st 2014 for 11 participating member states – the so called FTT-zone.

If the FTT is actually going to be implemented as planned it will not just be another regulation to cope with – it will have a severe impact on current business models. Here are some alarming key facts of the current FTT proposal:

  • The 0.01% of nominal for derivatives and 0.1% for the rest is just a minimum – each member state could apply a higher tax rate.
  • In general the tax applies to the buyer as well as to the seller as any exchange of instruments is considered as two transactions
  • There is no exclusion for intra-group transfers – even if they are just for hedging purposes
  • Repos and sec-lending are not excluded and will thus pose a problem for institutions relying on those transactions for funding
  • Any “material” change in a contract counts as a new transaction – this especially affects OTC derivative transactions (e.g. for novations, restructuring, etc.)
  • Centrally cleared OTC deals through the use of client-clearing via an FTT-zone clearing broker are not specifically considered and might therefore incure a multitude of FTT costs
  • The tax for derivatives is purely based on the notional disregarding any other factors like e.g. time-to-maturity
  • For everything done off-exchange the tax will have to be delivered within just 3 working days
  • Pension funds are not excluded. This clearly favors very conservative investment strategies like buying bonds when they are issued and holding them until maturity (in this case the tax would not apply at all)

Preliminary estimates indicate that the tax revenue could be as high as EUR 31 billion annually, making it very appealing to many politicians. On the other hand though, it puts a further strain on the profit margin of banks and other financial institutions.

Consequently, many financial institutions, both within and outside the FTT-zone, have already identified affected counterparties and financial instruments in order to analyze the economic impact of the FTT. Existing business models now need to be reassessed regarding their profitability. Without question, implications will be dramatic, so innovative strategic and operational adaptations are required to deal with the immense costs financial institutions will be faced with.

Due to the preliminary estimates by financial institutions, possibilities aiming to minimize or even trying to avoid the FTT need to be evaluated. Financial institutions within the FTT-zone may reduce hedging and transactions for intermediaries to downsize the total number of transactions, thereby reducing FTT costs. Especially the decrease in hedging could prove to be an issue of unintended consequences. Rather than purely internalizing the costs of the financial crisis, the incentive to decrease micro-hedging of the positions could actually increase the likelihood of a new crisis. Financial institutions practicing high frequency trading are even more affected, so their business models need to be reassessed and alternatives have to be developed.
Another dangerous consequence for the FTT-zone will be that financial institutions outside the FTT-zone may avoid counterparties of the FTT-zone and also avoid trading securities issued in that zone. Also clearing brokers outside of the FTT-zone might get more attractive for both – clients within as well as outside the FTT-zone.
As countries outside the FTT-zone already face taxes on financial transactions (e.g. UK stamp duty, US section 31 fee), double taxation may be an issue as well. The British Government has launched a legal challenge against FTT because of concerns that it would have negative impact on non FTT-zone countries.

Implications will not only affect strategy, but also cause extensive operational planning and costs. Relevant counterparties and securities, for example, need to be identified and flagged within the systems, pricing and valuation models need to be adapted to include FTT when prices are being calculated, and rule sets need to be implemented to reflect the various exemptions (e.g. CCPs, CSDs, etc.). Generally speaking, systems and processes need to be adjusted to ensure a smooth workflow in spite of all the necessary changes. Furthermore, already implemented financial transaction taxes (Italy and France) must be adapted to meet the new FTT-zone standards.

Whether the FTT will achieve the required results, is yet to be seen. Attempts to introduce a similar tax on transactions in Sweden have shown that the generated new tax income was entirely offset by the decrease in capital gains tax return due to lower trading volumes. You could argue that Sweden’s tax was badly designed and is not a good comparison, whereas the results from stamp duties as practiced today in the UK, Switzerland or Singapore to name just a few, support the idea of introducing such a Tobin tax. Whatever the final tax will look like though, the problem of unintended consequences will remain as illustrated by recent comments from Jens Weidmann, head of the German central bank or Bundesbank, on the possible negative implications on monetary policy of the currently proposed FTT.

The proposed FTT will without a doubt require substantial strategic and operational reassessment, evaluation and planning. Yet the final rule set is still being drafted, so how should financial institutions cope with this new topic?

We advise financial institutions around the world to assess the economic impact on a very high level, to analyze the implications on processes and systems and to define a rough plan of action for the day when FTT becomes a reality.

This exercise will create awareness within the firm and also enable an institution to discuss the topic with regulators, thereby shaping the final outcome of the regulation. Staying proactive on a high level and voicing your opinion to be considered in the law making process can make the difference between large negative impacts on your profitability and a sound action plan ready for whatever the final tax will look like.