Monday, 19 August 2013

The Financial Transactions Tax (part 1)

For the past three weeks, I have been researching the evolution of the FTT debate since the Commission initiated the proposals in 2010.

Two puzzles guide my research. 

The first puzzle is the reason I got into researching the FTT - the link to shadow banking. Since the European Commission (EC) published its draft Directive in February 2013, met with a sense of disbelief from various quarters, the resistance to the FTT has concentrated around the repo market, a market crucial to shadow banking activities, in particular collateral intermediation. Take for example the Goldman Sachs (2013) Report on the European Financial Transactions Tax:

…the bulk of the FTT impact stems from the European banks’ REPO books (€118 bn)
followed by derivatives (€32 bn), equities (€11 bn) and government bond books (€4 bn)

The FTT has brought repo out of the shadows. How? By being very ambitious, to me yet unprecedented in scope and reach. The EC calls it the AAA framework: all markets, all instruments, all actors. And they mean it.   In targeting both organized markets and over-the counter-transactions across all traded instruments, the FTT is broader in scope than the 2012 French and 2013 Italian FTT on equity (and equity derivatives in Italy), than the 1990s Swedish FTT on equity and fixed-income instruments, and the Tobin tax on currency transactions that served as the theoretical foundation for FTT initiatives. It combines a ‘residence principle’, if a party in a transaction is resident of an implementing Member State, with an ‘issuance principle’, that applies the FTT to transactions with instruments issued in the Member States, regardless of where that transaction is taking place. This intended extra-territorial effect would be supported by an ‘ownership principle’, in that the issuers would only recognize the legal ownership once the FTT is paid.

Forget about the tax revenue narrative - this matters, and may turn out to be a stumbling block - it's useful to shore up the legitimacy of the FTT. There is something more important at play. The FTT, in its current form, seeks to engineer a shift in business models in finance, and in particular to bring out of the shadow, and make more expensive, activities that the BIS/US FED/FSB have associated with systemic risk. The European FTT can be read as a deliberate attempt from the Commission to re-organize the European financial sector in a manner far more radical than the numerous regulatory initiatives at either European or global level, or indeed the national FTTs implemented by France or Italy since the crisis. 

What makes the FTT radical? Unlike previous proposals, the AAA framework - all instruments, all markets, all actors - affects shadow banking activities, and the interconnectedness these generate across markets and institutions.  This is crucial to understand how opposition to the proposals concentrated around the taxation of the repo market, a market that somehow manages to be both systemic and largely invisible (in the shadows) in European finance. Pension funds, repo lobbies, transnational banks, governments and the European Central Bank have all rallied to its defense. 

So, to understand the trajectory of the European FTT, it is useful to look at it through the lens of interconnectedness. Network approaches are the next big think in analysis of systemic risk/macroprudential policies/'too interconnected to fail' debates. Applied to the European FTT, they can also reveal the political economy dimension of the governance of systemic risk.

But interconnectedness cannot explain the other big puzzle of the European FTT. Contrary to similar processes in the field of financial governance, where initial ambitions get watered down through the interventions of various stakeholders, the EC’s proposals became more radical in the three year process that culminated in February 2013 with the publication of the draft Directive. This trajectory flies in the face of various streams of European scholarship that typically see the Commission as a conservative institution - on austerity or on global initiatives to tighten banking regulation; engaged in turf wars with other European institutions - while in the FTT, the EC adopted the proposals of the European Parliament on extrateritorriality. 

How come that the European FTT proposals became increasingly more radical throughout the various stages of consultation and re-drafting of the institutionally pragmatic DG Tax? And how did the repo market - that is, a shadow banking activity par excellence - turn to be central to contestations of the FTT, a market that is at once systemic and with minimal regulatory oversight? More on this in the next posts.

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