The European Repo Market, the FTT and Moscovici, new Tax Commissioner

The European repo market was last in the news when the Commission issued its FTT proposals last year in February.  France, through the voice of the new Tax Commissioner Pierre Moscovici, then Minister of Finance, immediately questioned the inclusion of the European repo market in the FTT plans:

To include such [repo] transactions will simply pose a major risk to the functioning of the credit market.

Yet it turns out that  the European repo market is European but in name.

Consider the membership of the European Repo Council (ERC), the private lobby that champions the interests of the repo market players in Europe. Of its 75 members in September 2014, 19 sit on the European Repo Committee, the governing board of the ERC.  Eleven of these – five headquartered in the EU - are on the FSB’s 2013 list of Globally Systemically Important Banks (G-SIBs). 

Table 1 Membership of the European Repo Committee, September 2014

Headquarters	G-SIB	Not G-SIB
Eurozone	Societe Generale (Newedge), Deutsche Bank, Unicredit	Caixabank, Bankia, Intesa Sanpaolo, Commerzbank
Europe	UBS, HSBC, Credit Suisse, Barclays
US	JP Morgan, Goldman Sachs, Citigroup
Asia		Nomura, Daiwa

 The ‘European’ repo market captures the systemic footprint of global banks headquartered in Europe and elsewhere. Its growth has been driven by what Haldane called the ‘collective migration’ of bank business models to interconnected, leveraged, high-yield trading activities. 

SFP vs Reverse Repos vs Fed bills

Remember the fuss around the Fed's RRP change of heart earlier this month?

According to the Treasury Borrowing Advisory Committee, the Fed could have chosen a different sterilization approach: it could have issued its own debt instruments or extended the Supplemental Financing Program, a misnomer for  the Treasury playing at central banking (issuing Tbills for sterilization purposes, for which banks pay in reserves that are held by the Treasury at the Fed).

For TBAC, a committee that brings the Treasury in dialogue with powerful market players (zerohedge calls it the Supercommittee that Really runs America), identified several criteria:

To sum up, the criteria can be grouped in:

- liquidity effects (for Tbills)
- institutional constraints (debt ceiling)
- shadow banks' access to Fed (the 'portable' reserve creation)
- theoretical (ideological) concerns with central bank independence.

Missing from that list is displacing the private repo market...

The topsy-turvy world of the Fed's exit strategy: all too familiar to emerging countries

Jon Hilsenrath, of Wall Street Journal, reflects on the details of the Fed's exit:

• The Fed’s primary tool is an interest rate it pays banks for the money they have on deposit with the central bank, known as interest on excess reserves, or IOER. This will be the upper end of the band. This rate is now 0.25% and seems likely to go to 0.5% with the Fed’s first rate increase. The lower end of the band will be interest the Fed pays money market funds and other nonbanks for cash not on deposit at banks (known as the overnight reverse-repo rate, or ON RRP in Fed lingo). This is now 0.05% and seems likely to go to 0.25% with the Fed’s first rate increase. “Most participants anticipated that, at least initially, the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range,” the minutes said.

The big winners, he argues, are foreign banks, who earn nice returns from this band: borrowing from money market funds at or around ON RRP, and then placing it with the Fed at the IOER rate. Domestic banks cannot play this game because fees to the Deposit Insurance Corporation eat in the spread.

Two observations:

1. The band -  - the corridor set by the IOER rate and the ON RRP - under QE is functionally different from the band set by the standing facilities under 'normal' interest rate policy. In the latter case, the upper limit is set by the rate at which the central bank lends to commercial banks. Currently, both the upper and the lower ends are rates at which the central bank mops liquidity from the system. Hence foreign banks' behavior. 

Carney's ambitions for shadow banking reform: empty promises?

Shadow banking is back in public light. The FT has just started a series on it. On the pages of the same FT, Mark Carney, Bank of England governor and crucially, chairman of the Financial Stability Board (FSB), recently outlined the reforms that the FSB has introduced to transform shadow banking into governable market-based finance:

1. Curtailing the links between regulated and shadow banking.

2. Regulating the two shadow banking markets: better incentives for safer securitization structures (think ABS initiatives by Bank of England and ECB) and minimum margin requirements (haircuts) for securities financing transactions in repo markets.

3. Improved transparency and monitoring. 

The reader will be tempted to believe that reform of repo markets, six years after the fall of Lehman Brothers and the run on repo it triggered, is progressing smoothly. This is an important front in the macroprudential battle, according to Carney, because:

A new game: spot the most innovative argument against financial reform

Six years after the collapse of Lehman Brothers, those interested in the dynamics of financial regulation can play a new game: spot the most innovative argument against the litany of reforms introduced since the crisis. Traditional ones such as the impact on lending, economic growth, liquidity do not count. Floyd Norris, of the New York Times, does well here: in the US debates over identifying some non-banks as systemically important, 'mutual fund industry says that designating a fund manager as systemically important could raise its costs. Those costs could be passed on to fund investors, who are taxpayers, and so would amount to a taxpayer bailout'.  Taken to its logical conclusion, this argument says forget about systemic risk, macroprudential policies, Basel III, since the taxpayer always pays, now or later. Of course, the mutual fund industry doesnt bother itself with internal consistency of the argument (which taxpayers would pay and how much in a regulation now, smaller crisis late). 

I have come across another innovative narrative: that regulation creates systemic risk. The view was put forward in a recent paper "Collateral is the new cash: the systemic risks of inhibiting collateral fluidity", written by the European Repo Council (ERC), the trade body representing the views of European repo participants, and presented at an ERC seminar on Friday the 16th of May, in London. The paper will also be presented in France, in partnership with Banque de France, that is to announce new ways to help market-driven manufacturing of high-quality collateral through Euro Secured Notes.

The ECB, repos and financial integration

Before 2008, it was fashionable for European institutions to exalt the virtues of financial integration. Very small yield differentials between German and Greek government bond markets were approvingly cited as evidence that the Eurozone project of financial integration was progressing at rapid speed, at least in wholesale money and securities markets. Now European institutions routinely blame financial markets for failing to notice default/credit risk in sovereign bond markets.

Yet the evolution of the repo market - where financial institutions exchange collateral for cash, with a promise to reverse that transaction at a later date - suggests that European institutions encouraged markets to disregard fundamental differences. The  European Commission's 2002 Financial Collateral Directive was premised on the idea that repo integration would increase cross-border holdings of financial assets if repo market players could use these assets as repo collateral.

The ECB also got involved, through its collateral framework:

Shadow interconnectedness

Research on the political economy of shadow banking, a fast growing area, typically explore the regulatory angle to explain shadow banking as regulatory arbitrage. What this type of argument does not take into account is a important, new phenomenon of shadow intermediation: interconnectedness generated through repo markets. Rather than tracing institutions crossing porous regulatory perimeters, analytical efforts would be better placed to theorize collateral networks, the institutions that act as key nodes in those networks, and the common exposure they generate. The collateral intensive nature of shadow banking underpins  two mechanisms of interconnectedness: the risk management framework and the re-use/re-hypothecation channel. Both have systemic implications, together generating an important political conflict for the management of shadow banking because private leverage is born in, and can destabilize, government debt markets. Collateral-intensive finance thus confronts central banks and governments with a deeply political question: what governance arrangement is best suited to manage the systemic risks generated through shadow activities that blur the lines between financial stability policy and fiscal policy? Institutional innovations that ensure coordination between the central bank and government work best to manage ‘shadow’ interconnectedness.

The full paper here. 

The (shifting) French position on the FTT

Cornelia Woll's analysis of hedge fund regulation in Europe points to a French puzzle: whereas UK and Germany behave in negotiations as expected to defend their type of financial capitalism, France changed positions ' as a result of electoral and geopolitical considerations'. The same occured with the French position on including repos in the perimeter of the FTT.

First, the French government, then led by Sarkozy, was the only government to offer an official reponse to the consultation that the European Commission initiated on a financial tax in Europe in 2011. In that response, the French government said :

Les repos, particulièrement lorsqu’ils sont conduits avec des entités non régulés, peuvent effectivement être à l’origine de vulnérabilités du secteur bancaire. Toutefois, le marché interbancaire joue un rôle très important de réallocation de liquidité. Une taxe qui découragerait l’usage de ce type d’instrument serait par nature peu discriminante et ne constitue pas le meilleur moyen de réduire ce risque, qui relève plutôt d’une amélioration de la qualité du collatéral et des incitations données aux contreparties non bancaires. En particulier, une interdiction de la collatéralisation par des instruments financiers sans prix de marché clair (niveau 3 de valorisation selon les normes IFRS) pourrait être envisagée.

Paraphrased shortly, repos  generate banking vulnerability, (as it is well established since the collapse of Lehman Brothers). Yet we cannot tax it because the repo market plays a key role in the re-allocation/distribution of liquidity. Instead impose limits on the type of collateral acceptable.

That position changed radically  in September 2011. The French and German 'engine' behind the FTT co-signed a letter to the European Commission urging it to tax repos/securities lending, particularly when 'these serve the purpose of short-selling'.  The context made all the difference: the turmoil in European financial markets throuhghout the summer of 2011 prompted France, alongside Italy, Belgium and Spain, to ban short-selling of financial shares, in France for eleven of its largest financial institutions.

Then, in September 2012, when the German and (now socialist) French governments were trying to harness support for a regional rather than European implementation of the FTT (through the enhanced cooperation procedure),  their joint letter again supports taxing repos.

But once the European Commission publishes its draft FTT directive in February 2013, the French government shifts position again. By June 2013, Pierre Moscovici joins the widespread view that taxing repos is a step too far, agreeing with the ECB that to include such transactions will simply pose a major risk to the functioning of the credit market. Clearly successive French governments need not share their assessment of the link between repos and systemic risk.

Put this in the context of deliberations of reform for the shadow banking system. The recent FSB recommandations describe repos as the shadow banking activity, linking it to leverage, asset bubbles and financial instability. Recently, the Financial Times threw its weight behind a tighther regulatory regime for repos. 

 So, how do we make sense of the shifting French position? One answer may be that the French government is now prepared to back away from its promise that it would get a much stronger FTT regime at European level compared to the narrow French FTT on equities (that excludes repos). A broader answer may be that such radical measures as taxing repos (with the trade-offs it involves for liquidity of securities markets, including government bonds markets) can only be conceived and adopted during crisis times. The European Commission certainly designed an increasingly radical FTT during moments of unprecedented turmoil in European finance. Yet adoption may be far more difficult during a benign environment, as Europe seems to be enjoying at the moment. If the later is true, we should expect that after the September elections, Germany will join the French position on repos. The difficult questions of the systemic consequences of repo markets will then again be only asked by the FSB.

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.