1. Take as much collateral as possible and park it at the ECB.
2. Watch as market bifurcates around quality/inferior collateral.
3. Disregard spikes in settlement fails.
4. Refuse to issue new quality collateral on account of 90 per cent debt-to-GDP death spiral fear.
5. Refuse to pool resources and issue a master bond, because Eurozone hierarchy must be observed.
6. Watch as excess liquidity drives quality collateral yields into negative territory.
7. Threaten negative rates, to spur investment in inferior collateral deals.
8. Just when everything is consolidating, threaten to introduce a transaction tax that increases the cost of funding to those requiring liquidity and simultaneously adds an effective negative interest rate to those seeking to invest funds.
9. Ignore all warnings against the move.
10. Sit back and watch the last remaining private funding market die.
——–
And on that note, warnings over how the Financial Transaction Tax (FTT) is likely to hurt the repo markets are growing by the day.
The latest comes from ICMA’s European Repo Council which says if the tax is implemented, it would likely contract the short-term repo market by at least 66 per cent. According to the group, this would have serious negative consequences for other financial markets and the real economy.
For example Richard Comotto, Senior Visiting Fellow at the ICMA Centre, noted the following in a supplementary report published on Tuesday:
Without the ability to trade collateral securities, it is likely that cash balances would have to increase, either for direct use as collateral or to allow other types of collateral to be purchased when needed. Increased cash balances are an inefficient and potentially risky use of capital. Commercial banks could deposit the cash in their local currency at their central bank but this would reduce their capacity to lend, ultimately to the real economy, and by raising the marginal cost of funding would increase the cost of lending. The alternative for commercial banks, and the only option for other financial intermediaries, would be to take greater credit risk by reinvesting increased cash balances in unsecured bank deposits or money market securities.
—
Given the systemic role of collateral, it should be a matter of the greatest concern for regulators, central banks, financial intermediaries, and investors and borrowers (not least governments) that, under the current proposal by the European Commission (EC) for a Financial Transaction Tax (FTT) in 11 of the Member States of the European Union (EU), movements of collateral through the repo market, as well as supplementary movements in support of efficient collateral management (optimisation and possibly margining), would be taxed at a flat rate that would extinguish the repo and securities lending markets.
There is no feasible alternative to repo and securities lending. It has been suggested that the same role could be played by secured deposits. However, there are fundamental legal and operational obstacles to the use of secured deposits for the same purpose. There is also a question mark over why we need to divert resources and risk critical disruption to the financial system by trying to ‘re-invent the wheel’.
The problem isn’t the tax per se, it’s the fact that the tax completely overshoots current dealer repo earnings.
There is therefore little incentive for dealers to continue to make repo markets once a tax is introduced, especially if you consider their other key revenue sources, rehypothecation and relending, have already been severely hit by the trend towards segregated accounts in the market..
As the following chart from ICMA shows, since the FTT tax would surpass what are already meek spreads, dealers would suddenly be faced with a negative cost of business unless they passed the additional costs directly to customers:
The problem with passing FTT costs to clients is that this may amount to as much as a 72 per cent increase in the cost of short-term liquidity for some in the market:
In a market that is already experiencing collateral scarcity — meaning some are having to pay to lend — this sort of additional cost could be a death knell for the private collateral markets. Furthermore, the move does little to makes funds more available or less expensive to those seeking to borrow them. Instead, as Comotto notes, available funds will likely be entrapped as secured deposits, slowing the velocity of money in the ECB system significantly.
Add to that any prospect of negative rates, and we get to a situation where the only logical option for most “liquidity long” instituions would be to vault up banknotes in physical form — all of which is hardly conducive to lending.
Furthermore, with private repo markets frozen, the only alternative to monetise collateral rather than to liquidate would be to repo it with the central bank. Since not all institutions have access to central bank repo facilities, this leaves the system vulnerable to collateral liquidation.
The case for the FTT, of course, insists this is nothing more than industry propaganda. Nobody, after all, wants to pay a tax if they don’t have to.
We however, think that on this occasion it’s really more than just vested interests defending their turf. The chances that liquidity could stall is really very great.
Related links:
It’s not a collateral shortage, it’s a scarcity of collateral - FT Alphaville
On the new purpose of government debt - FT Alphaville
Once you turn base money into short-term debt, can you go back? - FT Alphaville
The zombie credit mispricing – FT Alphaville