Briefing note. Importance of derivatives for end-users. 4 September Association for Financial Markets in Europe
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1 Association for Financial Markets in Europe Briefing note Importance of derivatives for end-users 4 September 2014 Executive summary The proposed FTT is expected to significantly increase the cost of derivative trading in the EU-11 market and lead to the migration of a significant proportion of all derivatives activity to non EU-11 jurisdictions. This could mean that in many cases corporates would face limited access to derivative services provided in their home markets; Derivative markets are needed by a variety of end-users for daily and termed hedges and risk management; The cascade effect of the tax drives total tax incidence many multiples higher than the headline rate; A sharp increase in transaction costs at the short end of the market is expected to render transactions of maturities less than 6 months unviable for EU-11 dealers to facilitate; this is predicted to drive an overall market-wide volume decline 1 ; Oliver Wyman predicts that EU-11 end-users will have a total impact of TN of un-hedged exposure. 1. Introduction At the ECOFIN on 6 th May, ten out of the eleven FTT Member States issued a joint statement which expressed the intention for introducing an FTT on a step by step approach with the first step being implemented on 1 January It is envisaged that the introduction of a harmonised FTT would start with the taxation of shares and some derivatives. In light of these developments some strategic questions need to be carefully considered by Member States in their discussions about, in particular, the taxation of derivatives. Derivative markets allow corporates and investors to hedge unwanted risk exposures efficiently and to focus on core business activities. The application of an FTT to some derivative transactions, either as a first or subsequent step, would have highly damaging effects for EU-11 companies and the real economy. Oliver Wyman recently conducted a study on the impact of the proposed FTT on end-users looking at the impact across a range of instruments, including derivatives. The report shows that, as a result of the introduction of the tax, it is likely that the EU-11 interdealer market would cease to exist, and that a significant proportion of all derivatives activity would migrate to non EU-11 jurisdictions. This would create a significant competitive disadvantage for EU-11 financial institutions, as it would impair the provision of derivative services by EU-11 based banks, with potential knock-on effects on the pricing of other banks services. In many cases corporates would thus face limited access to derivative services provided in their home markets. Because of the interconnectedness of Europe s financial markets it can be expected that the FTT would also have a negative impact well beyond the EU-11. Although the Oliver Wyman study focuses on the negative 1 Oliver Wyman (2013). The impact of the EU-11 Financial Transaction Tax on End-Users, p. 44 link 1
2 impact of the FTT on EU-11 end-users, any impact on their ability to hedge risks will have repercussions on the corporates and the banking industry at European, if not global, level. On top of these important market changes, Oliver Wyman predicts a significant increase in the annual cost of managing risk for corporate and investors in the EU11 conservatively estimated at around 5-15bn annually across interest rate and foreign exchange derivatives. 2. Use of derivatives by end-users Derivatives are important for corporates and investors in helping them to manage their business and investment risks 2. Oliver Wyman focused their analysis on the largest derivatives markets of EU-11 end-user activities, i.e. interest rate and FX derivatives, both traded OTC and on-exchange. They did not consider the impact on the smaller markets of commodity, equity and credit risk derivatives but the analysis and conclusion could be expected to be similar (see also page 4 for more info on the introduction of the FTT on the Italian equity derivatives market). They explain in the report that: derivative markets are used by a variety of end-users for daily and termed hedges and risk management. 3 Here are some examples included in the report: A German manufacturer imports aluminium from Russia for use in production, with payment due in Rubles (RUB) and uses a currency forward to lock-in the exchange rate and a listed aluminium contract to hedge against a rise in the price of aluminium; A French services firm receives a floating rate loan from a bank and enters into an interest rate swap to pay a fixed rate of interest to hedge a rise in interest rates; A pension fund uses an FX futures portfolio to manage the risk of currency movements and potential asset / liability mismatch; An asset manager of a Riester savings plan uses interest rate futures to rebalance portfolio durations on a daily basis to adjust the asset and liability (ALM) profile of the fund and to provide guaranteed income for retirees. The Oliver Wyman report then continues by saying that: The key driver behind these markets is end-user risk management. End-users, whether corporates or investors, are not in the business of running risk management. Derivative markets allow corporates and investors to hedge unwanted risk exposures efficiently and focus on core business activities. For flexibility, investors and sophisticated corporates tend to use short dated (sometimes daily) OTC and listed contracts to hedge risk. Derivatives provide a cost-effective and flexible tool for adjusting portfolio exposures. End-users will often use many different types of derivatives as is also explained in a specific example included in a study conducted by economic consultancy firm Oxera (2011) 4. As an illustration, Oxera considered a large car manufacturer which had a specific treasury function and was therefore considered to be a financial institution and which was exporting 1m of cars to the US: The following hedging activities would be subject to tax: payment is agreed 12 months before delivery, so a currency hedge is taken out. A change in the delivery date means that this hedge has to be revised to reflect the new date, incurring the tax again (FTT= 1m x 2 x 0.02% = 400); short-run debt to purchase the input materials (assumed to be half the value of the output) requires interest rate hedges (FTT= 0.5m x 0.02% = 100); 2 In the Annex to this note is a list of quotes from position papers and letters from end-user groups on the taxation of derivative transactions 3 Oliver Wyman (2013). The impact of the EU-11 Financial Transaction Tax on End-Users, p. 40 link 4 Oxera (2011). What would be the economic impact of the proposed financial transaction tax on the EU? p.25 link 2
3 naked credit default swap on 1m of counterparty s shares bought to provide insurance against default (FTT = 1m x 0.02% = 200); commodity price hedges for the output commodities (assumed to be two-tenths of the value of the output) (FTT = 200k x 0.02% = 40). In this illustration, the total cost of derivatives would be 740. For a manufacturer making a 10% margin, this would represent a 0.74% reduction in profits. In a recent paper 5 ISDA explained that the derivatives most commonly used by end-users are interest rate and FX instruments, followed by commodity, credit and equity products. The outstanding notional value of, for example, interest rate derivatives which involves end-users as one of the counterparts to the trade is many trillions of dollars and these transactions are very important for corporates and investors such as pension funds and insurance companies. In a recent survey 6 conducted by ISDA 85% of the end-users said that derivatives were very important or important to their risk management strategy. Also in the commodities space, derivatives are heavily used and commodities producers, processors and endusers manage their business and financial risks by entering into derivative contracts. For example, an airline is exposed to the risk of jet fuel price fluctuation and hedges this risk by entering into a commodity derivative that locks in the price of the jet fuel. A farmer, who grows crop, uses derivatives to hedge the risk that the crop's price declines by the time he harvests it. 3. How derivatives transactions work and cascading tax effect When a corporate or an investor decides to use a derivative, this will not simply lead to a single transaction between the end-user and the financial institutions. The financial institution will have to undertake several transactions on the back of the trade with the end-user. Going back to the Oliver Wyman report, this study explains that executing a single client trade typically involves several interdealer transactions as the dealer decomposes the risk and hedges in the interdealer markets. They continue by giving another example of how the cascading effect works in a derivatives transaction: The bespoke nature of many end-user transactions requires the dealer to intermediate and decompose this risk to properly hedge its own resulting exposure. As an example, a European corporate issuing a 10 year floating rate dollar-denominated bond (to attract US investor pools) may wish to reduce its exposure to currency fluctuations. The corporate will buy a cross-currency swap (taxed at 1bp on the dealer side) which is a hybrid interest rate and foreign exchange derivative tailored to fully hedge both the currency and interest rate risks of this capital raising. To facilitate this, the dealer will decompose and hedge this risk in interdealer markets to deliver a risk-neutral position. In this case it requires four additional interdealer transactions: 1. An FX swap of US Dollars to Euros to allow the proceeds to be used by the corporate; 2. A Euro interest rate swap from fixed to floating rates exposure; 3. A US dollar interest rate swap from fixed to floating; 4. A basis swap to hedge the basis risk between the interest rate and FX exposure differential. 5 ISDA (2014). Dispelling myths: end-user activity in OTC derivatives link 6 ISDA (2014). The Value of Derivatives, p. 3 link 3
4 Source: Oliver Wyman analysis Overall, this transaction chain will attract a multiple of the headline tax rate: Across the chain, this requires a minimum of five taxable transactions on the notional traded, equating to a tax 9x the headline rate. For non-linear transactions (e.g. with optionality, such as a put/call option) the interdealer multiple may be many times this. Therefore, the cascade effect in derivatives markets drives total tax incidence many multiples higher than the headline rate. 7 Under the current proposal, OTC derivative markets will not be taxed by the issuance principle. Therefore transactions between two non EU-11 institutions will not be taxed under the FTT. This means that EU-11 banks will be at a competitive disadvantage to other banks which are not in the EU-11 as they will have fewer taxable transactions down the chain. In calculating the direct impact, Oliver Wyman assumes that the EU-11 interdealer market ceases to exist, and that all derivatives activity which has the possibility to do so migrates to non EU-11 jurisdictions, such as London and Zurich. In Oliver Wyman s study this trend was confirmed in the interviews they held with end-users where, for example, a global consumer good company stated that they would migrate their derivatives trading activity to London or Luxembourg and cease trading with EU-11 banks. 4. Increasing costs for end-users and un-hedged risk exposures Oliver Wyman predicts that the FTT would drive an overall market-wide volume decline of 30 50% for FX forwards, and 40 60% for interest rate swaps. The total direct impact (post volume reductions) is 5 15 BN for EU-11 end-users, depending on the magnitude of volume reduction which is an increase in risk management costs 8. Even though Oliver Wyman predicts that the EU-11 interdealer market ceases to exist, there will still be a direct tax impact on end-users (the 5-15 BN quoted) given that the first, initial transaction between the EU-11 end-user and the non-eu-11 financial institution will remain taxable (more details on these numbers can be found in the Oliver Wyman report). A reduction in market volumes has also been seen in the Italian equity derivatives market following the introduction of the FTT on equity derivatives in September No official data is available yet regarding OTC derivative transactions in general, and in Italy in particular. However, a number of banks which actively participate in the market of OTC derivatives on Italian equities 7 Oliver Wyman (2013). The impact of the EU-11 Financial Transaction Tax on End-Users, page 41 link 8 Oliver Wyman (2013). The impact of the EU-11 Financial Transaction Tax on End-Users, page 40 link 4
5 have witnessed a sharp drop in client demand for these instruments, and an overall reduction in their liquidity. Such drop in the OTC market has not been offset by a material increase in the market of listed instruments. Public data on the listed market suggests that volumes have been relatively steady, with a slight change in the structure: fewer transactions, with larger average sizes. The introduction of the Italian FTT on derivatives is also responsible for part of the drop observed in the liquidity of the Italian equity markets, as less client demand means less hedging activity by banks. The impact is yet impossible to distinguish from the tax on equities. So as a whole, notwithstanding very limited revenue, the FTT on Italian equity derivatives has had a very material impact on the OTC derivative market, which is not offset by a pick-up in the listed market. In the context of the proposed enhanced cooperation FTT, also others have predicted that the tax would lead to a sharp increase in transaction costs at the short end of the market and render transactions of maturities less than 6 months unviable for EU-11 dealers to facilitate. As the GFMA Global FX Division 9 has calculated for EU corporates, their FX transaction costs can rise by up 700%. For a pension fund or fund manager, the impact is even greater and they could see their transaction costs rise by around 1500% and possibly by as much as 4700%, due to the double-sided nature of the proposed tax. In addition to the annual cost increase for end-users for the use of derivatives of 5-15 BN, Oliver Wyman predicts that EU-11 end-users will have a total impact of TN of un-hedged risk exposure 10. As Oxera pointed out before, 11 the Commission has not assessed the effect of this un-hedged risk exposure and does not consider any costs arising from end-users not using derivatives due to the FTT: The Commission assumes that the loss of trading simply reflects a drying out of the rent-generation business models for the financial sector itself 12. However, this position appears less tenable if particular types of derivative currently demanded by end-users are particularly discouraged by the FTT, resulting in end-users not demanding those derivative contracts. In this case, end-users will need to shift to some new (more expensive, but not taxed) activity for the cheaper (before tax) derivative contract. This cost shock can be expected to be reflected in final product prices (or wages/profits). Hence there will be higher prices in the final product market, but no tax revenues. 5. Conclusion In summary, based on the available research, we believe that the application of an FTT to derivatives transactions, either as a first or subsequent step, would: push derivatives trading activities outside the EU-11 zone and greatly impact the competitiveness of, and impair the provision of derivatives services by EU-11 based banks, with potential knock-on effects on the pricing of other services that they are able to offer to their clients; force many end-users to reduce hedging activities as derivatives transaction costs increase, while others will term-out derivatives activity moving to longer-dated instruments with less flexibility; lead to a significant increase in the annual cost of managing risk for corporates and investors in the EU- 11 and thereby highly damage EU-11 companies and thus the real economy; increase earnings volatility for corporates and investors as a result of the reduction in hedging activities. 9 GFMA Global FX Division (2013). GFXD Analyses Impact of Proposed EU Financial Transaction Tax on Foreign Exchange Markets link 10 Oliver Wyman (2013). The impact of the EU-11 Financial Transaction Tax on End-Users, page 45 link 11 Oxera (2013). Analysis of European Commission staff working document on the proposed Financial Transaction Tax link 12 European Commission (2013). Staff working document impact assessment accompanying the document proposal for a Council Directive implementing enhanced cooperation in the area of financial transaction tax analysis of policy options and impacts link, page 30 5
6 Annex AmCham Belgium (letter, 26 April 2013): The direct implications of the proposal potentially include providing fiscal disincentives for business to: Hedge commercial risks, including, but not limited to, currency, interest rate and commodity; CBI (position paper, May 2013): Risk Management activities of non-financial companies can be caught within the scope of the FTT, yet are beneficial corporate functions and not financial speculation. Derivatives are utilised by businesses in a number of ways to manage the risk that a certain activity will lead to a loss. Many pension funds and schemes actively manage their portfolios (including the use of derivatives) to not only optimise investment performance but also as a risk management strategy. These will therefore be heavily impacted by the FTT. DAI (FTT impact study, July 2013): Companies in the real economy will also be impacted negatively by the financial transaction tax. The total tax burden is estimated at 2.4 to 3.7 billion, resulting primarily from the use of derivatives, which are applied in order to hedge against fluctuations of exchange and interest rates. EACT (position paper, May 2013): Increased cost of hedging: corporates use derivatives in order to mitigate their business risks; this benefits the economy by introducing greater certainty in planning and forecasting together with more stable prices for customers. The importance of safeguarding hedging has been recognised by the exemptions included in EMIR and CRR (CRD IV) for non-financial counterparties; the FTT proposal threatens a partial reverse of this policy. Hedging will be particularly impacted by the FTT as one derivative contract usually necessitates several underlying transactions, all of which will be taxed. European Issuers (position paper, 23 January 2014): An increase in the cost of hedging, which is an indispensable tool for non-financial companies to offset various risks of their commercial and treasury activities (foreign exchange and interest rate derivatives, derivatives on commodities, energy, CO2, etc.); this would as a consequence disadvantage non-financial companies in participating countries visà-vis competitors from other countries, would counter the advantages of an integrated and centralised risk management and may force non-financial companies to take financial risks on their own books that should better be hedged. Joint corporate trade associations (letter, 18 February 2014): In this case the EU FTT would affect their [corporates] financing - especially their long-term financing - because of its effect on the hedging of their risks as well as on the management of their intergroup activities. InsuranceEurope (position paper, 20 June 2013): Derivative instruments are used in insurance to match liabilities and assets. In order to maintain a sustainable derivatives market, the taxation of derivatives should be reconsidered. In particular, by taxing the notional value of derivative contracts, the FTT would have a considerable impact on insurers ability to ensure efficient asset management and control of risk, and would effectively eradicate the European derivatives market over time. BDI/MEDEF (joint statement, December 2013): In the current economic and financial context, any further taxation on financial companies and/or financial transactions would indirectly affect the financing of all companies especially long term financing, their hedging as well as their intragroup management activities. 6
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