EC recognises member state fears that FTT will hurt clearing
The European Commission has acknowledged concerns about the impact of its proposed financial transaction tax (FTT) on cleared over-the-counter derivatives trades, after a leaked discussion document revealed member state fears that the tax regime could encourage market participants not to clear and even threaten clearing house solvency.
The document – dated April 16 and seen by Risk – was prepared for the European Council working party on tax questions by the European Commission’s Taxation and Customs Union, DG Taxud. Delegations from six member states submitted questions, with those from the Czech and UK delegations focusing on how the tax would apply to cleared trades.
DG Taxud declined to comment on the leaked document, but a spokesman for the directorate says: “We can confirm that we are aware about the concerns that have been expressed about possible effects of the tax on complex transactions involving several intermediaries. In our proposal of last February, this effect is mitigated by article 10(2). This proposal is now being discussed in the council.”
Under current proposals, supported by 11 members of the European Union, both counterparties to an over-the-counter derivatives trade would be taxed at a rate of 0.01% of the contract’s notional value. But Europe’s clearing model rests on a chain of back-to-back trades, in which members of a central counterparty (CCP) stand between their clients and the clearing house, acting as principal to trades with each side.
In response to questions from the Czech delegation, the document confirms the tax would be payable on these trades. That would result in six instances of the tax on a single cleared transaction – it would be paid once by each of the original counterparties, a second time by each counterparty as it faces its clearing member and once by each clearing member on that transaction. The trades between the clearing member and the CCP would be exempt, the document states.
Article 10(2), which DG Taxud argues would mitigate the impact, states: “Where a financial institution acts in the name or for the account of another financial institution only that other financial institution shall be liable to pay FTT.” It is understood this exemption applies only to clearing members facing clients on an agency basis, rather than as a principal – at the moment, OTC clearing in Europe takes place on a principal basis.
In the discussion document, the Czech delegation clarifies the burden generated by a vanilla, cleared trade and then highlights the discrepancy between that and a more complex, uncleared transaction.
“In the case of highly tailored OTC derivative contracts which cannot be cleared between two French financial institutions there will be only one taxable transaction. Is this result correct?” the delegation asks. DG Taxud replies that it is.
The Czech delegation goes on to ask whether the CCP would be liable to pay the tax in the event that it is not paid by any of the other actors in a cleared trade – an issue raised by article 10(3) of the tax, which makes “each party to a transaction, including persons other than financial institutions… jointly and severally liable”.
DG Taxud’s response says that a CCP “shall be” liable, in the instance that the tax had not been paid on time, or in the instance that a member country decides the tax should apply to financial intermediaries.
The Czech delegation warns: “The quantity of contracts cleared through a CCP is enormous. Such a liability may send a CCP directly into insolvency.” There is no direct response to that comment in the document.
The commission also declined to comment on other analyses of the FTT impact on clearing. In a research note published in April, Hans Lorenzen, European investment-grade credit products strategist at Citi, said: “Because the tax would apply to both sides of a transaction (buying/selling) there would be a cascading of tax payments, implying that the true level of taxation ends up far higher than the headline numbers suggest. For instance, a simple transaction from one investor through a broker-dealer, a clearing house, a broker-dealer on the other side to another investor would end up incurring no less than six payments of the tax.” It is understood DG Taxud disputes that conclusion – again on the basis of article 10(2).
By some measures, however, the cascading effect of the tax could be still more onerous than the example given by Citi, which considers a so-called directly cleared trade involving a CCP, two clearing members and two clients. Under indirect clearing provisions contained in Europe’s clearing regime, the European Market Infrastructure Regulation (Emir), those clients would also be able to take on clients of their own, extending the chain by another step and theoretically exposing a single trade to 10 instances of the tax.
This is believed to be the scenario raised by TJ Lim, global head of markets for UniCredit, at the annual meeting of the International Swaps and Derivatives Association at the end of April. Lim said: “By the time the instruments end up at a clearing house, the FTT will amount to as much as 10 basis points, meaning the FTT could be bigger than the bid-offer spread. The FTT will kill the market. Politicians don’t really understand what they are getting into.”
And similar concerns are voiced by a European tax expert with one financial trade organisation: “The situation highlights one of the inconsistencies between the FTT and Emir. With a bilateral transaction, the situation is simple: you have a swap between two counterparties, and two taxable legs of one transaction. If it’s cleared, then you have a client, a broker and a clearing member; who knows how many times the same trade will be hit?” he says.
This article was first published on Risk