Exhibit 1: European Equity Turnover 2012
Source: Thomson Reuters/ TABB Group
The addition of the Italian Financial Transaction Tax will have a far greater effect on overall European volumes in 2013. While only accounting for a 6% of European market share, the cumulative effect of the combined two tax regimes, plus the extensive reach of the Italian regulation, will cripple model-driven strategies, stunting the recent return of higher volumes. Add in a worsening economic environment and the addition of a further nine countries looking to implement the financial transaction tax by January 2014, and the prognosis for European equity trading looks bleak indeed.
No One Is Safe
The original objective to regulate HFT activity and make markets more transparent and fair for all is in danger of restricting all automated flow for all market participants – across the globe. The shift of focus in the legislation to cover both the “residence” principle and the” issuance” principle would in effect mean that no one is beyond the reach of European regulators. Meanwhile, the legislation is so complex and contradictory that for many, it will be easier simply to cease trading rather than establish what tax is due when and on which venue.
The irony is that HFT was already on the wane in Europe. Due to a combination of reduced volatility and increased correlation between stocks, there has been limited opportunity to arbitrage. As a result, HFT strategies were diversifying their flow – and given the lack of alternative liquidity, there were those on the buy side that were willing to engage with it.
By including all automated flow in the new regulations, however, the ability of market participants to interact will be severely impaired. Without natural orders to ease the flow of liquidity, we risk returning to volatile markets, which will further deter investors and create the very conditions that would make HFT profitable once more.
[Related: “The Fool and the Financial Transaction Tax”]
At a recent SunGard “Meet the Regulators” event last month in London, it became apparent that European regulation is at risk of unraveling due to its level of complexity. Regulators disagree among themselves what is required, and where; politicians are manipulating policy; and the financial markets are at risk of grinding to a halt under the weight of complexity. As countries become impatient with the lack of progress in Brussels, independent legislation is emerging that serves only to add to the confusion.
The Death of the Dark in Italy
The rules out of Italy are still in the proposal stage, but so far the draft outline for March 1 looks like this:
A tax will be liable regardless of the place of residence and where the contract is concluded, and is applicable for firms with a market capitalization of EU 500 million or more.
The initial tax of 0.12% in 2013 will reduce to 0.1% in 2014, but will incur an additional increase to 0.22% for 2013 (to 0.2% for 2014) if trades are executed OTC.
There is an additional tax of 0.02% on high-frequency trading, which will be applicable if the ratio between canceled and modified orders exceeds 60% and if the order is canceled or modified within half a second -- added to which, the tax is only applicable to the number of securities exceeding the threshold multiplied by the average price on the netted transactions – easy!
Derivatives will be taxed on a sliding scale, depending on instrument and notional value of the transaction. You could be charged anything from 1.5bps on index derivatives to 10bps on single stock – and so confusion reigns.
Brokers’ internal dark pools will be the first hit, as there is no mention as yet of the new organized trading facility (OTF) category, which looks to have been given a reprieve under MiFID II. Clients will ask brokers to turn off their routing systems to avoid higher fees in internal dark pools for Italian stocks, and it will become more difficult and expensive to trade blocks. Algorithms will have to be throttled back, and electronic trading will become less efficient as a result. Only a decreasing number of Italian stocks will have sufficient liquidity to trade on the lit exchange without incurring market impact. And if model-driven trading is driven out of the market, a significant chunk of liquidity will disappear, and we will revert to wider spreads and increased volatility.
Of course, the elections this weekend will provide an answer to whether the Italian tax gets shelved or not. We could all come to work on Monday and discover Berlusconi is back. But this would not be the end of European regulation. The MiFID II compromise is now expected this summer, with a final vote in the Autumn. Given there is now contention between the regulators, the European Commission and the Council, it is up for debate what will finally be delivered.
There is a real danger that in the interim, European politicians will make European capital markets irrelevant. Market participants will not be willing to – or will not be able to – support the added cost burden and investors will simply head to Asia.
The issue of liquidity and transparency in European equities will be discussed at the EMEA Trading Conference organized by FIX Protocol next Thursday in London. Please come and join the debate.