Treasury Today Country Profiles in association with Citi

FTT: a ticking time bomb for bonds

With bank finance contracting, smaller businesses in Europe are finding it increasingly difficult to access credit. In response, governments in Europe have been busy promoting capital markets as an alternative source of funding. But experts warn that the proposed Financial Transaction Tax (FTT) runs in contradiction with this ambition.

European leaders want to foster the development of deeper, more liquid bond markets for small and medium-sized enterprises (SMEs) to fill the funding gap left by weakened banks.

But the plans of 11 eurozone governments, including France and Germany, to bring corporate debt markets under the umbrella of a Financial Transaction Tax (FTT) will have the opposite effect, experts warn. If the FTT is passed in its current form, it could cut off many companies – small and mid-caps particularly – from a vital source funding. In a worst-case scenario, nascent platforms in Europe that help such businesses issue could even disappear completely.

The FTT will apply a 0.1% levy on the value of bond transactions in the EUR-11 area for each participant in the trade. It is difficult to quantify precisely the upward effect that the FTT would have on corporate bond yields, which would already be higher due to the impact of the FTT in the underlying sovereign debt markets. However, it would be reasonable to assume that issuers of corporate debt will have to offer investors higher returns to compensate for the erosion the tax will have on their earnings.

In addition liquidity in the secondary market will inevitably diminish, warns Dr. Gerrit Fey, Head of Capital Market Affairs at Deutsches Aktieninstitut, a federation of companies and institutions in Germany’s capital markets. Small and medium-sized issuers, but also large non-financial issuers, in the bond market rely on market makers to access the capital market as a source of funding. They support the trading of corporate securities by continuously placing bids and ask orders to ensure market liquidity. Because the profit margins of these market makers are relatively small, Dr. Fey fears that the business of market making is in danger of receding, if not disappearing altogether.

“It would be very difficult for small and medium-sized issuers to obtain finance through the capital markets under these circumstances,” Fey says. “And that, of course, completely contradicts what politicians in the European Council said in a recent Green Paper about wanting to improve access to the capital markets for SMEs.”

The German example

This must surely be very troubling for the companies who have issued through the recently developed platforms on European stock exchanges, where the bonds of small and mid-caps can be traded. In Germany, especially, the SME bond market has blossomed over the past few years. Via the platforms that have sprung up at regional stock exchanges in Düsseldorf, Hamburg, Munich and Stuttgart, German companies have successfully issued over €3 billion worth of debt to investors, according to Standard & Poor’s (S&P).

Since its launch in 2010, the Bondm platform on the Stuttgart Börse has facilitated 50 issuances, at a time when ‘Mittelstand’ firms were finding it very difficult to gain access to credit through traditional bank channels. The Bondm platform is very much geared towards the needs of the smaller issuer – companies can promote their bonds directly to retail and institutional investors without the help of an underwriter, allowing them to considerably reduce the costs of an issue.

Executives at the exchange fear that all this progress could be lost if the FTT proposal is introduced by the EC in its current form. Echoing Fey, Christoph Boschan, Managing Director of the Stuttgart Börse, says he is concerned that liquidity in the secondary market will be seriously diminished if market makers are not exempted from the EC’s final proposal.

Speaking as a former market maker himself, Boschan says that a tax burden of 10 bps is completely unacceptable considering that the average gains made in market making transactions are between 2-5 bps. Therefore it came as no surprise to him, when the Stuttgart Börse teamed up with the Karlsruhe Institute of Technology to study the impact of France’s own – albeit weaker – FTT introduced in August 2012, that the study showed liquidity in the market declined by approximately 25%. In fact, one might expect that this loss in volume would have been even greater had the French government not included an exemption for market makers. “This is the real problem of the tax,” he says. “Market liquidity will decrease, spreads will widen and execution times will be longer.”

The issue is particularly acute with respect to SME bonds. In this area where Bondm operates, market making is of the very essence, as these are relatively illiquid instruments. A properly functioning secondary market is vital – even when it comes to primary market trading. This is because investor participation in a primary market is interconnected with the potential to reinvest on the secondary market. If that opportunity is not there anymore then Boschan expects the willingness of private investors to participate in initial bond offers (IBOs) will decrease.

The Stuttgart Börse, together with the other German exchanges, recently raised these concerns in a letter to the EC. But Boschan is keen to emphasise that he does not oppose the introduction of the FTT outright. Instead what he and the other exchanges are calling for is, in his words, “a responsible introduction of such a tax”. This would involve looking again at the impact of the tax upon the real economy and providing an exemption for market makers and private investors.

“From a political perspective, the solution should be clear,” he says. “The objective of the FTT is to compel those who caused the crisis to pay towards the costs of the crisis. But the market maker, the private investor and the bond issuer did not cause this crisis, and they already incurred heavy losses as a result of the mistakes made by the banks.”

Looking ahead

According to the EC in its recent Green Paper ‘Long-Term Financing of the European Economy’, it is the mid-caps and SMEs that will drive the economic recovery in Europe. The problem, as the EC acknowledges, is that in the wake of the banking crisis and the subsequent regulatory tightening, banks are not lending as much as they used to.

Citing the recent surge in German SME high yield bond issuance as an example for the rest of Europe to follow, the EC proposes that more should be done to help smaller companies access capital markets in order to fill the funding void left by banks. This could be accomplished, the EC argues, by improving the information provided by credit scoring companies, and making existing research and ratings information on such companies available to a wider set of potential investors.

But what the EC gives with one hand may well be taken away with the other. By undermining the market maker model that has sustained platforms such as the Bondm on the Stuttgart Börse, the introduction of the FTT would clearly damage the funding opportunities for SMEs in Germany’s capital markets, not to mention stifling the development of similar platforms in other European countries.

European policy-makers are presently engaged in reworking the FTT. Recent press reports indicate that the European Central Bank (ECB), responding to opposition from the financial sector, has offered to help the EC redesign its proposal and assuage industry concerns over its “negative impact” on market stability. However, the financial sector will now have a long, nervous wait to see the EC’s final proposal. No definitive political decision on the tax is expected to be made until after federal elections in Germany have concluded in September.

Chart 1: Corporate bond’s price development over the last year
Chart 1: Corporate bond’s price development over the last year

Source: Bondm Index

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