Although overall European volumes increased in the first half of 2013, France and Italy have seen a continued decline in trading volumes and a growth in the use of synthetic instruments in France. France’s market share of 20.73% ahead of the FTT declined to 12.78% after implementation, and remains at 12.45%. There are those who believe the decline is entirely attributable to deterioration of France’s economy and investor appeal rather than due to the introduction of the tax – evidently not so looking at Spain’s turnover, which remains untouched at €128bn in July 2013 versus €126bn in July 2012. Overall market share in Spain has dropped by a mere half a percent in comparison – from 6.59% to 6.15% in 2013.
Liquidity, Liquidity, Liquidity
There are those who see declining turnover as a victory – the return of true volumes to the market. However, without flesh on the bones of this liquidity, institutional investors will continue to struggle to execute; few pension funds wish to switch exactly the same size investments at exactly the same time. Client facilitation of order flow remains essential for European markets.
As we outlined last year in our European Equity trends research, the greatest concern for pension fund traders is the ability to find the other side of their trade – an activity which is becoming increasingly complex the further down the index curve you go. Small- and mid-cap firms are coming under increasing pressure – issuers beware: there is no primary market without a well-functioning secondary market.
Migraines in Milano
Yet it is the addition of the Italian Financial Transaction Tax that has had a far greater effect on European market structure. Despite accounting for less than 5% of European market share, the extensive reach of the Italian regulation has crippled model-driven strategies and has dramatically shifted market activity as a result.
The Italian FTT charges an additional 10bps for OTC activity. As we predicted earlier this year, clients asked brokers to turn off their routing systems to avoid higher fees in internal dark pools for Italian stocks. Algorithms were to be throttled back, making electronic trading less efficient, with some choosing to step away from the Italian market entirely. Only a decreasing number of Italian stocks will have sufficient liquidity to trade on the lit exchange without incurring market impact. As model-driven trading is driven out of the market, a significant chunk of liquidity disappears – hence the decline to under 5% of overall European market share.
Why does this matter? Because volumes have not automatically returned to the lit markets – in fact, continuous lit volumes have declined since the introduction of the FTT. What has increased is off-order book activity reported to the lit markets, making trading yet more opaque for the institutional investor – hardly what the politicians and regulators hoped for.
[Related: “Amid Equities Rebound, European Dark Trading Hits New Heights”]
Germany, France, Italy, Spain, Austria, Portugal, Belgium, Estonia, Greece, Slovakia and Slovenia were planning to adopt the tax on stocks, bonds, derivatives, repurchase agreements and securities lending after the wider EU block voted against full implementation. However, negotiations stalled somewhat over how the tax should be implemented and how far-reaching it should be. Even before the recent legal opinion, there was growing consensus among many within the European bloc that the tax was significantly flawed and, in some cases, unworkable, with even the head of the French central bank, Christian Noyer, urging caution. German manufacturers have also recently issued statements claiming that the EU-11 FTT will have damaging impacts on end-investors and will fail to achieve its desired objectives.
The latest hurdles are unlikely to sound a total death knell of the FTT. According to the Financial Times, one EU official said, “The commission stood by its legal assessment and strongly disagreed with the council legal service arguments.”
Whether the legal opinion stands or not, the view of TABB Group is that it remains folly to impose a tax that damages the underlying pension funds or SMEs. There is a trade-off between the potential value of raised revenues versus the impact on the stock market and subsequent knock-on effect for underlying pension funds and small- and mid-cap stocks.
You don’t buy a house you can’t sell; and as implicit costs exceed explicit costs, there is less incentive to invest in a company. Lower liquidity further impacts the cost of trading, and pretty soon you are in a downward spiral impacting small- and mid-cap stocks to a far greater degree than large caps.
We have already witnessed the clear impact an FTT can impose on equity markets – the damage to bond markets would have been far worse. There may well need to be a tax on the industry, but the FTT is definitely not it.