Including updates on financial transaction tax, recapitalisation plans for European banks, internal governance and product intervention


EC outline detailed financial transaction tax proposals

The European Commission (EC) has laid out its plans for a financial transaction tax (FTT), in an effort to influence the G20 agenda, when it meets in Cannes next month. The tax will apply to most financial transactions, where at least one party to the transaction is established in a Member State and where an EU financial institution is party to the transaction.

Under the proposals, trades of stocks, bonds and other similar instruments will be taxed at 0.1%, with complex derivative contracts taxed at 0.01%. The EC believes the levy could generate over 57 billion euros in revenues each year from 2014, and would go some way to ‘repay’ the 4.6 trillion euros support which has been provided to banks by Member States since 2008. According to EC President, José Manuel Barroso, the levy would allow the “under-taxed” financial sectorto make a “fair contribution” to public finances at a time of heightened fiscal consolidation.

The scope of the tax covers a wide variety of financial instruments, including structured products, both in the organised markets and over-the-counter, as well as the conclusion and modification of derivative contracts. It is also defined broadly as regards the types of trade and financial actors and applies to transactions carried both inside and outside a financial group, in an effort to mitigate gaming by financial institutions as they develop possible avoidance strategies to circumvent the levy.

To concentrate taxation on the financial sector, the tax will apply directly to financial institutions carrying out transactions. However, this does not prevent financial firms from passing on additional costs to clients to recoup costs. The proposals also outline provisions where both parties to a transaction would normally be charged for transactions, even if one party was based outside the EU. The EC have outlined a number of other key features of the FTT including:
  • The use of the residence principle - taxation in a Member State where the firm is located, independent of the location of the transaction.
  • Collecting the tax - the moment of chargeability will be defined at the instance the financial transaction occurs (subsequent cancellation cannot be considered as a reason to exclude chargeability of tax except in cases of errors). The EC will expect firms to build electronic systems to ensure that the FTT is paid within three working days to the relevant tax authority.
  • The tax rate will be a minimum standard - countries will have sufficient margin of manoeuvre to set tax rates above the rate set by the EC and the specification of accounting and reporting obligations.
The FTT will not apply to:
  • financial transactions conducted by central banks or national governments
  • financial transactions on primary markets for securities (to ensure sovereign and private funding is not disrupted), and currencies (to preserve the free movement of currencies) - however, derivative agreements based on security/ currency transactions will be covered by FTT
  • day-to-day financial activities of private households, businesses, and financial firms such as lending and borrowing, consumer credit, payment services etc.
Business and financial groups have reacted negatively to the EC’s plans, highlighting that it will actually cost significantly more to the economy than it generates in exchequer revenue. In its impact assessment, the EC estimates that the FTT would reduce long-term gross domestic product (GDP) in the EU within a range of between 0.53- 1.76 %, against an increase in tax revenues associated with the FTT equivalent to 0.08% of GDP. Much of the costs to the economy associated with the tax are related to the ‘strong risks’ of relocation, which could be reduced if the tax is adopted internationally.

According to the EC’s own analysis, the FTT will likely “wipe-out” or, at best, displace up to 90% of the derivative trading taking place in the EU if no international agreement has been agreed. Various market behaviours and business models will also be ‘severely’ affected. For example, in high frequency trading, the tax-induced increase in transaction costs will erode profit margins and will likely result in a shift toward automated trading based on algorithms that trigger less frequent but higher-margin transactions, making EU financial institutions less competitive than their international peers. The FTT may also increase the cost of capital to firms according to empirical studies, which runs contrary to other initiatives, for example proposals at creating a venture capital trusts across the EU, which are designed ease credit for firms and reduce funding costs. However, the EC intends to set the ultimate tax rates at a level to reduce the ‘eventual impacts’ on the cost of capital for non-financial investment.

Recognising these concerns, President Barroso argues that the FTT could have the effect of cleansing the market from a lot of high-tech practices which fuel speculation, noise and technical trading and market volatility. Therefore, the loss of GDP to the EU economy due to the FTT would be offset by more stable and sustainable financial practices. Such sentiments have been echoed elsewhere recently. Adair Turner, Chairman of the UK Financial Services Authority, in a speech to the University of Southampton, rallied against the current orthodoxy in financial reasoning, calling it ‘wrong and dangerous’. In particular, he suggested that we now need to question whether financial innovation is automatically good, whether more trading and market liquidity are always economically beneficial, and whether regulations are ‘radical’ enough to address key market challenges.

Regardless of these arguments, the initiative will still face significant hurdles in Europe and elsewhere before it is adopted. The proposals — which requires unanimous approval from the Council of Economic and Finance Ministers (Council) — have the backing of the bloc’s two largest members Germany and France, but are vigorously opposed by the UK, amongst some others, unless it is adopted internationally. This view is supported by Jean-Claude Trichet, President of the European Central Bank, who in July called on European parliamentarians not to pursue plans for a FTT — warning that the competitiveness of financial centres across Europe would be damaged unless the scheme was adopted internationally.

The EC admits that a coordinated approach to a FTT at an international level is the best option. However, the chances of international agreement are slim. The U.S. administration is against a tax on financial transactions. Moreover, as we reported previously, the IMF believes that there are more efficient ways of taxing the financial sector than a FTT. In a 2010 report, the IMF argued that a backward looking charge on financial instruments, based on past balance sheet items, would be a more effective way of recovering the costs of government support during the crisis, noting that FTTs reduced the value of securities, increased the cost of capital to users and had the effect of lowering overall liquidity in financial markets.  

Therefore, it is difficult to see how the EC will be able to build consensus amongst international partners, given the challenges it has faced trying to sell the merits of a FTT in Europe. Given the EU sovereign debt crisis, the November G-20 summit in Cannes is more likely to focus on that than long-term mechanisms to mitigate the costs of financial crisis, making gaining international support for a FTT less likely.

For further insights, we have produced a Global FS Tax Newsflash on the proposed financial transaction tax.


European governments step-up their efforts to address sovereign debt concerns

José Manuel Barroso, European Commission President, is preparing a coordinated action plan to recapitalise European banks, as a strategy to replenish troubled banks’ balance sheets in light of possible sovereign debt write-downs. Mr. Barroso's comments were followed by a statement on Wednesday by German Chancellor Angela Merkel, indicating her government was ready to reactivate a national mechanism for bank recapitalization, while French Finance Minister François Baroin spoke about the need for a further European recapitalisation exercise.

As the European Banking Authority (EBA) concluded it two-day meeting on Thursday, rumours were circulating that a second round of stress tests was imminent. The EBA is under intense pressure after its chairman Andrea Enria admitted that its July stress test exercise, which Dexia passed, did not reassure financial markets. Defending the pan-European stress tests, Commissioner Almunia said they were “serious operations”, however, the deepening of the credit crisis had meant that more banks needed recapitalisation than in July when the tests were conducted.

Late on Thursday, an EBA spokesperson refuted suggestions that it will actually do a new round of stress tests on banks but didn’t rule it out completely in the near future. Reading between the lines on what the EBA said, it is most likely that it will remodel sovereign write-downs using historical data in its July stress test, to assess the impact of pricing their sovereign debt at the going rate.

These developments are welcome and are a far-cry from statements last month, as Christine Lagarde drew criticism in Brussels after stating that European banks required “urgent” and “substantial” recapitalisation. European governments need to be resolute in the next few months with their recapitalisation plans in order to credibly address sovereign and banking system concern. A failure to do so could increase contagion risks and result to a further wide-scale pullback in European bank assets from investors.


Regulators to get tough on internal governance

From 2012, national regulators are likely to shift their attention from designing and implementing regulations, to focusing more on monitoring and supervising, as the single rulebook becomes increasingly populated and they start to relinquish certain regulatory functions to the European Supervisory Authorities. Along with consumer protection and retail products, internal governance systems at financial institutions are likely to receive increased attention from regulators. Financial institutions need to be prepared for more intensive scrutiny of their corporate structure and processes, risk management procedures and internal controls.

To help banks prepare for greater oversight, the European Banking Authority (EBA) has published guidelines on internal governance in line with its efforts to enhance and harmonise supervisory expectations across the EU. The guidelines address weaknesses which were revealed following a survey in 2008, in terms of oversight of the supervisory function, risk management and internal control frameworks at EU banks. Most of the changes are incremental. Here we focus on the new guidelines related to ‘Management Body’ which were significantly enhanced to ensure that managers devote sufficient time to their functions.

In total, three sections were added on the composition, appointment and succession of management, together with new guidelines on the qualifications of the management body. On the former area, the following are the most important changes:
  • the management body will be adequately resourced with an appropriate composition
  • the management body will be responsible for having policies in place for selecting, monitoring and planning the succession of its members. These policies should include the delineation of necessary competencies and skills to ensure sufficient expertise.
  • appointments to the management body should be for an ‘appropriate period’. Nominations for re-appointments should only take place after careful consideration of the performance of the relevant member during the previous term.
On qualifications, management should have an up-to-date understanding of the nature of business of the firm, its risk profile, governance structure, associated risks and have adequate experience of the material activities of the firm. Firms must have explicit procedures in place to ensure that the management body members, individually and collectively, have sufficient qualifications commensurate with their responsibilities. Institutions need to ensure that members have access to individually tailored training programmes which should take account of any gaps in the knowledge profile needed by the institution and members’ actual knowledge. Areas that might be covered include:
  • products or markets and mergers
  • institution’s risk management tools and models
  • new developments
  • complex products
  • changes within the organisation.
These guidelines appear straightforward but the challenge for firms will be demonstrating that they have sound procedures in place to ensure they comply on an ongoing basis with the requirements. The EBA expects national supervisors to implement the guidelines and to incorporate them within their supervisory procedures by 31 March 2012.


ESMA call for great transparency and product intervention powers

Steven Maijoor, chair of the European and Securities Market Authority (ESMA), at the FMS Supervision Conference in Vienna, called for legislation to harmonise powers on product intervention throughout Europe. He believes that transparency requirements can only go so far in protecting investors, and in certain instances it is necessary for regulators to intervene early at the product design stage as well as the point of sale, to ensure certain complex and high sophisticated products are not sold to retail investors.

In the interest of protecting investors, ESMA are considering supplementing greater transparency requirements for highly sophisticated and complex products (which can be difficult to understand and evaluate), such as Exchange Traded Funds and structured UCITS, with product intervention measures such as bans.

Currently, ESMA has the power to overrule Member States if local regulations do not take appropriate action to sufficiently address a threat to investor protection. In these circumstances, ESMA has power to issue ‘investor alerts’ and also ban or restrict distribution on certain products of activities, directly in national markets.

This is the second time in the last few months that Maijoor has highlighted the need for effective product intervention legislation across Europe. In his most recent speech, Maijoor indicated that ESMA had established a new Financial Innovation Standing Commission (FISC) to assist the regulator in the issuing of warning for products, product intervention, and collecting data on consumer complaints. FISC’s main aim, according to the press release announcing its establishment, is to achieve ‘a co-ordinated approach to the regulatory and supervisory treatment of new or innovative financial activities’. FISC may make proposals for the co-ordination of national responses to any issues identified in the area of financial innovation.

While enhanced transparency is not always sufficient to guarantee the proper functioning of markets, Maijoor did call for more disclosure on sovereign debt exposures. This is in line with recommendations of the European Systemic Risk Board, which on 21 September emphasised the need for transparent and consistent valuation of sovereign exposures.

Maijoor also trumpeted ESMA’s role in coordinating the recent rounds of short-selling bans across four European countries. As we reported previously, despite ESMA’s best efforts to reach a European consensus, countries such as the UK declined to participate, while Germany is still holding out for an EU ban on naked short-selling of stocks, government bonds and credit default swaps, before committing to any joint efforts. However, the August round of short-selling was much better co-ordinated than measures introduced following the 2008 collapse of Lehman Brothers and more consistent. This time, ESMA was able to develop almost identical prohibitions in all four countries.

Demonstrating its enhanced coordination responsibilities, ESMA announced on 29 September that Italy, France and Spain have renewed their temporary bans on short selling/short positions, which were due to expire on 30 September 2011. Spain did not specify a date on when the restriction will be lifted, suggesting it will remain in force until market conditions dictate. The French and Italian extensions are until 11 November 2011. The Belgian regulator noted previously that its prohibition on short-selling has no end-date but that it will consider lifting its ban as soon as market conditions allowed. Maijoor noted that European Parliament and the Council are close to concluding negotiations on the short-selling proposals. New legislation around short-selling would avoid confusion and regulatory arbitrage in the future and help firm’s operationalise procedures relating to short-selling.


BIS highlights concerns on high-frequency trading in FX markets

The increased use of high-frequency trading in foreign exchange (FX) markets has raised considerable concerns amongst market participants and regulators as to the functioning and integrity of markets as well as general systemic risk considerations, according to a recent report by a Study Group of the Bank for International Settlements (BIS).

According to the report, the structure of the FX market has been radically altered in the last decade, as the advent of new alternative trading venues, together with the development of prime brokerage credit sponsorship, has helped support the rapid growth of high-frequency trading (HFT). While this has increased market efficiency and compressed spreads, it has resulted in the exit of many traditional market-makers, with the ones who remain changing how and where they provide liquidity. As a result, the FX market is much more concentrated and sensitive to risk. The Study Group is concerned that HFT liquidity may ‘evaporate rapidly’ in stressed situations or if there is a further reduction in the already low number of key FX participants providing liquidity. There is also a concern that the current tight FX bid-offer spreads do not fully reflect these risks, particularly in relation to sources of liquidity on large trade sizes.

According to the BIS report, systemic risk is more likely to be triggered by a ‘rogue’ algorithmic trade, as with the 6 May 2011 flash crash in US equities, than by pure HFT given the small size of trades, their short horizons and diverse strategies. However, there are a number of key differences in the structure of FX markets that makes a flash crash-type event less likely during normal trading hours. Firstly, FX is a relative and not absolute price, which means that wealth will be redistributed and not reduced (as with equities) during a crash. Next, there is a natural demand for FX related to cross-border trade and financial flows that provides some basic underpinnings to market liquidity. Finally on market integrity, the report sensibly notes that HFT is simply a manifestation of the operational advantage gained by superior technology which has been present in the market, in some shape or form, for many decades. As such HFT strategies can actively seek out large orders and quickly take advantage of the effects such orders have on market price. However, the growing percentage of orders that are processed by banks internally, rather than in the market, presents a problem implying that these banks may achieve a certain information advantage over other market participants.

Overall, the report concludes that HFT’s impact on market functioning is ‘generally benign’. Supervisors should maintain dialogue with those monitoring trades, i.e. prime brokers and the trading platforms, and the algorithmic and HFT community in FX to identify potential problems early on, and bring about lasting solutions. Whether ongoing regulatory reform initiatives — especially new guidelines on automated trading from ESMA and the European Commission’s MiFID II — will impact the ecosystem of the FX market remains to be seen. Final proposals on MiFID II are expected later this month, which will be covered in detail on this site as well as our accompanying MiFID II page.