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Why is no one talking about the biggest headache facing asset management? The European Commission’s Financial Transaction Tax (FTT) is due to hit the world January 1, 2014. In case you’ve been vacationing on the moon, here is the lowdown: 11 countries are planning to impose a 0.1% tax of the value of share and bond transactions and 0.01% on derivatives. If a firm involved in the transaction is based in the FTT zone, it will be taxed. A transaction will also be taxed if it involves financial instruments issued in one of the 11 countries: Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia, and Slovakia.
It’s eight months away, but when aiCIO asked asset managers to tell us how they were planning to help their institutional customers lessen the impact of this new tax, very few of them got back to us. Is this because, as one analyst suggested, they are currently in the middle of their own impact assessment reviews? Are they ignoring it because they think it won’t happen (or at least won’t be a big deal for the sector)? Or are they simply behind the curve?
Just two fund managers returned aiCIO‘s call—JP Morgan Asset Management (JPMAM) and Blackrock. Blackrock was only able to provide us with its letter to the UK’s House of Lords. The letter said the FTT would hit their client’s investment performance hard. It warned the FTT would create “unintended investment incentives” and “undermine sound asset management principles such as diversification, proper hedging and efficient execution.” Active portfolios would be forced to take higher levels of risk and/or invest in more derivatives to deliver the same level of returns. It would also reduce market liquidity and increase volatility, further hurting investment performance for pensioners and savers.
However, JPMAM had a different take, stating that the FTT would not bring about a wholesale change in pension funds’ asset allocation. “The idea that you would avoid an entire market to avoid a transaction levy of 0.1% is a bit extreme,” said John Stainsby, head of UK institutional at JPMAM. “This is just like stamp duty in the UK, which has not historically proved a barrier to investment, despite being a materially higher levy than the proposed financial transaction tax…This is just a change of one of the assumptions going into the investment decisions we make.”
But that view hasn’t satisfied everyone. ATP, one of Europe’s biggest pension funds, said it was considering using more derivatives to keep the fund’s tax bill down, as well as investing in countries unaffected by the FTT.
Kevin Cummings, a tax partner at BDO, reported that some asset managers were considering moving traders and business overseas, most likely to Singapore to avoid the tax. The relocation may have been on the agenda already, but the EC FTT was “another good reason to move,” he said. “If you look at the UK’s stamp duty tax for example, there is a relatively generous exemption for intermediaries-the real surprise was there was no equivalent for the EC FTT…You’ll also get a whole bunch of intermediaries who will only transact as an agent, rather than as a principal, so there’s no cascading impact for them,” Cummings added.
There are considerable behavioral risks from the FTT as well, surrounding just what investors might do to evade the levy. Some schemes may decide to grow their derivatives exposure—but under the EU accounting standards, derivatives have to be held at fair value, leading to an increased volatility on earnings increases and the balance sheet of the business. A scheme’s exposure to losses could also be greater: If you would normally buy exposure to $100 worth of shares, but the equivalent derivative costs $10, you might choose to leverage your exposure—buying $100 of exposure to shares worth $1,000.
But the leverage is risky, because the investor could be called upon to settle the full value of the contract. Are schemes ready for this? And if you decide to invest outside the 11 FTT countries—to Japan for example—that means changing your counterparties, which brings another level of risk. So what are your options if you want to avoid the forthcoming tax?
Lawyers are already warning investors that the European Commission won’t make things easy for tax dodgers. According to Eversheds’ tax expert Ben Jones, the FTT was specifically designed to prevent traders from circumventing it.
There are potential ways in which the FTT could be limited however, centering on ensuring the transaction does not create a taxable “financial instrument.” Entering into fixed-rate loans, for example, rather than floating rate loans with an interest-rate hedge might accomplish this. “Given the general flexibility of financial instruments, opportunities to circumvent the FTT in certain circumstances are inevitable,” Jones said.
Leveraged CDOs part II anyone?