Investors will abandon short-term trades amid a "dramatic" market contraction if the EU fails to exempt the repo market from its proposed financial transaction tax (FTT), according to Ulf Bacher, head of the agency cash management platform at prime broker Newedge.
"One of the consequences I expect is that traders will extend the trade maturity," said Bacher. "If we assume the tax goes through as drafted, market participants would think about their trading style. There would be a much greater incentive to do long-term, rather than short-term, trades." Currently up to 90% of repo trades mature in fewer than three months.
His comments follow the publication of a report earlier this week claiming the tax would only be "economically tolerable" to the repo market beyond one year. The ICMA European Repo Council report also claimed the tax would contract the European repo market by 66% - if repo activity beyond six months survived at all.
"Introducing the FTT as suggested would have a negative impact on collateral management because every collateral movement would be taxed," said Bacher. "The general idea of collateralising exposure would be compromised, even though the market understands and aims for the advantages of secured versus unsecured exposure."
Based on the proposed 10 basis points tax, a trader doing 220 one-day trades would pay a per annum 22% tax. Bacher cited one of Europe's largest European tri-party agents totalling1,000 collateral moves in an hour - all of which would be subject to the FTT.
In a presentation this week, ICMA report author Richard Comotto criticised the regulator's assumption that central banks would take over if the repo market pulled back. "Central banks cannot and are unlikely to want to substitute for the money market," said the former central banker, now a senior visiting fellow at the University of Reading.
Bacher echoed scepticism that the European Central Bank would become the major counterparty. "There is a clear interest in a far broader base for the financing and cash market beyond the interbank market and central banks," he said.
In the meantime, he forecast significant changes to the proposed tax. "It must be changed dramatically. A reduction from 10bp to 5bp won't be enough," he said. "The repo market is the oil in the engine of financial markets. To tax the repo market will hit the liquidity in underlying securities markets, including bonds and equities."
By Shayla Walmsley