EFTA01464308.pdf

Deutsche Bank Markets Research Global Foreign Exchange FX Spot Date 30 July 2013 Exchange Rate Perspectives FX and the Financial Transaction Tax Oliver Harvey Macro strate ist Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013. EFTA01464308 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Table Of Contents Currency Forecasts The Big Picture: FX and the Financial Transaction Tax 5 Monitors: G10 FX Valuation Monitor: Lines in the sand 18 Capital Flows and Basic Balances 25 Commodity Price and Currency Monitor 34 U.S. Trade Balance 39 Central Bank Reserves Currency Composition Monitor 46 Page 2 Deutsche Bank Securities Inc. EFTA01464309 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Currency Forecasts Industrialized Countries Currency US $ Exchange Rates U.S. Euro DB USD Index EUR/USD (Fwd. Rates) Japan USD/JPY (Fwd. Rates) U.K. Asia Spot 3M 6M 12M 70 71 74 76 - --1.33 1.26 1.20 1.18 - 1.33 1.33 1.33 98 102 110 112 - 98 98 98 GBP/USD 1.53 1.47 1.41 1.40 (Fwd. Rates) - 1.53 1.53 1.53 Canada USD/CAD 1.03 1.00 1.02 1.04 (Fwd. Rates) - 1.03 1.03 1.04 Australia AUD/USD 0.92 0.98 0.98 0.95 (Fwd. Rates) - 0.91 0.91 0.90 N.Z. NZD/USD (Fwd. Rates) SwitzerlandUSD/CHF (Fwd. Rates) Euro Cross Rates Japan EUR/JPY U.K. (Fwd. Rates) EUR/GBP (Fwd. Rates) SwitzerlandEUR/CHF Norway Sweden (Fwd. Rates) EUR/NOK (Fwd. Rates) EUR/SEK (Fwd. Rates) EFTA01464310 0.80 0.80 0.80 0.77 - 0.80 0.79 0.78 0.93 0.99 1.04 1.06 - 0.93 0.93 0.93 130 129 132 132 - 130 130 130 0.86 0.86 0.85 0.84 - 0.86 0.86 0.87 1.23 1.25 1.25 1.24 - 1.23 1.23 1.23 7.86 7.35 7.25 7.15 - 7.88 7.91 7.97 8.58 8.25 8.05 8.00 - 8.60 8.62 8.66 Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts Emerging Europe Currency Czech Rep. EUR/CZK (Fwd. Rates) USD/CZK (Fwd. Rates) Hungary EUR/HUF Latin America Currency Argentina USD/ARS (Fwd. Rates) Brazil USD/BRL (Fwd. Rates) Chile USD/CLP (Fwd. Rates) Colombia USD/COP (Fwd. Rates) Spot 3M 6M 12M 5.49 5.60 5.98 6.62 - 4.63 4.87 5.33 2.26 2.12 2.15 2.17 - 2.31 2.35 2.44 509 505 502 500 - 516 521 531 1887 1910 1930 1950 - 1907 1924 1960 Mexico USD/MXN 12.7 12.6 12.1 11.9 (Fwd. Rates) - 12.812.913.1 Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts Poland (Fwd. Rates) USD/HUF (Fwd. Rates) EFTA01464311 Spot 3M 6M 12M 25.9 25.8 25.6 25.3 - 25.9 25.8 25.8 19.5 20.5 21.3 21.5 - 19.5 19.5 19.4 299 285 279 275 - 301 304 308 224 226 233 234 - 227 229 232 EUR/PLN 4.214.134.004.00 (Fwd. Rates) - 4.24 4.26 4.31 USD/PLN 3.183.283.333.40 (Fwd. Rates) - 3.20 3.21 3.25 Russia USD/RUB 32.8 31.8 31.8 32.0 (Fwd. Rates) Turkey USD/TRY (Fwd. Rates) South Africa USD/ZAR 9.789.909.709.50 (Fwd. Rates) Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts - 30.3 30.9 31.5 1.921.941.951.98 - 1.96 1.99 2.07 - 9.90 10.04 10.32 Currency Spot 3M 6M 12M China USD/CNY 6.13 6.13 6.15 6.07 (Fwd. Rates) - 6.17 6.20 6.25 Hong Kong USD/HKD 7 76 7.77 7.80 7.80 (Fwd. Rates) USD/INR India (Fwd. Rates) - 7.75 7.75 7.75 59.3 57.0 55.0 55.0 - 60.6 61.8 63.9 Indonesia USD/IDR 10278 10500 10500 10000 (Fwd. Rates) Philippines USD/PHP 43.3 42.6 42.3 41.7 (Fwd. Rates) - 10723 11000 11412 Malaysia USD/MYR 3.243.173.153.13 EFTA01464312 (Fwd. Rates) - 3.26 3.27 3.30 - 43.3 43.4 43.6 Singapore USD/SGD 1.27 1.27 1.28 1.30 (Fwd. Rates) - 1.27 1.27 1.27 South Korea USD/KRW 1112 1130 1120 1130 (Fwd. Rates) - 1118 1122 1127 Taiwan USD/TWD 29.9 30.0 29.6 29.7 (Fwd. Rates) - 29.9 29.8 29.7 Thailand USD/THB 31.1 30.5 30.0 30.0 (Fwd. Rates) - 31.3 31.4 31.7 Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts Deutsche Bank Securities Inc Page 3 EFTA01464313 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax G10 FX Forecasts: End of Quarter Spot 2013 2014 2015 Q3 Q4 Q1 Q2 Q3 Q4 Q4 USD-crosses EUR/USD 1.331.261.201.191 181.171.151.10 USD/JPY GBP/USD 1.531.471.411.391.401.401.391.38 USD/CAD 1.031.001.021.031.041.041.051.10 AUD/USD 0.920.980.980.970.950.930.900.85 NZD/USD 0.800.800.800.790.770.750.720.68 USD/CHF 0.930.991.041.051.051.061.071.12 USD/SEK 6.486.716.886.836.786.796.877.05 USD/NOK 5.935.836.046.056.066.076.136.23 EUR-crosses EUR/JPY EUR/GBP EUR/CHF EUR/SEK Source: Deutsche Bank 98 102 110 111 113 114 115 120 130 129 132 132 133 133 132 132 0.860.860.850.860.840.840.830.80 1.231.251.251.251.241.241.231.23 8.588.458.258.138.007.957.907.75 EUR/NOK 7.867.357.257.207.157.107.056.85 Page 4 Deutsche Bank Securities Inc. EFTA01464314 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax FX and the Financial Transaction Tax T. In February 2013, the European Commission published a detailed proposal of a Financial Transaction Tax (FTT) to be implemented based on an 'enhanced cooperation' agreement between 11 participating EU member states. T. The proposal will tax transactions in securities at 0.1% of notional value and derivatives at 0.01%. The FTT will be levied on all transactions involving financial institutions where one of the counterparties is established in a participating member state and/or where the financial instrument is issued in a participating member state. The FTT would have wide ranging implications for the FX industry. While FX spot transactions will not be taxed, forwards, swaps, NDFs and options may be taxed. Transactions in these products would be taxed at the rate for derivatives. In its current form, the FTT would dramatically increase transaction costs for FX market participants. This could result in the effective closure of the non-spot FX market in participating member states. T. The FTT would translate into substantial costs for the real economy. It would be passed on to end users of FX derivatives, reducing corporate competitiveness and acting as a tax on extra-EMU exports. The FTT would also drain liquidity from markets, impair market efficiency and widen bidoffer spreads. T. The design of the FTT may be incompatible with existing global efforts in financial reform. By discouraging forms of financial intermediation, the FTT appears to run counter to the goals of US and European legislation, which are designed to encourage greater clearing and margining of transactions in order to reduce credit risk. The Bottom Line On 22nd January 2013 the European Council gave the go ahead to 11 EU member states to negotiate a Financial Transaction Tax (FTT).1 The European Commission originally proposed an EU-wide FTT in September 2011. The three stated objectives of the FTT were to avoid the fragmentation of the internal market for financial services, enhance the contribution of the financial services sector to the tax base and discourage financial transactions inconsistent with efficient market functioning. 2 After EU finance ministers failed to reach unanimous agreement on the original proposal, it was decided that progress would be made through a limited group of 1 Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia, Spain 2 A number of Eurozone states, including France and Italy, have already introduced financial transaction EFTA01464315 taxes at a national level. The goal of the European Commission was to harmonize these efforts and prevent an uncoordinated multi-approach system in Eurozone financial markets. Deutsche Bank Securities Inc. Page 5 EFTA01464316 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax member states. In February 2013, the European Commission published its detailed proposal of the FTT under the aegis of an enhanced cooperation agreement.3 The proposal closely mirrors that of the September 2011 original. Transactions in securities will be taxed at 0.1% of their notional value, transactions in derivatives at 0.01% of their notional value. Financial institutions will be captured by the tax with a few exemptions. Non-financial institutions are not directly liable to pay the FTT. However, financial entities will be liable to pay when undertaking transactions with non-financial entities. Any trade involving a counterparty established in, or a financial instrument issued in a participating member state will be captured. The FTT would have wide ranging implications for the FX industry. While FX spot transactions will not be taxed, forwards, swaps, NDFs and options may be taxed. These products currently make up nearly two thirds of FX market turnover.4 Transactions in these products would be taxed at the rate for derivatives. While the FTT is only being introduced in 11 member states, the extra-territorial impact of the FTT under the current proposal is wide, and would have a significant effect on all major global trading centres of foreign exchange. The European Commission's proposal still has some way to go before it is agreed, let alone implemented. The eleven member states will continue to debate the proposal until it achieves unanimous agreement. In recent weeks there has been speculation over the future of the FTT after participating member states wrote to the European Commission for acknowledged that implementation by the target date was unlikely.5 In its current form, the FTT would dramatically increase transaction costs for FX markets with the likely result of effectively closing the non-spot FX market in Europe. Indirect impacts would include changes to market structure, shifts in the behaviour of investors and hedgers and the relocation of global liquidity hubs In research carried out for the Global FX Division of the Global Financial Markets Association, Oliver Wyman estimated that the FTT would result in price EFTA01464317 increases of up to 1790% at the short end of the FX swap market (1 week EUR/USD swap) and 270% at the long end (6 month EUR/USD swap). 6 transaction costs for FX swaps in recent years, the impact of the FTT would be comparable to the rise in transaction costs around the Lehman liquidity crisis. These costs would be magnified further by the FX market's high turnover and deal velocity. Many market participants roll shorter-dated FX forwards and swaps for liquidity management, asset-liability matching and short-term funding purposes. Each transaction would be captured by the FTT, while the impact on short- dated instruments is far higher than long-dated instruments. The effective rate of the FTT would also be higher than the headline rate. This is because the FTT would apply to every step and, where applicable, leg of a transaction. By definition, swaps and forwards trade with multiple legs and often 3 The Enhanced Cooperation procedure allows member states to proceed with integration within the structures of the EU but without the participation of all member states. 4 BIS Triennial FX Survey, September 2010 50n 30th May 2013 spokesperson for EC Tax and Customs Algirdas semeta acknowledged that implementation by the 2014 target date was 'unlikely.' 6 Proposed EU Commission Financial Transaction Tax Impact Analysis on Foreign Exchange Markets, Oliver Wyman January 2012 Page 6 Deutsche Bank Securities Inc clarification on key details and EC officials Looking at the average EFTA01464318 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax involve very large notional amounts. The FX market is also intermediated, with several potential stages between client and ultimate liquidity provider. We are concerned that the FTT would result in higher costs for end users of FX markets. Transactions between non-financial entities (e.g. corporate clients) and their dealers are not exempt from the FTT and higher transaction costs incurred by liquidity providers may have to be passed down. While non-financial entities are not primarily liable for payment, where the FTT goes unpaid both counterparties are jointly and severally liable, potentially introducing a new risk to corporate hedging decisions where none previously existed. A less liquid FX market would also mean non-financial research suggests that financial transaction taxes lead to wider bid-offer spreads.7 Since the stated purpose of policymakers in introducing the FTT is to increase the tax contribution of the financial sector in the interests of a level playing field with the non-financial sector, we think it is surprising that the proposal contains no exemption for transactions involving non-financial entities. As well as being counter to the goal of the proposal, this risks reducing the competitiveness of European companies. We calculate below that the FTT would impose a direct cost of between EUR 1 to 2.4bn per year on German exporters and importers. The FTT would, therefore, involve a significant direct cost for the real economy. We believe the European Commission's proposal poses significant risk to liquidity and efficiency in the foreign exchange market. Historical examples of financial transaction taxes show significant declines in deal volume shortly after their introduction, while academic literature suggests that they impair market efficiency and liquidity. We are also concerned that the proposal may offer market participants economic incentives that run counter to post-2008 international efforts at financial reform. By discouraging financial intermediation, the FTT flies in the face of mandatory clearing rules introduced in the wake of the 2008 financial crisis. Were the FTT to EFTA01464319 apply to the exchange of margin, it would discourage some market participants from collateralizing trades, hindering efforts to reduce counterparty credit risk. An understanding of how the FTT will apply to FX transactions is the key to determining the impact on the FX market. We therefore begin our discussion with an outline of the current proposal. How the Financial Transaction Tax Will Work The FTT would be charged on all security transactions at a rate of 10bp and all derivative transactions at a rate of lbp. FX products which are eligible for taxation are FX forwards and swaps, NDFs and FX options. FX spot is excluded. The European Commission had previously noted that a 'Tobin Tax,' on FX spot transactions could run counter to EU law by restricting the free movement of capita1.8 The Commission appears not to have extended this consideration to FX swaps and forwards although there are questions as to whether they also represent 'capital flows.' entities have access to poorer pricing, as academic 7 Pomeranets and Weaver, Security Transaction Taxes and Market Quality, Bank of Canada Working Paper, November 2011 8 European Commission, Staff Working Document, Innovative Financing at a Global Level, 1st April 2010 Deutsche Bank Securities Inc. Page 7 EFTA01464320 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax The FTT would apply to all financial institutions. Financial institutions are defined as investment firms, trading platforms or exchanges, insurance companies, pension funds, alternative investment funds, special purpose entities (SPEs) and special purpose vehicles (SPVs) and any other entity for which the average annual value of financial transactions constitute more than fifty percent of overall net turnover.9 There are limited exceptions. Non-financial entities are not required to pay, but financial institutions transacting with non-financial entities are. Moreover, nonfinancial entities would be held jointly and severally liable if a financial institution fails to pay. Transactions with Central Counter Parties (CCPs), Central Security Depositories (CSDs) and International Central Securities Depositories (ICSDs), national debt management offices, member state central banks, the ECB and other international organizations do not fall under the FTT. The FTT would also not be charged on primary market transactions, or underwriting The proposal envisages a broad territorial reach of the FTT. It would apply to all financial entities established in participating states. It would also apply to all financial entities transacting with a counterparty based in the participating states. Transactions involving securities issued within a participating member state will also be caught, irrespective of where the counterparties to the deal are based. This 'issuance principle' is designed to strengthen anti-relocation provisions of the FTT, by making less desirable for entities established in participating states to move trading activities abroad. The issuance principle would apply to instruments like bonds and stocks. It is uncertain as to whether it would apply to the euro currency. Euros are issued by the ECB, an EU-established entity. It is not clear whether eurodenominated derivative contracts traded on an organized platform will be subject. The proposal anticipates that the broker or settlement agent would be liable for the calculation for the FTT. For electronic transactions, collection and payment EFTA01464321 is assumed to be immediate. For other types of transactions, the proposal suggests that a period of three working days is an appropriate time period within which the FTT should be paid. The proposal does not state which counterparty should be held responsible for paying the FTT, but that in the event the tax is not paid, both counterparties would be held jointly and severally liable. Headline versus Effective Costs The headline rates established by the European Commission are 10bp for securities transactions and lbp for derivatives. However, the effective rates for financial transactions are higher. This is because the FTT is levied on a gross basis, at every stage of the transaction. This approach would cause a 'cascade effect,' whereby the effective tax rate increases in a linear fashion with the amount of intermediation in the deal. The draft proposal distinguishes between financial institutions that are a 'party' to a financial transaction and those that act on an 'agency' basis. 'Parties' are required to pay the FTT, while those acting on an 'agency' basis will not be caught. There is still a lack of clarity over which entities would fall under each definition (for example, whether the tax would capture a prime broker executing a 'give up,' since the prime broker bears credit risk for the transaction). The FTT would, however, appear to capture entities acting independently that facilitate a single 9 European Commission, Proposal for a Council Directive, Implementing Enhanced Cooperation in the Area of Financial Transaction Tax, 14th February 2013 Page 8 Deutsche Bank Securities Inc. EFTA01464322 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax transaction. For example, where a dealer provides liquidity to a financial entity and simultaneously hedges the same transaction with a third counterparty, all three entities are likely to be caught. The FX industry would be impacted by this cascade effect. FX is an intermediated market, with several potential stages between the client and ultimate liquidity provider. These stages have evolved in response to demand for tighter pricing and a more efficient market. For example, in the case of an NDF transaction, a dealer is able to provide a better price for a client by being able to hedge that transaction through an offsetting one with a third counterparty. By discouraging this kind of intermediation, the FTT may result in dealers providing wider prices for clients. By definition many FX transactions also contain multiple legs, each of may be subject to the FTT. For example, an FX swap is composed of two forward transactions, meaning that the FTT could be charged twice. FX transactions can also involve very large notionals, which would increase gross costs. As illustrated by the diagram below, a headline rate of lbp translates into a much higher effective rate once the multiple steps of a typical FX transaction is taken into account. In this case, the final cost for a USD/INR NDF potentially increases up to 8bp, meaning the absolute cost for a USD 10,000,000 notional becomes USD 8,000. Figure 1: The FTT 'Cascade Effect' Source: Deutsche Bank Deutsche Bank Securities Inc. Page 9 EFTA01464323 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax There are questions as to whether the FTT will be levied on the exchange of collateral but at the moment there is no clear exemption. Given that many FX transactions are regularly collateralized, in some cases with the exchange of variation margin on a more than a daily basis, this could involve a substantial increase in transaction costs. If the FTT was levied on initial margin, this would also increase costs. The FTT would dramatically increase current transaction costs for FX markets. In research carried out for the Global FX Division of the Global Financial Markets Association, Oliver Wyman estimated that the FTT would result in price increases of up to 1790% at the short end of the FX swap market (1 week EUR/USD swap) and 270% at the long end (6 month EUR/USD swap). These extremely large increases in transaction costs are the result of the very small bid-offer spreads quoted by liquidity providers. In the most liquid FX swaps, such as a 1 week EUR/USD swap, spreads are often lower than one tenth of a basis point. The FTT would therefore introduce a permanent cost to transactions magnitudes higher than is typical for these markets. Indeed, looking over average transaction costs for FX swaps over recent years, the impact of the FTT can be compared to the Lehman liquidity crisis in terms of its impact on transaction costs. These costs would be magnified by the FX market's high turnover and deal velocity. The BIS estimates the total daily turnover in the swaps and forwards market alone to be USD 2.24 trillion, more than seven times that of all global equity markets. Much of this liquidity is concentrated in shorter tenors. According to the BIS, more than 40% of global market turnover is concentrated in tenors of 1 week or less for FX forwards. For FX swaps, this figure is 70%. FX swaps and forwards are rolled over on a daily or weekly basis by a wide range of market participants in order to meet a broad range of objectives. These include liquidity management, assetliability matching and short term funding. These transactions would be hit each time by the tax. Additionally, the impact of the FTT on short-dated instruments is much greater than on long-dated instruments. EFTA01464324 Figure 2: The FTT Impact Similar to Global Financial Crisis on Transaction Costs Source: Deutsche Bank, * existing transaction costs are calculated as the bid -offer spread for FX fonvard points expressed as a percentage of the FX market rate. Data from Bloomberg Finance LP. Page 10 Deutsche Bank Securities Inc. EFTA01464325 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Figure 3: FX Forwards Percentage Global Turnover Figure 4: FX Swaps Percentage Global Turnover 10 20 30 40 50 60 0 Up to 7 days 7 days -1 year Source: Deutsche Bank, BIS Triennial Survey, September 2010 Over 1 year Participating member states Global 10 20 30 40 50 60 70 80 0 Up to 7 days 7 days -1 year Source: Deutsche Bank, BIS Triennial Survey, September 2010 Over 1 year Participating member states Global A Tax on the Real Economy Many have noted that the proposed FTT would have wide-ranging negative implications for financial markets, reducing trading volumes, disrupting short term funding markets and curtailing the profits of financial firms.10 The FTT would also have a significant impact on the real economy. The fact that the proposal does not exempt transactions involving non-financial corporations would result in costs being passed down to end users of derivatives. This would make hedging financial risks more expensive and less attractive, potentially increasing the volatility of firms' cash flow and share prices. Non-financial corporations use FX derivatives to hedge cash flow and balance sheet risks arising from currency fluctuations. As the largest economy among the participating member states and one of the foremost proponents of the FTT, a useful case study is the impact the tax would have on German importers and exporters. Surveys suggest that an overwhelming majority of German corporates use EFTA01464326 derivatives to hedge FX risks.11 Using a simple approach based on German trade and BIS data, assumptions about hedging ratios, hedge rollovers and basis point cost per transaction, we calculate that the FTT would impose an annual cost of anywhere between EUR 1 to 2.4bn on German importers and exporters. Using export elasticities from the IMF we calculate that German exports could be reduced by as much as EUR 3.3bn per year. In recent years, German exports to outside the Eurozone have grown as the economy has responded to weak demand in the single currency area. Germany's relatively strong growth compared the rest of the Eurozone is in no small part due to this flexibility, with exports to East Asia in particular playing an important role. The FTT would hamper Germany's export flexibility by 10 See, for example, International Capital Market Association report, 'The Impact of the Financial Transaction Tax on the European Repo Market, April 8th 2013 11Gordon Bodnar and Gunther Gebhardt, Derivatives Usage in Risk Management by US and German NonFinancial Firms, A Comparative Study, 1999 Deutsche Bank Securities Inc. Page 11 EFTA01464327 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Figure 5: Ex-Euro Area German exports have gained share 10,000 20,000 30,000 40,000 50,000 60,000 70,000 Jan-93 Dec-95 Nov-98 Oct-01 Sep-04 Aug -07 Jul-10 Source: Deutsche Bank, Bloomberg Finance LP Euro-Area Non-Euro Area German exports, mns. EUR Figure 6: Two ways of measuring the FTTs impact on German trade Source: Deutsche Bank, Bloomberg Finance LP, BIS Triennial FX Survey September 2010 Page 12 Deutsche Bank Securities Inc. EFTA01464328 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax imposing an effective tax on non-Euro area exports. Moreover, given our economists' view that Eurozone growth is expected to significantly underperform the rest of the world for some years to come, the opportunity cost to German exporters is likely to be significant.12 As well as impacting non-financial corporations, the FTT would diminish pensions, increase insurance premiums and may raise costs for retail investors. Despite extensive discussions with the European Commission, the pension industry will not be excluded from the FTT. The European Commission estimates that for actively managed pension funds the FTT could reduce final pensions by as much as 8%.13 Market Impact There have been numerous academic studies on the impact of financial transaction taxes on financial markets. There is a broad consensus that financial transaction taxes reduce trading volumes. Schmidt (2007) estimated trading volume elasticities in foreign exchange markets. Based on a multilateral implementation of the tax which reduced the prospect of relocation of trading activities, he estimated an elasticity of -0.4 for the world's four most traded currencies (USD, EUR, JPY, GBP). Empirical studies have largely focused on securities rather than derivatives markets. Froot and Campbell (1994) found that the impact of the Swedish equities transaction tax on trading volumes was relatively modest. However, the impact of a tax introduced on bonds and bills of between 0.2 and 3bp in 1989 was significantly larger, with bond trading volumes falling 85% in the first week. The Froot and Campbell study illustrates an important characteristic of financial transaction taxes. Where the opportunity to migrate trading activities to jurisdictions outside of the tax regime exists, or an effective substitute to a taxable product is available, trading volumes of the taxable products within the tax jurisdiction experience significant falls. In the case of Sweden, Froot and Cambell found that offshore investors were able to access liquidity, tax-free, from offshore markets in the same equity securities. This resulted in a greater fraction of the trade in these securities taking place abroad. In the case of bonds and bills, market participants were able to substitute these products for non-taxable products EFTA01464329 such as forward rate agreements (FRAs) and variable-rate notes (VRNs). This has important implications for FX markets. FX is a highly globalized industry with multiple global liquidity hubs. The portability of those FX transactions impacted by the tax is, therefore, likely to be high. This would involve liquidity seekers from non-participating states currently transacting with dealers based in participating member states relocating business, and liquidity seekers of participating member states relocating their trading activities to foreign liquidity hubs. This may have the impact of effectively shutting down the non-spot FX market in participating states. 12 DB Focus Europe, Europe Outlook 2013, A false sense of security, 14th December 2012 13 European Commission Technical fiche, Pension funds in the context of the FTT proposal Case study of Dutch pension fund market, assuming pension fund follows 'active' strategy, turning over 90% of assets twice a year, and hedging 90% of its assets four times a year. Deutsche Bank Securities Inc. Page 13 EFTA01464330 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax A stated goal of the FTT is to reduce transactions that do not contribute to market efficiency. One aspect of efficient market functioning is the rapid incorporation of news into asset prices, or price discovery. Liu (2007) examined how market efficiency evolved in line with financial transaction taxes in Japan. He measured price discovery using the autocorrelation of returns in the Japanese securities market. In a more efficient market, new information should be incorporated immediately into asset prices. This should, in turn, reduce the autocorrelation of returns. Lui found that reductions in the financial transaction tax in the securities market reduced the autocorrelation of Japanese stock price changes, suggesting that financial transaction taxes diminish price discovery. A key feature of an efficient financial market is liquidity. This can be briefly summarized as the ability to transact when needed at a reasonable price. The best measure of liquidity is the bid-offer spread. We have already noted how bid - offer spreads would widen by the amount of tax that 'cascades' down the transaction. The FTT may widen bid-offer spreads still further through secondary effects. Academic evidence suggests that financial transaction taxes result in wider bid offer spreads. Pomeranets and Weaver (2011) study New York State Security Transaction Taxes on the NYSE and AMEX stock markets throughout the 20th century. They found that correlation to bid-offer spreads. Figure 7: Historically, financial transaction taxes have led to wider bid - offer spreads Percentage change in New York State Stock Transfer Tax versus changes on bid-ask spread on sample stocks, NYSE & AMEX exchanges 2 Jun-33 1.5 Mar-32 1 0.5 Oct-81 Jan-45 EFTA01464331 -0.6% -0.4% -0.2% Aug-78 Oct-79 0 Oct-80 -0.5 0.0% 0.2% 0.4% 0.6% 0.8% Changein tax Source: Pomeranets and Weaver, Security Transaction Taxes and Market Quality, Bank of Canada Working Paper, November 2011 Wider bid-offer spreads would result in higher transaction costs for all market participants. In their research, Oliver Wyman estimated that based on a 70% fall in volumes, the most liquid G10 derivative products could see spreads widen by 110%, while in less liquid G10 products spreads could widen by as much as 200%. It is worth noting that under the European Commission's initial assessment a fall in derivative trading of 90% in participating countries was anticipated, suggesting that the Oliver Wyman estimates were conservative. Page 14 Deutsche Bank Securities Inc. Jul-66 Aug-75 financial transaction taxes had a strong positive impact Change in bid-ask spread EFTA01464332 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Global regulation and the FTT A concern surrounding the FTT currently proposed by the European Commission is that it offers economic incentives that conflict with existing international efforts at financial market reform. Because the FTT is imposed at every stage of a financial transaction it discourages financial intermediation. Mandatory clearing rules introduced by the Dodd Frank Act in the US and EMIR in Europe aim to reduce counterparty credit risk by migrating OTC bilateral transactions to clearing houses. This has the effect of increasing transaction intermediation in cases where trades were bilaterally executed. Central clearing is designed to reduce systemic risks in the financial system. The central counterparty (CCP) acts as buyer to every seller and seller to every buyer. In so doing, it is designed to centralize financial risks that were previously dispersed between multiple counterparties. Central clearing reduces counterparty credit risk by requiring firms to post collateral against potential future losses on trades (initial margin) and the mark to market value of the same trades (variation margin). Basel III rules are similarly designed to encourage greater collateralization of OTC trades by imposing higher capital requirements on banks for trades which are not collateralized.14 Many financial firms will be required to clear derivative transactions using CCPs. Most non-financial corporations, however, will not. The FTT, therefore, may discourage non-financial entities from centrally clearing derivative transactions as doing so would incur higher transaction costs. Under the current European Commission proposal, it is unclear whether the FTT is to be applied to the exchange of collateral. If it were applied, this would clash with efforts to reduce counterparty credit risk. Again, financial corporations are likely to be subject to prudential margin standards which will require them to collateralize trades even when they are not cleared. Nonfinancial corporations will likely not be subject to the same standards. In the case of non-financial institutions that are not subject to prudential margin requirements, a number of factors will determine whether they choose to bilaterally margin uncleared derivative transactions, or trade via a credit value adjustment (CVA) approach where credit charges are incurred. These include the cost of credit charges, the availability of high quality collateral that can be used as margin and the sensitivity to cash flow risk arising from margining. If it were to tax the exchange of collateral, the FTT would provide an incentive for non-financial institutions to choose the CVA approach. EFTA01464333 Other market efforts at reducing risk may be impacted by the FTT. For example, portfolio compression trades, where offsetting positions are netted by counterparties in order to minimize counterparty risk, may be subject to the tax. The FTT would have broad implications for all major trading centers of foreign exchange. Many international dealers provide liquidity to clients based in participating member states. For example, London, which provides the world's largest trading hub of foreign exchange, would be particularly adversely impacted. 14 We examine the impact of OTC derivative regulation on FX markets in more detail in our report: Exchange Rate Perspectives How Regulation will Reshape FX Markets, Part 2, 31st July 2012 Deutsche Bank Securities Inc Page 15 EFTA01464334 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax It is also unclear as to whether the 'issuance principle' outlined in the European Commission's proposal would apply to the euro currency and eurodenominated products. The ECB, which issues euro currency, is established in Frankfurt, one of the participating member states. If it were, the FTT would have far reaching effects across global financial markets given the euro's status as the world's second most traded currency and the importance of participating member states to the global economy. Final thoughts As of the time of writing, there is uncertainty surrounding the future of the FTT. In April, participating member states wrote to the European Commission to ask for clarification on a number of key issues including how collection of revenues would work and how key terms such as 'purchase and sale' and 'netting and settlement,' were defined. The decision by the European Council to permit participating member states to enact the FTT using 'enhanced cooperation' is now subject to a legal challenge by the UK government. In addition, a number of European policymakers have expressed concerns over the tax, particularly concerning its impact on bank funding and credit.15 Most recently, the media have reported that the FTT is unlikely to be enacted in its current form. Last month, European Commission officials have acknowledged that implementation of the tax by January 2014 now looks 'less likely.'16 In its current form, the FTT would have major adverse consequences for the FX markets. It would dramatically increase transaction costs for market participants. This could result in the effective closure of the non-spot FX market in participating member states. The FTT would result in substantial costs to the real economy. The tax would be passed on to end users of FX derivatives, reducing corporate competitiveness and acting as a tax on extra-EMU exports. The FTT would also result in less liquid markets, impair market efficiency and widen bid -offer spreads. The design of the FTT may make it incompatible with existing global efforts at financial reform. By discouraging forms of financial intermediation, the FTT potentially runs counter to the goals of US and European legislation, which are to encourage greater clearing and margining of transactions in order to reduce credit risk. Ultimately, we hope that policy makers will take note of these considerations, and in particular take in the interests of non-financial corporations, pension funds and the real economy in their decision making process. EFTA01464335  or examp e, un es ank President Jens Weidmann in a speech in Dresden, 24th Banque de France Governor Christian Noyer, in remarks made to journalists 28th 16 Reuters Article, 'Europe Plans Major Scaling Back of Financial Trading Tax,' 30th Page 16 April 2013 and May 2013 May 2013 Deutsche Bank Securities Inc. EFTA01464336 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Legal Disclaimer: This article is intended to provide background information only. Readers should consult with their legal and compliance advisers as to the potential impact of any regulatory provisions noted in this article upon their respective businesses. The author would like to thank Bilal Hafeez and Matt Holmes for their help in writing this report. Deutsche Bank Securities Inc. Page 17 EFTA01464337 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax G10 FX Valuation Monitor: Lines in the Sand* Figure 1: The euro looks expensive and the dollar cheap 10 20 30 40 -20 -10 0 Source: DB FX Research 29.0 25.8 19.8 15.0 12.0 10.5 7.0 -2.3 -8.5 -12.3 NZD AUD CHF CAD EUR NOK GBP SEK USD JPY Source: DB FX Research Figure 2: The dollar is 9% cheap to fair value 100 110 120 130 60 70 80 90 USDTWI PPP USDTWI 20% Band 60 70 80 90 100 110 120 130 Figure 3: EUR/USD: The euro is expensive though remains within the 20% threshold _ Figure 4: USD/JPY: _The yen is very cheap to fair value 0.6 0.8 1.0 1.2 1.4 EFTA01464338 1.6 EUR/USD PPP EUR/USD 20% Band 0.6 0.8 1.0 1.2 1.4 1.6 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research 100 150 200 250 300 350 50 73 77 81 85 89 93 97 01 05 09 13 20% Band USD/JPY PPP USD/JPY 50 100 150 200 250 300 350 Source: DB FX Research Figure 5: USD/GBP: GBP is expensive Figure 6: USD/CHF: as well as CHF 0.25 0.35 0.45 0.55 0.65 0.75 0.85 0.95 20% Band USD/GBP PPP USD/GBP 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research 0.25 0.35 0.45 0.55 0.65 EFTA01464339 0.75 0.85 0.95 0.8 1.3 1.8 2.3 2.8 3.3 3.8 20% Band USD/CHF PPP USD/CHF 0.7 1.2 1.7 2.2 2.7 3.2 3.7 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research *Our measure of relative PPP is calculated using long-term averages from Jan-80 to Dec-04 and deflating by monthly CPI differentials. We refer to current spot rates as "cheap" or "expensive" with explicit reference to this measure of fair valuation; these statements are not intended in any way to be "buy" or "sell" recommendations. Page 18 Deutsche Bank Securities Inc. EFTA01464340 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Figure 7: USD/CAD: CAD overvaluation is being unwound Figure 8: USD/AUD: AUD is very expensive, beyond 20% threshold 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 20% Band USD/CAD PPP USD/CAD 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 0.6 0.9 1.2 1.5 1.8 2.1 Source: DB FX Research USD/AUD 20% Band PPP USD/AUD 73 77 81 85 89 93 97 01 05 09 13 0.6 0.9 1.2 1.5 1.8 2.1 Figure 9: USD/NZD: .and so is NZD Figure 10: EUR/JPY: The euro is very expensive against the yen 0.5 1.0 EFTA01464341 1.5 2.0 2.5 3.0 Source: DB FX Research USD/NZD 20% Band PPP USD/NZD 73 77 81 85 89 93 97 01 05 09 13 0.5 1.0 1.5 2.0 2.5 3.0 100 150 200 250 300 350 400 450 50 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research EUR/JPY 20% Band PPP EUR/JPY 50 100 150 200 250 300 350 400 450 Figure 11: EUR/GBP: Sterling is cheap against the euro 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Source: DB FX Research EUR/GBP 20% Band PPP EUR/GBP EFTA01464342 73 77 81 85 89 93 97 01 05 09 13 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Figure 12: EUR/SEK: SEK is very cheap versus the euro 10 11 12 4 5 6 7 8 9 10 11 12 EUR/SEK 20% Band PPP EUR/SEK 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research 4 5 6 7 8 9 Deutsche Bank Securities Inc. Page 19 EFTA01464343 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Figure 13: EUR/CHF: CHF is expensive against the euro 1.0 1.5 2.0 2.5 3.0 3.5 4.0 EUR/CHF 20% Band PPP EUR/CHF 1.0 1.5 2.0 2.5 3.0 3.5 4.0 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research Figure 14: EUR/CAD: CAD is close to fair value against euro 0.9 1.1 1.3 1.5 1.7 1.9 EUR/CAD 20% Band PPP EUR/CAD 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research 0.9 1.1 1.3 1.5 1.7 1.9 Figure 15: AUD/NZD: NZD is fair value against AUD.... 0.6 0.8 1.0 1.2 1.4 1.6 1.8 AUD/NZD 20% Band EFTA01464344 PPP AUD/NZD 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Figure 16: CAD/NZD: ....and is expensive against CAD 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Source: DB FX Research CAD/NZD 20% band PPP CAD/NZD 73 77 81 85 89 93 97 01 05 09 13 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Figure 17: JPY/NZD: NZD is expensive against the yen 0.000 0.005 0.010 0.015 0.020 0.025 Source: DB FX Research JPY/NZD 20% Band PPPJPY/NZD 0.000 0.005 0.010 0.015 0.020 0.025 73 77 81 85 89 93 97 01 05 09 13 Figure 18: GBP/JPY: JPY is very cheap against GBP EFTA01464345 100 200 300 400 500 600 700 800 0 73 77 81 85 89 93 97 01 05 09 13 Source: DB FX Research GBP/JPY 20% Band PPP GBP/JPY 100 200 300 400 500 600 700 800 0 Page 20 Deutsche Bank Securities Inc. EFTA01464346 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax FX Behavioral and Fundamental Equilibrium Exchange Rates (BEER and FEER)* Figure 1: USD-cross BEER and FEER valuations 10 20 30 40 -40 -30 -20 -10 0 29 24 20 15 10 10 8 8 7 -1 -5 -10 -15 -21 -26 -5 -6 11 8 4 2 2 1 2 -2 -2 -3 -4 -4 -4 -4 -1 -7 -9 -2 -6 -11 -11 -11 -12 -12 -13 -13 -14 -12 -21 -28 -28 -1 8 7 19 14 11 7 3 20 23 BEER FEER 17 EFTA01464347 24 21 22 Source: DB FX Research Figure 2: EUR/USD is a bit expensive vs. BEER FV Figure 3: USD/JPY is now above fair value vs. BEER FV 0.6 0.8 1.0 1.2 1.4 1.6 1.8 EUR BEER Fair Value Spot 100.0 150.0 200.0 250.0 300.0 50.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research 8082848688909294969800 0204060810 12 Source: DB FX Research JPY BEER Fair Value Spot Figure 4: GBP/USD is very undervalued vs BEER FV 2.5 GBP 2.0 BEER Fair Value Spot Figure 5: USD BIS TWI is fair value vs. BEER FV 1.5 100.0 110.0 120.0 130.0 140.0 80.0 90.0 1.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research Source: DB FX Research *Sources: BIS, Bloomberg, Deutsche Bank. Notes: For details on model, see Exchange Rate Perspectives, Jan-13. BEER model is relative PPP adjusted for terms-of-trade and productivity effects. EFTA01464348 (structural) surpluses/deficits. Over/undervaluation calculated off TWIs and converted to USD-crosses using matrix algebra. EM graphs available upon request. Deutsche Bank Securities Inc. Page 21 808284 86889092949698000204060810 12 BEER Fair Value Spot Relative FEER model is based on current account surpluses/deficits relative to long-term NZD CHF SGD AUD ILS PHP CAD EUR THB CZK BRL MYR IDR HUF COP HKD MXN TRY RUB TWD CNY NOK CLP PLN SEK GBP KRW JPY INR ZAR ARS EFTA01464349 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Figure 6: USD/CAD is cheap vs. BEER FV Figure 7: AUD/USD is quite expensive vs. BEER FV 0.8 1.0 1.2 1.4 1.6 1.8 CAD BEER Fair Value Spot 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research 0.4 0.6 0.8 1.0 1.2 1.4 AUD BEER Fair Value Spot 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research Figure 8: NZD/USD is very expensive vs. BEER FV Figure 9: USD/CHF is quite cheap vs. BEER FV 0.2 0.4 0.6 0.8 1.0 1.2 NZD BEER Fair Value Spot 0.5 1.0 1.5 2.0 2.5 3.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research CHF BEER Fair Value Spot 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: Deutsche Bank Figure 10: USD/NOK is a bit expensive vs. BEER FV EFTA01464350 10.0 2.0 4.0 6.0 8.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research NOK BEER Fair Value Spot 9.0 Figure 11: USD/SEK is expensive vs. BEER FV 12.0 SEK BEER Fair Value Spot 6.0 3.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research Page 22 Deutsche Bank Securities Inc. EFTA01464351 30 July 2013 Exchange Rate Perspectives: FX and the Financial Transaction Tax Figure 12: EUR/USD is cheap vs. FEER FV Figure 13: USD/JPY is very cheap vs. FEER FV 0.6 0.8 1.0 1.2 1.4 1.6 1.8 EUR Relative FEER Fair Value Spot 100.0 150.0 200.0 250.0 300.0 350.0 50.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: DB FX Research 8082848688909294969800 020406