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EU transaction tax could increase FX dealing costs by up to 18 times

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The EU-wide financial transaction tax (FTT) could cause a huge rise in transaction costs on the most liquid FX products and negatively affect the real economy as end users bear the majority of the levy, research conducted by Oliver Wyman shows.

The consulting firm estimates the tax would directly increase transaction costs for all deals by three to seven times and as much as 18 times in short-dated swaps, the most liquid part of the FX market, in which spreads are already very tight. With swaps alone accounting for nearly half of all FX trading volume and 75% of transactions in the highly liquid, short end of the market, this would have a huge impact on the currency market. “The proposed tax could, in effect, penalise Europe’s businesses for sensible risk management by using FX products to manage currency fluctuations and also threaten to impose further costs on the investment returns of pension funds and asset managers,” says James Kemp, managing director at Global Financial Markets Association (GFMA). The EU FTT, unveiled by the European Commission president José Manuel Barroso in September, would be levied on all FX forwards, swaps and derivatives, and could come into effect from January 1, 2014. Proponents of the tax argue it is a means of taxing speculative dealings in the financial sector that add little social benefit. However, the research conducted by Oliver Wyman, commissioned by GFMA’s Global FX division, shows the tax may cause more damage than good in the FX space. The report estimates that 70-75% of transactions eligible for taxation could simply relocate outside of EU jurisdiction to avoid the tax. That would reduce market liquidity and indirectly cause a further increase in transaction costs beyond that initially caused by the tax as bid-offer spreads widen. Oliver Wyman says that financial counterparties – such as dealing desks and, in particular, non-EU domiciled hedge funds – would be most able to avoid the tax by booking transactions outside the EU tax jurisdiction, given their legal structures, and would make up most of relocated flows. Pension funds, insurance companies, asset managers and corporates, however, would be less equipped to relocate their transactions, facing greater constraints on running treasury functions outside of their home locations. The report estimates these participants would be able to relocate only 30-40% of their current FX volumes. The report concludes that the FTT would be an inefficient tax mechanism due to the indirect costs resulting from reduced liquidity and widening spreads. Given that the direct costs alone resulting from the tax would be between one and 18 times the amount a broker-dealer earns on a transaction, these costs cannot be absorbed by the banks and so it will be the end users that bear the tax burden.