While securities lending transactions are not directly affected by the Financial Transaction Tax due to temporary transfers of ownership remaining exempt—the underlying trades that drive borrower demand are impacted, sending shock waves out into other sectors of the industry.
As currently drafted, the FTT could effectively close down the securities lending markets across the 11 affected countries and, given time, this would have considerable implications for long-term investors and the mobility of collateral.
According to the International Securities Lending Association (ISLA), at least 65 percent of the European securities lending market could eventually disappear as a result of the FTT—with France becoming one of the markets most impacted.
Over €2 billion of revenues could be lost to long-term investors, while almost €500 billion of Euro government bonds would be removed from the lending and collateral markets altogether.
Some in the industry believe that, in its simplest form, such a tax could create a drag and downward pressure on the markets as has already been seen in the French stock markets—with some observers claiming a 25 percent drop in activity in France following the unilateral imposition of the 0.2 percent tax.
Though France, along with Germany, were the two countries to press ahead with a levy (after failing to persuade all 27 EU member states to sign up), the country’s finance minister Pierre Moscovici expressed concerns last year about widening the tax beyond shares to government debt, with the fear that it could discourage investors from buying their bonds.
“Looking at the most popular equities in France, from a securities lending viewpoint, one can infer a great deal about the levels of short interest in any particular security,” says David Lewis, senior vice president of Astec Analytics, SunGard’s capital markets business.
“Solocal Group (LOCAL PA), for example, is a media stock which has been under scrutiny for some months as they have struggled to refinance their business—balances on loan, as a proxy for short interest, tripled in November last year, pushing utilisation levels up into the 90 percent range and making this a hard to borrow security. This gave investors a good insight into how market sentiment is running.”
Lewis remarks that another precarious short is PSA Peugeot Citroen SA (UG PA). “The ailing car producer has seen a significant increase in borrowing around the negotiations with their Chinese investor, Dongfeng Motors. A rescue package including a €800 million cash injection for 14 percent of Peugeot Citroen calmed the market to an extent, but shares on loan remain at 75 percent of their peak for the last twelve months—indicating some expectations of further trouble ahead.”
Despite the country’s tax positive stance, there are still opportunities to be had in the French lending industry, in the form of yield enhancement trading.
Yield enhancement trading in France is a key source of income, despite it recently coming under pressure after a ruling by the European Court of Justice. Prior to this, the French government had levied a withholding tax on foreign investment funds ranging anywhere from 15 percent to as much as 25 percent.
Lewis comments “Despite the European Court of Justice ruling in 2012 that the French withholding tax applied to non-domestic funds was discriminatory in nature, the yield enhancement market opportunity is still more than active and a significant part of French securities lending activity in 2013.”
“Equity balances on loan rise dramatically during the dividend season, namely April to June, peaking at around 2.5 times the average balance for the year in 2013. Average fee levels for the year are less than one quarter of the levels reached at the height of the French dividend season—which would suggest that this part of the French securities lending remains vibrant and valuable.”
The increasing harmonisation of dividend tax policies throughout Europe continues to threaten the yield enhancement trade by reducing the supply of tax disadvantaged securities. Other commentators, such as BNP Paribas Securities Services’ David Raccat, who is head of global markets for FX, STIR and securities lending, claim that yield enhancement is not as valuable to their side of the market.
Raccat says: “As a custodian, yield enhancement has never been the main driver of what we do, our mission instead is to support efficiency and liquidity in the market. I feel that yield enhancement is, little by little, going to disappear with the introduction of tax harmonisation rules. This will result in much more scrutiny on the products themselves as well as much more regulatory pressure.”
Regardless of whether this pressure will be detrimental to the French market in the long-term, it is a certainty that the industry as a whole will have to learn to adapt to evolving regulations. This trend is ubiquitous in terms of the global securities lending markets, and companies are already attempting to find solutions.
Raccat continues: “Rather than yield enhancement, I see the future of the market as being able to contribute to the collateral demands or requests that are going to come along as a result of the upcoming regulation. We want to make sure that clients understand what they are doing and can manage all their risks, from regulatory to reputational.”