The European Covered Bond Council has called for all LCR-eligible assets to be exempt from a proposed Financial Transactions Tax in a position paper released today (Monday), arguing that implementation of the tax could otherwise lead to a collapse in covered bond liquidity.

The industry body says that while it agrees that financial institutions should make a fair and substantial contribution to public revenues and in particular the costs of the crisis, the FTT, which is due to be implemented in January 2014, has unintended consequences that conflict with other regulatory initiatives aimed at stabilising the banking sector, such as CRD IV.

The ECBC says that the tax could result in “a potential collapse in liquidity of the covered bond market and a consequent misallocation of resources as well as higher costs, which would ultimately be borne by end investors and retail consumers”.

As envisaged in a European Commission proposal published in February, a 0.1% tax will be imposed on all securities traded, with carve-outs for primary and retail markets. Each party to a transaction is subject to the tax if at least one of them is established in the FTT states or if the financial instrument is issued in the FTT states.

The ECBC says that for intermediated trades, the tax would amount to 0.4% – 0.1% each for the end seller and end buyer, and 0.2% for the intermediary, who trades with both sides.

“The proposed tax, being magnitudes greater than the average fee earned intermediating these trades for end investors, will either be fully passed on to end investors or the market intermediaries will be forced to pull out of market making of these instruments all together,” says the industry body. “Given the current low yield environment, this represents a very significant tax on their total income.”

The ECBC says that liquidity in the secondary markets will dry up if the tax is implemented on a wide range of financial transactions.

“With transaction costs so high in real terms, it will almost never be economically worthwhile for an investor to sell a security, even if it no longer meets its needs or if the investor has a negative view of its creditworthiness,” it says. “This will considerably lower the ability for investors to reallocate efficiently their assets, to react to credit news such as, for example, a credit downgrade and avoid potentially catastrophic credit losses. This will also impede the capacity of European issuers to buy back their own bonds, for either market making purposes or bond cancellation, and to adapt their bond outstanding to current market conditions.

“More specifically, against a backdrop of low yields and short duration, it appears economically irrational in many cases for investors and for banks to trade on secondary markets as the new tax would significantly decrease the expected return to the investor.”

The ECBC cites the example of a Pfandbrief with a yield of 45bp and a remaining life of three years, saying that a one-off 0.1% tax represents nearly 15% of the total return to the investor over the life of the security, or a “massive” 44% of the total return to the investor this year.

The FTT proposal’s potential impact on liquidity is at odds with other regulatory initiatives, according to the ECBC. It points to CRD IV, with banks having to hold large stocks of liquid assets of high credit quality, including covered bonds, that can be liquidated as and when needed in a crisis.

“Therefore, we believe that the European Commission should remain coherent in this respect and avoid any measures that could impede the capacity of banks to sell these assets under a stress scenario,” says the ECBC. “Thus, we recommend to exempt assets eligible for banks’ liquidity buffers from the tax.”

The ECBC also argues that the FTT would significantly hit banks’ funding costs at a time when the European Commission, with the publication of a green paper in March, is discussing how to foster the supply of long term finance to the economy. The FTT would also lead to market fragmentation and discourage some form of hedging activity, it adds.

The ECBC paper can be found on its website.

Exemption is also sought for transactions between a parent bank and its covered bond vehicle or guarantor SPV, which the ECBC says would be consistent with other regulatory measures such as EMIR and CRD IV, where such transactions are exempt from clearing and CVA charges.