are seeing a move from single- to multiple-dealer sites, where dealers are put in more direct competition with each other for customer business.

"Some market participants noted it is a matter of time before trading in these products (foreign exchange and sovereign bonds) takes place on a platform to which dealers and end-users have equal access" (BIS, CGFS, 2001, p 15). If so, a centralized customer-driven market could expand at the expense of the present decentralized dealer-driven market. The foreign exchange market would become closer to a stock exchange. The provision of liquidity by customers through limit order books would substitute for the current interdealer mechanism of risk-sharing. The "hot potato chain" would shorten even more, with customers getting into contact more directly, although dealers would not disappear totally.

The CTT would accelerate this trend because each participant would want to reduce the number of transactions to reduce the times they pay the tax (J. Frankel, 1996, p 66). One important feature of this evolution is the shift of power from banks to customers and towards a more transparent market. This evolution is important to determine how the burden of the tax can be shared between banks and customers. In so far as customers have more power and can more easily compare the price offered by banks, they will be in a more favourable situation to ask banks to pay a higher share of the tax.

Would a much more centralized market be for the better or for the worse? It is difficult to answer this question because the theoretical literature is inconclusive. One may say that a lower number of dealers, especially market-makers, will reduce liquidity especially in times of stress. "However it is not so obvious from previous examples of market turbulence that market-makers did provide liquidity when it was required. There have been cases in various volatile markets where market-makers simply stopped answering their phones. Ultimate liquidity may be provided by those end-users able to take a long-term view because they are neither leveraged nor subject to daily marking to market" (BIS, CGFS, 2001, p 20).

The CTT has exactly this objective of increasing the weight of long-term horizons propitious to stability.

### 1.8.5 The protected monetary zone

We advocate for what we call a "protected monetary zone", by which we mean a target zone coupled with a mechanism that does not oblige a country to use the interest rate instrument to stabilise the exchange rate and keep it inside the band of fluctuations. This relative disconnection between the exchange rate and the interest rate is precisely what J. Tobin had in mind when he conceived his tax on currency trade.

But it is possible to go one step further and contemplate a more cooperative and administered version. A group of East Asian countries, or African countries, or the Mercosur, could decide to follow an explicit exchange rate policy targeting semi-fixed foreign exchange rates for economic and social reasons. Governments would meet regularly to establish the targeted foreign exchange rates and coordinate their economic policies. The band of fluctuations would turn into a target zone protected by the CTT (37). There have been experiences of target zones in the past like the "European Monetary Snake", from 1971 to 1973, which, not only created a target zone for European currencies but also tied the target zone to the dollar. The "European Monetary System" (EMS, 1979-1999) maintained the target zone for the European currencies but without any attempt to stabilize the fluctuations between them and the US dollar. It has been a real success in term of stability.

<footnote>(37) For more elaboration on this proposal see D. Felix (1999), J. Grieve Smith (2002, pp 146-148) and B. Jetin (2002, pp 206-213).</footnote>
In Asia, under the “Chiang Mai Initiative”, 13 countries have agreed arrangements to monitor foreign exchange markets and to aid currencies in difficulty. All these experiences were more or less successful, but their weakness is that they were only based on pooling official reserves, on swaps and repurchase agreements. And these mechanisms were never sufficient against the power of speculation. The EMS broke up in 1992-93 under the pressure of a major speculative attack despite the combined efforts of the European central banks to resist. The same happened to the Thai Baht in 1997 despite Asian central banks support of the Bank of Thailand. But it was not a fatality. Was the EMS defeated by speculation because it was insufficiently protected by anti-speculative instruments?

"Would a Tobin tax have saved the EMS"? asked O. Jeanne (1996). The answer is positive. The author studies a target zone "à la Svenson" where a government is faced with a trade-off between a foreign exchange objective and a domestic interest rate objective. When the Tobin tax is introduced, it stabilises the fixed exchange-rate system through two different channels. "First the Tobin tax allows the monetary authorities to insulate (to some extent) domestic monetary policy from external shocks that the system is able to withstand. The second, more indirect, effect of the tax is to reduce the size of realignment expectations" (O. Jeanne, op cit p 504), that is the expectations that the currency be devalued, because speculators know that it is less costly for the government to defend the currency. The model is tested with data on the French Franc in 1991-93. The author shows that a 0.1% tax would have allowed France to keep its interest rate much closer to the desired level. And the expected devaluation of the French Franc vis-à-vis the Deutsche Mark would have been divided by five. The 0.1% tax has a sizeable stabilising effect on a fixed exchange rate system. This proves that a regional monetary zone can be efficiently protected by a CTT.

The advantages could be the following:

1) Part of the tax revenues, maybe 20%, could be used to create an intervention fund to help the monetary authorities to counter-speculate in the foreign exchange markets. The rest of the revenues would be used for financing global public benefits, the universal access to social basic services defined by the millennium development goals, and the financing of national economic, social and ecological development plans in poor countries.

2) There will be an enhanced autonomy at the national level to implement full employment and other welfare goals without being immediately sanctioned by anticipatory capital flight. This comes from the fact that the tax widens the interest rate differentials across currencies required to make arbitraging profitable.

3) The creation of "regional protected monetary zones" could be a transition from the present deregulated capital markets toward a new international monetary system based on multilateral cooperation and capital controls. One cannot simply jump from the present globalised capital markets to the international clearing union defended by Keynes in 1944.

The market friendly "protected monetary zone" could be implemented unilaterally. The EU, for example, does not need US permission to enforce it. This is because the band of fluctuations is defined in relation to flexible exchange rates without any explicit target rates. Whatever the fluctuations of the US dollar, the band of fluctuations defined by the EU will incorporate and smooth them according to the period of reference of the moving average. If the moving average is defined on a long range, say 3 months, a very volatile US$ would trigger very often the surcharge. But this is a purely empirical and political question. The way of calculating the average, the limits of the band, the level of the surcharge can be modified in accordance with experience and the objectives of the exchange and monetary policies. But in any case, there is no need to wait for a universal treaty to put the CTT in place.
The managed version requires a higher degree of cooperation between countries. In principle, each country must coordinate its fiscal and monetary policy in order to keep its interest rates in accordance with the targeted foreign exchange rate. The Louvres Agreement in 1987, between the USA, Japan and the European Union is a good example of an attempt to reduce the exchange rate volatility between the US$, the Yen and the European Currencies. And it failed, after a significant period of success, for lack of will to further co-ordinate economic policies and because of rampaging capital flows. But with a CTT properly defined, the need to coordinate economic policy would be substantially reduced thanks to the possibility to maintain different interest rates and because speculation would be held at bay. These characteristics leave open the possibility for a group of countries to create a target zone in order to stabilize their exchange rate in relation to the US dollar even without the cooperation of the US government with a much greater chance of success. For Latin American countries, it offers an alternative to the "dollarisation" process where the autonomy of the monetary policy totally disappears in favour of the American monetary policy.

But of course, the higher the cooperation between all countries, the more efficient will be the protected regional monetary zone. The financial stability created by the CTT is an additive process. The more countries and regions join in, the more efficient it becomes.
## 2 THE FEASIBILITY OF THE CURRENCY TRANSACTION TAX

Usually, governments, whether they are friendly to the tax or hostile, agree to declare that it is unfeasible on technical and political grounds. The major criticisms are the following:

1. Offshore financial places and tax havens would allow evading the tax quite easily.

2. Financial engineering would quickly create new financial products to avoid paying the tax, in particular by avoiding making transactions on the foreign exchange market. It is the case for instance of over-the-counter (OTC) derivatives.

3. Like every tax, the CTT would create a costly bureaucracy and corruption.

To answer these criticisms, it is now necessary to precise about how the tax could be collected. The basic idea is that the tax should not be collected by a new fiscal institution but through the financial system itself as it is now. Financial markets are introducing technical progress intensively to gain time and reduce costs. Financial transactions are now nearly totally dematerialised and rely extensively on computer networks. Automation of all steps of a transaction is nearly completed. The consequence is that financial transactions need robust audit trail reporting just to prove that a transaction has been made, and who owns what. This same powerful technical progress can be used to collect the tax. It will be secure and cost efficient.

Let's see how the foreign exchange market works and how a transaction on currency is executed from the moment it is traded until the moment when it is definitively settled. We will have also to distinguish the different types of transactions, how the foreign exchange market functions, and to explain how the national system of payment works in modern economies, especially in the EU.

### 2.1 The specific nature of the foreign exchange markets

Financial markets differ according to the kind of assets they trade and to national rules and traditions. Stock exchanges like Wall Street or the London Stock Exchange that trade equities are the best known. On these markets, prices are posted and appear on large screens; everyone can see them and trade in consequence. The market is centralised and said to be order-driven meaning that prices follow orders. Orders are sent to a central location (the computer system of the stock exchange) and prices are derived from the interaction of these order flows.

Currencies markets, like fixed-income market (bonds) differ in the sense that currencies are not traded on a centralised market and prices are not made public. Until recently, traders had to make orders just to discover which prices were being practised minute by minute. These are Over-The-Counter (OTC) markets and they are usually quote-driven, meaning that orders follow prices. Dealers quote prices at which they are willing to buy and sell securities or currencies. The willingness of the customer to transact at these quotes determines market prices. Prices result from a bilateral interaction, and not from a multilateral interaction as on a centralised market. Transparency is limited.

Foreign exchange markets are also segmented. End-users, i.e. the customers, do not trade directly with each other, but do so through intermediaries, the dealers. Customers are corporations and non-bank financial institutions such as pension funds, mutual funds, hedge funds, and insurance companies. Dealers are exclusively banks and brokers. Dealer-to-customer transactions form the retail market. This is where banks meet their customers' needs. Interdealer transactions form the wholesale market.
Figure 2-1 shows that the wholesale market has lost nearly 10% in relative proportion to the benefit of the retail market. It represents now 53% in 2004, down from 64% in 1995. The reason is the on-going process of concentration in the banking sector and the growing importance of electronic trading. A closer look shows that the growth of the retail market is due to the strong increase of non-bank financial institutions (called "other financial institutions" on Chart 1) from 20% in 1995 up to 33% in 2004. Corporate customers accounts for a meagre 14%.

The increase of the non-bank financial institutions is explained by the return of speculative opportunities on currencies since the bubble burst on equity markets in March 2000, the presence of clear trends and the renewed volatility of currencies, and the interest rate differential that supported carry trades (see G. Galati and M. Melvin, 2004).

The foreign exchange market being divided in nearly two equal parts, one has to consider a way to collect the tax on both markets. In terms of currency composition of turnover, the dollar was on one side of 89% of all transactions in 2004, followed by the euro (37%), the yen (20%) and the pound sterling (17%) (³⁸). Dollar/euro continued to be by far the most traded currency pair with 28% of global turnover, followed by the dollar/yen with 17%, and dollar/sterling with 14%. The share of trading in local currencies in emerging markets increased slightly to 5.2% in 2004.

If the CTT was created inside the E.U., its currencies would then cover around 58% (³⁹) of world turnover and 64% with Switzerland (for a total of 200%). This is a good starting point in the perspective of further enlargement to other countries.

62% of the transactions are cross-border in nature, i.e. involving traders located in two different countries, against 54% in 1995, reflecting the growing international integration of foreign exchange markets. The remaining 38% of global turnover are transactions between two counterparties located in the same country. This means that the CTT cannot be levied only on transactions whose counterparties are located on the national territory, but also on transactions which involve a foreign counterparty. If not the major share of the transactions would not be taxed.

<footnote n="38">³⁸) "Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%", (BIS, 2004).</footnote>

<footnote n="39">³⁹) This figure is the sum of the euro share (37%), the Sterling share (17%), the Swedish Krona (2.3%), the Danish Krone (0.9%), the Polish Zloty (0.4%) and the Czech Koruna (0.2%). The Swiss Franc amounts to 6.1% of global turnover. Source, BIS 2004.</footnote>
<figure><img src="image_6.png" /><figcaption>Fig. 2-1 : Evolution of Foreign Exchange Turnover by Counterparty</figcaption></figure>

Foreign exchange transactions are of different types. There are spot transactions, swaps, straight forward transactions, futures and options (See box 2-1 for definitions).
Box 2-1 : The Different Categories of Foreign Exchange Transactions and Their Definitions

Foreign exchange spot and derivatives transactions are defined and categorised as follows:

**Spot transaction** Single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) within two business days. The spot legs of swaps were not included among spot transactions but were treated as swap transactions even when they were for settlement within two days (i.e. including "tomorrow/next day" transactions).

**Outright forward** Transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) at some time in the future (more than two business days later).

**Foreign exchange swap.** Transaction which involves the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of conclusion of the contract (the short leg), and a reverse exchange of the same two currencies at a date further in the future and at a rate (generally different from the rate applied to the short leg) agreed at the time of the contract (the long leg). Both spot/forward and forward/forward swaps are included. Short-term swaps carried out as "tomorrow/next day" transactions are also included in this category.

**Currency swap** Contract which commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.

**Currency option/warrant.** Option contract that gives the right to buy or sell a currency with another currency at a specified exchange rate during a specified period. This category also includes exotic foreign exchange options such as average rate options and barrier options.

**Currency swaption** Option to enter into a currency swap contract.

Source: "Triennal Central Bank Survey, 2004, BIS, p 32-33.

There are different ways to classify these transactions. Traditional foreign exchange markets include spot transactions, outright forwards and foreign exchange swaps. Derivatives include futures (40), currency swaps, currency options and swaptions. They are called "derivatives" because their value is derived from the value of another foreign exchange transaction, for instance, a spot transaction, which is called the "principal". Derivatives, like traditional transactions, are double-edged swords: they allow transferring risks from economic agents that do not want to assume those risks to other agents that do want to assume those risks because they think they will make a profit from these assets. Hedging needs speculation.

From our point of view, the most important is to determine how these transactions are done in order to assess how they could be taxed. There are two important points. There are transactions that are delivered, i.e. settled, and some that are not. Transactions that are settled include spot transactions, outright forwards and swaps. In 2004, they represented at least 87.8% (See table 2-1).

<footnote n="40">40) Some outright forwards are traded on an exchange. They are then called "Futures". The most important exchanges for futures are located in Chicago, New York, London, Paris, Frankfurt, Tokyo and Singapore. Traders don't trade directly between themselves, but buy or sell futures to the exchange that operates as a central counterparty. These exchanges are private firms that establish their own regulations in accordance with monetary authorities. Contracts are standardised in order to facilitate their trade. Forward contracts are not standardised but adapted to customers' needs and this is why they trade over-the-counter.</footnote>
<table><caption>Table 2-1 : Global Forex Market by Type of Transaction</caption><thead><tr><th>Daily average, billions of US $</th><th>1995</th><th>1998</th><th>2001</th><th>2004</th></tr></thead><tbody><tr><td>SPOT</td><td>494</td><td>568</td><td>387</td><td>621</td></tr><tr><td>OUTRIGHT FORWARDS</td><td>97</td><td>128</td><td>131</td><td>208</td></tr><tr><td>FOREX SWAPS</td><td>546</td><td>734</td><td>656</td><td>944</td></tr><tr><td>CURRENCY SWAPS</td><td>4</td><td>10</td><td>7</td><td>21</td></tr><tr><td>OPTIONS</td><td>41</td><td>87</td><td>60</td><td>117</td></tr><tr><td>OTHER</td><td>1</td><td>0</td><td>0</td><td>2</td></tr><tr><td>ESTIMATED GAP IN REPORTING</td><td>53</td><td>60</td><td>26</td><td>107</td></tr><tr><td>TOTAL OTC FOREX MARKET</td><td>1236</td><td>1587</td><td>1267</td><td>2020</td></tr><tr><td>EXCHANGE TRADED CURRENCY DERIVATIVES</td><td>17</td><td>11</td><td>10</td><td>23</td></tr><tr><td>TOTAL FOREX MARKET</td><td>1253</td><td>1598</td><td>1277</td><td>2043</td></tr><tr><td>In %</td><td>1995</td><td>1998</td><td>2001</td><td>2004</td></tr><tr><td>SPOT</td><td>39.4</td><td>35.5</td><td>30.3</td><td>30.4</td></tr><tr><td>OUTRIGHT FORWARDS</td><td>7.7</td><td>8.0</td><td>10.3</td><td>10.2</td></tr><tr><td>FOREX SWAPS</td><td>43.6</td><td>45.9</td><td>51.4</td><td>46.2</td></tr><tr><td>CURRENCY SWAPS</td><td>0.3</td><td>0.6</td><td>0.5</td><td>1.0</td></tr><tr><td>OPTIONS</td><td>3.3</td><td>5.4</td><td>4.7</td><td>5.7</td></tr><tr><td>OTHER</td><td>0.1</td><td>0.0</td><td>0.0</td><td>0.1</td></tr><tr><td>ESTIMATED GAP IN REPORTING</td><td>4.2</td><td>3.8</td><td>2.0</td><td>5.2</td></tr><tr><td>TOTAL OTC FOREX MARKET</td><td>98.6</td><td>99.3</td><td>99.2</td><td>98.9</td></tr><tr><td>EXCHANGE TRADED CURRENCY DERIVATIVES</td><td>1.4</td><td>0.7</td><td>0.8</td><td>1.1</td></tr><tr><td>TOTAL FOREX MARKET</td><td>100.0</td><td>100.0</td><td>100.0</td><td>100.0</td></tr></tbody></table>

Source: BIS Triennial Central Bank Survey of Foreign Exchange for data. Author's calculations.

Options and futures (around 6%) are usually not settled. They are sold before they come to term. This means that if the tax is levied at the point of settlement, these transactions will not be taxed. Between 2001 and 2004, options and futures have doubled. If they were the only transactions not to be taxed, they would certainly increase further.

For a very small part of options and futures, called "exchange traded derivatives", the solution is easy. These transactions are traded on an exchange in Chicago, New York, London or Paris. They could be easily taxed at the moment of the trade capture. Usually, private firms that own the exchange use software that integrates trade, netting and settlement. The problem is that the exchange traded derivatives represent a very small part of foreign exchange transactions: only 1.1% in 2004. The foreign exchange market is still a decentralised market where 98.9% of global transactions are traded in a decentralised way, over-the-counter.

Therefore taxation must combine several approaches. It cannot rely on a single venue and must embrace every type of transaction, traditional or derivatives, settled or unsettled, over-the-counter or exchange traded, national or cross-border, on the wholesale or retail market. It has to be flexible in order to accompany the evolution of the market. This requires examining in detail how transactions are made, the nature of firms and institutions implied, and the changing nature of the market due to technical progress and legal context.
## 2.2 The different steps of a foreign exchange transaction

Foreign exchange transactions adhere to common rules and practices accepted by the banking community in order to reduce as much as possible the operational risk (41). These rules and practises are getting stricter and tend to homogenise at the international level since monetary authorities are getting more preoccupied by the risk that the failure of one bank will trigger a cascade of failures of other banks participating in the market. Money laundering and criminal activities are also another source of concern. This is the reason why monetary and financial authorities are recommending “best practices” for the foreign exchange community that are becoming professional standards (42).

Following the Federal Reserve Bank of New York (2004), it is possible to distinguish seven steps of the foreign exchange trade process flow:

1) Pre-trade preparation, 2) trade capture, 3) confirmation, 4) netting, 5) settlement, 6) nostro reconciliation, and 7) accounting/ financial control processes.

How each of these seven phases integrates with the others in the FX process flow is outlined in figure 2-2 below that describes a trade between one bank and another bank, or with a non-bank customer. The definition of each step is given in Box 2-2.

<figure><img src="image_7.png" /><figcaption>Fig. 2-2 : The FX Process Flow</figcaption></figure>

Source: "Management of Operational Risk in foreign Exchange". The Foreign Exchange Committee, Federal Reserve Bank of New York, New York, 2004.

The process flow described above involve several private firms whose number is increasing due to outsourcing and technical innovations. The customer initiates the trade, and the bank is in charge of its execution. But to trade, the bank can directly contact another bank, or a voice broker, or increasingly, an electronic trading platform. The electronic trading platform can also in part take charge of confirmation, netting and even settlement. Or this can be done by different specialised private firms. For instance, netting can be done by one clearing institution, and settlement by another. Final settlement is executed by a central bank. Nostro reconciliation involves correspondent banks. Accounting and financial control is frequently outsourced, for instance to Bangalore (India), the new capital of outsourced back offices. When the customer that initiates the trade is not a productive firm that trades products and services internationally, but rather a financial institution that spec-

<footnote n="41">41) Operational risks are the risk of direct or indirect loss resulting from inadequate or failed procedures, people, and systems, or from external events (Committee on Banking Supervision, 2002)</footnote>

<footnote n="42">42) See the “best practises” list available on the Foreign Exchange Committees web sites of the USA, Canada, Japan, and the UK among others.</footnote>
ulates, the currency used to buy another currency is not owned by the customer but bor-
rowed from a “prime broker”. And to communicate, all these private firms and public institu-
tions use a message carrier, the most important being SWIFT (⁴³). SWIFT not only transfers
messages between all agents involved in the process flow, but also executes some of the
steps, like confirmation or netting, in competition with other specialised firms, like electron-
ic trading platforms or clearing houses. SWIFT is the nervous system of foreign exchange
and other financial markets.

Deregulation and technical innovations have profoundly transformed the foreign ex-
change market, especially since the beginning of the current decade. This new complexity
has to be taken into account and our views about the way to collect the tax must change
accordingly.

Up to now, there exists a consensus among the CTT supporters that the settlement
is the most appropriate moment and place to collect the tax for reasons that will be justified
below. But taxing at the settlement site has also some defaults and weaknesses. The first
is that some transactions, like options, are not settled and hence cannot be taxed at the
settlement site. The second is that when transactions reach the settlement phase their
number has decreased due to the netting process, and this would reduce the tax base sig-
nificantly.

Our approach is therefore to combine all the opportunities offered by the transaction
flow to consider a more comprehensive way to collect the tax. The basic idea is that all for-
eign exchange transactions should be identified by a numerical tag that would follow the
transaction through the process flow. The tag would include among other things the follow-
ing information: if the tax has already been paid or has not yet been paid. This information
would be automatically transferred to the ministry of finance of the relevant country via the
central bank that would be the operating agent.

Banks and their customers would be free to pay spontaneously the tax when a
transaction is captured or confirmed, when a transaction goes through the netting process,
or when the transaction goes through the settlement process. Usually transactions are net-
ted before being settled because it reduces costs. But some of them avoid the netting pro-
cess and are directly settled when they are more urgent, even if it costs more. Hence the
necessity to pay the tax at the netting site or at the settlement site providing that each indi-
vidual transaction is clearly identified by its tag that informs the fiscal authorities about
whether the tax has been already paid or not.

In summary, when banks trade with their customers or with other banks, they could
spontaneously pay the tax when they trade. When banks use an electronic platform to
trade, this can very easily collect the tax and transfer it to the central bank. Clearing
houses, which are the legal institutions responsible for the netting, could be the third cat-
egory of tax collecting agents. Once netted, transactions are irrevocably paid by the settle-
ment system managed by the central bank which is the main crossroads of the financial
system. Institutional relationships between clearing houses and central banks already exist
and need not be created. Settlement would be the fourth and probably most important pos-
sibility to pay the tax.

We will now describe some features of each of these steps of the process flow to
show that the necessary information and the technical and institutional infrastructure to
collect the tax already exists and can be used without extra costs.

<footnote n="43">⁴³) SWIFT stands for the “Society for Worldwide Interbank Financial Telecommunication”. It is an industry-owned supplier of (payment) message carrier services.</footnote>
# Box 2-2 : The Seven Steps of a Foreign Exchange Transaction. Definition and Explanations

## Pre-Trade Preparation.

"The pre-trade preparation and documentation process initiates the business relationship between two parties. It allows both parties to mutually agree on procedures and practices to ensure that business is conducted in a safe and sound manner. An understanding of each counterparty's trading characteristics and level of technical sophistication is developed. It involves coordination with sales and trading and operations as well as other support areas such as systems, credit, legal and compliance to establish trade capture parameters and requirements that should be in place prior to trading".

## Trade Capture.

"It is the second phase of the foreign exchange process flow. Deals may be transacted directly over a recorded phone line, through a voice broker, via an electronic matching system (for example EBS and Reuters) or through Internet based systems or multidealer trading platforms)." "After the deal is executed, the trader, or trader's assistant, inputs trade data into the front-office system or writes a ticket to be entered into a bank's operations system. Deals done over electronic dealing systems such as Reuters or EBS allow deal information to flow electronically to the front-office system. Trade information typically includes trade date, time of trade, settlement date, counterparty, financial instrument traded, amount transacted, price or rate, and may include settlement instructions" (we underline). "Trade information from front-office systems flows through the operations system (Accounting and Financial control on the figure), where it is posted to sub-ledger accounts, and the general ledger is updated as trades are processed. Operations staff should be responsible for ensuring that appropriate settlement instructions are captured so that the required confirmation message can be issued. For interbank, institutional, and corporate counterparties with Standard Settlement Instructions (SSIs) on file, the deal is immediately moved to the confirmation process.

## 3. Confirmation.

"The transaction confirmation is legal evidence of the terms of a FX or a currency derivative transaction. Therefore, the management of the confirmation process is an essential control". "Given the significance of the confirmation process, it is important that the process is handled independently of the trading room. In most institutions, the operations department performs this activity". "Confirmations should be transmitted in a secure manner whenever possible. In the most developed markets, confirmations are generally sent via electronic messages through secure networks. In some instances, proprietary systems have been developed to provide access to confirmations to clients. However, a significant number of transaction confirmations are also sent via mail, e-mail, and fax". "A transaction confirmation should include all relevant data that will allow the two counterparties to accurately agree to the terms of a transaction. All relevant settlement instructions for each transaction should be clearly identified in each confirmation".

## 4. Netting.

"Bilateral settlement netting is the practice of combining all trades between two counterparties due on a particular settlement date and calculating a single net payment in each currency. If, for example, a bank does twenty-five trades in dollar-yen with the same counterparty, all of which settle on the same day, bilateral settlement netting will enable the bank to make only one or two netted payments instead of twenty-five. "Multiple settlement netting is the practice of combining all trades between multiple counterparties and calculating a single payment in each currency". "Netted payments are calculated for transactions done in the same currencies with equal value dates. The bank and counterparty continue to confirm all deals on a daily basis either directly or through a system that helps support settlement netting. These systems allow a bank to view netted amounts of trades on a screen". "Operations generally confirm netted amounts again on the day before settlement date in addition to confirming the transaction itself on the trade date".

(box continues on next page...)
**BOX 2 - 2, Continued.**

**Settlement.**

"Settlement is the exchange of payments between counterparties on the value date of the transaction. The settlement of FX transactions can involve the use of various secure international and domestic payment system networks". "Settlement occurs and payments are exchanged on the value date of the transaction. For counterparties that are not settled on a net basis, payment instructions are sent to nostro banks for all the amounts owed—as well as for expected receipts"." A nostro bank, or correspondent bank, is usually a foreign bank that provides payment services to the bank that initiates the transaction. "Settlement instructions should include the counterparty's nostro agent's name and SWIFT address and account numbers if applicable". "All payments are exchanged through the aforementioned nostro accounts. These accounts are denominated in the currency of the country where they are located. When a bank enters into a contract to buy dollars and sell yen, for example, it will credit its yen nostro account and debit its dollar nostro account. The counterparty credits its dollar nostro account and debits its yen nostro account in Japan. Both banks initiate a money transfer to pay their respective counterparties; this is done by a funds movement between the two banks using the local payment system. The money transfer is complete when both counterparties have been paid the appropriate amounts."

**6. Nostro reconciliation.**

"Nostro reconciliation occurs at the end of the trade settlement process to ensure that a trade has settled properly and that all expected cash flows have occurred. A bank should begin reconciliation as soon as it receives notification from its nostro bank that payments are received. If possible, reconciliation should be performed before the payment system associated with each currency closes". The main objective of the nostro reconciliation function is to ensure that expected cash movements agree with the actual cash movements of currency at the nostro bank.

**7. Accounting/Financial Control.**

"The accounting function ensures that FX transactions are properly recorded to the balance sheet and income statement". "Accounting entries are first booked following the initiation of a trade. At this point, details of the deal are posted to contingent accounts (typically in a system used by operations). At the end of each trade day, all sub-ledger accounts flow through to the general ledger".

*Source: "Management of Operational Risk in Foreign Exchange". The Foreign Exchange Committee, Federal Reserve Bank of New York, November 2004, New York.*

### 2.2.1 Step 1: the pre-trade preparation

A first critical point is the "Know Your Customer" (KYC) procedure in force in the US but also in the E.U. for collecting information relating to the identity of a counter party and its activity (Federal Reserve Bank of New York, 2004). The second point is the presence of master agreements <sup>(44)</sup> that have developed as industry-standard forms that include "close-out netting" and standard settlement instructions.

1) KYC procedures have recently become "the cornerstone for combating criminal activity" (op cit p 11). And for this reason the Federal Reserve, together with the Singapore Foreign Exchange Market Committee, has not hesitated to recommend the elimination of a new practice on the foreign exchange market which is trading on an unnamed basis.

"Trading foreign exchange on an unnamed basis refers to the practice whereby an investment manager trades on behalf of a client without revealing its identity to the dealer in order to maintain client anonymity. Such practices constrain a dealer's ability to assess the creditworthiness of their counterparties and comply with "know your customer" and anti-money laundering rules and regulations. These conditions expose dealers to clear and significant legal, compliance, credit, and reputational risks, as well as heighten the risk of

<footnote><sup>(44)</sup> A master agreement sets forth the standard terms and conditions applicable to all or defined subset of transactions that the parties may enter into from time to time, including the terms and conditions for close-out netting. See below, step 3, confirmation.</footnote>
fraud”.

The solution is “... to develop a process to disclose client names to a dealer’s credit, legal, and compliance functions prior to the execution of foreign exchange trades. In turn, dealers should establish procedures to ensure the strict confidentiality of the intermediary’s clients and restrict the disclosure of this information to the front office except in the event of default. This is a commonly achieved practice in other markets through the use of identification codes or similar identifier systems” (45).

2) Master agreements include closeout netting provisions to help protect a bank in the event of a counterparty default. They also include settlement netting that permits parties to settle multiple trades with the counterparty with only one payment instead of setting each trade individually with separate payments. There are master agreements covering spot transactions, forward currency transactions, and currency options.

Several lessons can be made for the tax collecting issue. The first is that even before the transaction is made, there exists the necessary information regarding the identity of the counterparties and the nature of their transaction. This information does not need to be created specifically for fiscal issues and therefore will not create extra costs for market participants.

The second lesson is that not disclosing customer identity to the dealer, while revealing it to other departments of the bank is common practice. It should be therefore technically possible to add the fiscal authority to the disclosure list.

The third lesson regards the settlement procedure. As we shall see, the settlement is the cornerstone of the collection of the tax. What we've learnt is that there is the technical possibility to "tag" a transaction in advance, even before it exists, indicating how it will be settled. It is therefore possible to trace this transaction from the cradle (the trade capture) to the grave (the settlement) with something similar to the bar code of an item that is registered a first time when it is brought into a supermarket, and a second time when it passes through a cash-register.

### 2.2.2 Step 2: Trade capture

Taxing at the trading site is considered to be the best way by J. Tobin (1996), following P. Kenen (1996), and it is worth looking at the advantages and disadvantages of their proposal. The tax could be collected at the dealing site by banks themselves when they trade with other banks and brokers on the wholesale market or with their customers on the retail market. The tax would be assessed at the dealing site using the paper trail generated at that site. Governments of the countries where the sites are located would keep part of the revenues for domestic use and transfer the rest to international institutions.

The first and main advantage of this proposal is that each single transaction could be traced and taxed before it is netted (46). The tax base is then bigger than after the transactions or positions are netted and the amount sent to the settlement system.

The second advantage is that there are trading rooms in each country where foreign exchange transactions are realised, and this would create an incentive for countries to ad-

<footnote n="45">45) Letter of the Foreign Exchange Committee of the Federal Reserve of New York and The Singapore Foreign Exchange Committee, February 2004, available on their respective web sites.</footnote>

<footnote n="46">46) Netting is "an agreed offsetting of positions or obligations by trading partners or participants. The netting reduces a large number of individual positions or obligations to a smaller number of obligations or positions. Netting may take several forms which have varying degrees of legal enforceability in the event of the default of one of the parties" (BCE, 2001, p 742).</footnote>
opt the tax and control banks as a part of the revenues would be kept at the national level. This would increase the geographical coverage of an international treaty.

What is the relevance of these two points? The first advantage is a real one. To reduce risks and costs, banks are making efforts to net, as much as possible, their transactions before settlement. Taxing at the settlement site would only encourage them further in this way. Furthermore, since 1996, when J. Tobin and P. Kenen were writing, there have been major improvements toward automation called "straight-through-processing" on financial markets that allows major changes in the architecture of the foreign exchange market.

"Straight-through-processing" (STP) <sup>(47)</sup> now allows tracing of all transactions comprehensively and at much lower cost than the paper trail that was used before, when trading was realised manually through telephone and confirmed by fax. Furthermore, this automation process is fostering a centralisation of the foreign exchange that could make things easier for tax issues.

As we have seen in the first part of the report, on the wholesale market (inter-dealer market) spot transactions are now automated at the level of 85% to 95% since 2001. The automation of other types of foreign exchange transactions are growing. In London, 46% of forward and swap transactions were conducted via electronic platforms, versus 76% for spot transactions (Bank of England, 2005). Only two electronic brokerage platforms, EBS and REUTER <sup>(48)</sup>, dominate the wholesale market. With a slight modification of their software, it would be now technically possible to tax nearly all interbank transactions. There is a small share that is still traded by telephone but it is destined to decline further in the future. On the retail market (dealer-to-customer market), straight-through-processing is less advanced but growing quickly.

In Germany, electronic trading of foreign exchange is still small, around 10% of daily turnover, but growing due to deregulation of the financial system that especially hit the regional business between small and medium enterprises and Landesbanken <sup>(49)</sup>. In the USA, a recent Greenwich Associates study reflects the fact that the value of on-line currency trading volumes doubled between 2002 and 2003, to $8,000 trillion <sup>(50)</sup>. In fact, according to Greenwich the proportion of corporates conducting their foreign exchange business electronically rose to a significant 43% in 2003, up from 32% in 2002, a growth which will undoubtedly continue as corporates, already using electronic trading services, shift more of their foreign exchange business onto electronic platforms. Another survey of 375 U.S. companies by U.K. technology consulting firm "Clientknowledge" found that 42% trades were conducted electronically. General Electric (GE), which belongs to the top ten multinational companies and whose financial arm is also one of the biggest financial companies in the world, does about 20,000 foreign exchange trades a year with a total value of about $80 billion and has achieved a full straight-through-processing. GE's STP is integrated with GE's internal billing system and some of its general ledgers. It can upload trades into "FXpress", GE's data warehouse, which in turn uploads them into FXall, the electronic trading platform that GE has elected to execute its trades (S. Kelly, 2003).

<footnote n="47"><sup>47</sup> Straight-through-processing is "the automated end-to-end processing of trades/payment transfers including the automated completion or confirmation, generation, clearing and settlement of instructions" (ECB, 2001, p 750). It enables one to do a trade and then convey the data back into the company's accounting system without re-keying any information.</footnote>

<footnote n="48"><sup>48</sup> EBS (Electronic Broking Services) covers essentially the trade in US dollars, euro, yen and Swiss franc. Reuters' Dealing 2000-2 dominates transactions in pounds sterling, Swedish Kronor, Australian dollars, Canadian dollars and New-Zealand dollars, together with some emerging countries currencies.</footnote>

<footnote n="49"><sup>49</sup> "Online foreign exchange trading in Germany, a market poised for growth". E-forex, July 2004.</footnote>

<footnote n="50"><sup>50</sup> Greenwich Associates Report, March 30, 2004.</footnote>
Electronic trading platforms (51) between customers and dealers like FXall (52), Currenex (53) and FXconnect (54) are registering big increases in their activity. In 2002, the global turnover of these platforms was around 14 billion dollars per day. Now, Currenex trades on average 12 to 15 billion dollars per day, and FXall and FXconnect 30 billion dollars a day apiece (55). Most of these platforms have been created by banks that are also selling platforms to smaller banks and big customers for their internal foreign exchange risk management. According to Currenex, "40% of their revenues come from the selling of trading platforms". Lavatrading, Citigroup's subsidiary specialised in technology, has announced that it wants to turn the whole foreign exchange industry into a big electronic platform.

This is not mere propaganda. Since 2004, Reuters and EBS have been trying to extend their activities beyond the wholesale market to include the major traders of the retail market, the so-called buy side. In reaction, electronic trading platforms are willing to provide bank to bank trading, even if building a community to match EBS's and Reuter's would take a considerable amount of time.

Reuters announced in May 2004 a link with the Chicago Mercantile Exchange (CME) to provide CME pricing (in spot market terms) on Reuters Dealing 3000. These two institutions have not yet decided to pool neither their liquidity nor their order books. But this could change because of EBS's initiative. EBS announced in September 2004 that it has made its services (EBS Prime service) accessible to what it terms the "professional trading community" that includes hedge funds, asset managers, commodity trade advisers, and institutional investors that typically trade high frequency in the forex market and assume risk therein. This will increase speculation on the forex market. Hedge funds, which have targeted currencies as a speculative asset in their own right since the equity bear market of 2000, are now able to trade directly in the spot interbank foreign exchange market for the first time, gaining access to interbank market liquidity.

All these initiatives point toward the creation of exchanges for currency transactions as there are stock exchanges for equities. Hedge funds and other systematic traders are eagerly demanding the creation of such a currency exchange.

The idea of a currency exchange that would serve the foreign currency market as national bourses serve the stock market is not new. Ironically, it has been advocated by supporters of global taxes such as R.P. Mendez (1996, 2001, and 2002).

"Through an automated global computer network, matching buy and sell orders electronically, it would lower the cost to consumers of changing foreign currencies by giving them competitive rates and access to other buyers and sellers, which they now lack. FXE would also bring order, transparency, and efficiency to the present market. If properly designed, managed and sponsored, it could generate considerable revenues from licensing and transaction fees from its member traders and customers, as is done in the stock exchanges". The FXE would be created by the United Nations (UN) that would invest in the project in partnership with an existing electronic platform, and the revenues would be appropriated directly by the U.N.

<footnote n="51">51) An electronic trading platform is a facility that provides some or all of the following services: electronic order routing (the delivery of orders from users to the execution system), automated trade execution (the transformation of orders into trades) and electronic dissemination of pre-trade (bid/offer quotes and depth) and post-trade information (transaction prices and volume data) (BIS, 2001, p 3).</footnote>

<footnote n="52">52) FXall has been created in 2000 by Bank of America, Credit Suisse first Boston, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, and UBS Warburg. It has been joined since by more 50 banks.</footnote>

<footnote n="53">53) Currenex has been founded by Shell and the capital risk fund Thomas H. Lee and has been rejoined by ABN AMRO, Citigroup, Deutsche Bank, Lehman Brothers, Merrill Lynch, Calyon, Société Générale and again HSBC.</footnote>

<footnote n="54">54) FXconnect is owned by State Street Bank.</footnote>

<footnote n="55">55) Source: « Vers une bourse électronique des échanges ? » In "Les Echos, February 28th 2005".</footnote>
R.P. Mendez's project has encountered criticisms and scepticism, in particular on the UN political will and capacity to engage in such a project due to the US ban on any fiscal issue (M.A. Brown, 2002, S. Corbridge and A. Hudson 1996, C. Chavagneux, 1996). Paradoxically, what has been deemed at the time as totally unrealistic may realised naturally by market forces. Of course a future currency exchange will not be placed under the authority of the UN. There will be several private currency exchanges as there are a few stock exchanges in the US or in the EU. But at least there will probably be currency exchanges in the coming future.

On an economic theory point of view, there is no decisive argument in favour or against the efficiency of such a foreign currency exchange (see J. Frenkel, 1996, p 66). In these circumstances, empirical examples can help to figure out what could happen.

Government bond markets, which are also traditionally over-the-counter markets, have already experienced the same process. In Europe, the Italian government bond market (MTS), an inter-dealer quote-driven electronic market, provides an example of what could happen on the foreign exchange market. The introduction of the euro has highlighted the need to have facilities for cross-border trading in different government bonds of the Euro zone. New MTS were created forming a “galaxy” composed of several national markets (MTS Italy, MTS France, MTS Belgium, MTS Netherlands, and MTS Portugal) along a pan-European market, EuroMTS. Government bonds are traded both on national MTS markets and on the Euro-MTS. In the case of Italy, MTS Italy maintained its current trade volume and bid-ask spread while Euro-MTS increased its activity at the expense of transactions previously traded over-the-counter (CGFS, 2001, p 21). On the whole, the share of Italian government bonds traded centrally on an exchange increased clearly due to the electronic trading.

As far as foreign exchange markets are concerned, we are still not there, but the convergence towards currency exchanges could be similar. Probably, the centralisation process of the foreign exchange market due to the growing share of electronic platforms will slow down and the future exchange market will be divided in two segments: a traditional over-the-counter market driven by quotes for big corporations and a new centralised market maybe driven by orders for hedge funds and other speculators.

But even this partial evolution would be a major improvement for the CTT collection. Collecting the CTT would be as easy as paying the commercial fees for the use of these private electronic platforms.

A critical feature of these electronic platforms for taxing objectives is that they automatically capture all pre and post trade information, i.e. confirmation. Transparency and anonymity rules reflect the need of users of these systems and also the business interests of their owners. Non-disclosure of information can be an important element of the corporate strategy of an electronic platform. Information availability is decisive in the way a platform is designed and works. In principle, dealers have only access to the information related to their activity conducted on the platform. But system providers, however, have access to all information: The identity of dealers, the number and value of transactions they make. The CTT could be then collected automatically without changing anything to the way information is presently disclosed to participants. But legal provisions should establish that the audit trail would be at the disposal of fiscal authorities for regular checking. These legal provisions already exist for securities transactions on stock exchanges, where gains are submitted to taxation.

So, in principle, the natural evolution of foreign exchange markets toward more centralised and electronic markets could provide the basis for collecting the tax at the trading level. This is one of the inferences made by D. Rime (2003) about the policy implications of new electronic trading systems such as EBS and Reuter. "By regulating brokers
and requiring banks to use only regulated electronic brokers, the way could be opened for implementing trading halts, for example. Another possibility is to collect a transaction tax ("Tobin tax") through the electronic brokers". (op. cit., p 494, we underline).

Not only could we collect the tax, but there appears the technical possibility to implement automatically the surcharge conceived by P.B. Spahn, which works exactly as a trading halt. Another important feature is that "... several central banks have electronic brokers installed and use them for monitoring the market among other things" (op. cit., p 494).

Central banks that are destined to play a major role in collecting the tax could then have a direct link with the market and monitor banks activity. Electronic trading platforms establish operational performance reports that serve to control and monitor risk and performance. These reports contain quantifiable performance metrics at the level of details and summary. At FXall for instance, these reports contain a summary of a firm's volume done on FXall over any time period, a breakdown of request for quotes, sent, answered and dealt. Customers and banks have to maintain records of their past activity up to seven years in some countries. Electronic trading platforms can dot it efficiently. The full audit trail of every action taken by individual users is logged instantly and stored. Reports of every trade are available in html, pdf, csv formats, and the frequency can be real time or via scheduler with notification upon completion. Fiscal authorities can check quite easily and cheaply trading volume, the tax to be paid and the tax effectively paid.

In summary, recent technical progress since 2000 and the evolution of the institutional architecture of the forex market has created the technical possibility to collect the tax at the trading step.

But there remain some questions to be answered. The geographical location of these electronic platforms has to be considered if the CTT is created in the E.U. only. On the wholesale market, EBS and Reuter are British companies located in the UK, and subject to British law. If the tax was adopted by the EU, it could be theoretically possible to ask EBS and Reuter to declare any currency transaction traded on their platform to the fiscal authority. But if the E.U. was the only area to adopt the CTT, the danger is that EBS and Reuter headquarters could leave London to migrate to the USA where they have subsidiaries.

On the retail market, many of the electronic platforms are American and situated in the USA. There is the potential danger that customers and banks trade whatever currencies on these American electronic platforms in order to avoid a tax adopted in the EU. It is technically possible to trade from Europe with a remote access with electronic platforms and even stock exchanges abroad. In fact, it could give them an important competitive advantage. The increased of the US share in the global turnover from 15.7% to 19.2% (see Table 2-2 below) is in great part due to funds and commodity trading accounts using electronic platforms (56) in New York.

The answer to this potential problem is the following: Foreign exchange trading is considered as an "investment business". For instance, in the UK, the "Securities and Futures Authority" has ruled since 1996 that "advising, arranging, dealing or managing forex or other transactions" constitutes an "investment business" (57). This is important because it means that EBS, Reuter, FXall, Currenex and others are legally considered as "investment firms" and have to be registered in the UK or in any of the EU countries to have the right to sell services to British or other European customers.

This decision is in line with European directives. Electronic trading platforms are

<footnote>(56) See "New York takes a bigger slice of the currency pie". Financial Times October 28, 2004.</footnote>

<footnote>(57) See: "Board Notice 302, Guidance. Foreign Exchange and the Financial Services Act 1986". 1 February 1996, The Securities and Futures Authority, SFA, on its web site.</footnote>
ruled by the “Directive on Financial Instruments Markets”, (also known as the “Investment Services Directive”), and the “Electronic Commerce Directive”. Spot transactions on foreign markets are not explicitly covered by the first directive but options, futures, swaps, forward rates agreements, and any other derivatives contracts relating to currencies are listed in the list of financial instruments concerned <sup>(58)</sup>. With such a list of complex transactions, spot transactions could be added with no difficulties.

To have the right to sell services in the EU, electronic trading platforms must be reviewed by the appropriate authority of one EU member which gives the authorisation to conduct business in the relevant country. This authorisation is then extended (thanks to the “passport regime”) to other EU countries under the EU’s investment Services Directive which was first adopted in 1993 and updated in 2004 <sup>(59)</sup> to take full account of the impact of electronic trading platforms <sup>(60)</sup> on the structure of financial markets and market competition between exchanges and electronic platforms. For instance, FXall has been reviewed by the UK Securities and Futures Authority and has been authorised to operate in the UK and the rest of the E.U and even in non EU European countries members of the European Economic Area. In France, for instance, FXall <sup>(61)</sup> and Currenex are considered as branches of investment firms of the European Economic Area, whose head office is located in London, and operating as services providers in France. They are monitored for the part of their activity in France by a French regulator, the “Financial Market Authority”. If FXall and Currenex did not have the legal statute of “branches” in France, they would be monitored by the Financial Services Authority in London. FXall and Currenex have also to comply with applicable legal and regulatory requirements in each jurisdiction in which they operate, especially business codes.

The “electronic commerce directive” adds some new principles. “The directive defines the place of establishment as the place where an operator actually pursues an economic activity through a fixed establishment irrespective of where web-sites or servers are situated or where the operator may have a mail-box”. “Such definition will remove current legal uncertainty and ensure that operators cannot evade supervision, as they will be subject to supervision in the member state where they are established”. Services Providers are obliged “to make available to customers and competent authorities in an easily and accessible and permanent form basic information concerning their activities (name, address, e-mail address, trade register number, professional authorisation and membership of professional bodies where applicable, Value Added Tax number)” (we underline) <sup>(62)</sup>. Concerning the payment of the VAT, the principle held is that when the services are delivered through Internet by a firm located in a non EU country to a customer located in the EU, VAT must be paid by the customer.

With such legal provisions in place, European customers cannot use electronic platforms services if these are not registered and authorised in the EU whatever the geographical location of these platforms’ headquarters or trading web sites. Non EU firms have the choice to establish a branch in the EU or not. If they open a branch, i.e. a fixed establishment, they can benefit from the European passport. If they don’t, they have to be

<footnote><sup>(58)</sup> “Options, futures, swaps, forward rates agreements, and any other derivatives contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices, or financial measures which may be settled physically or in cash”. Annex 1, Section C of the Directive 2004/39/EC on Markets in Financial Instruments, Official Journal of the European Union, 30/04/2004.</footnote>

<footnote><sup>(59)</sup> See “Investment Services: final adoption of directive is boost for investment firms and their clients”, Brussels, 27th April 2004. http://europa.eu.int/rapid/pressReleaseActions.do?reference=IP04 The full text of the directive is available on the EU web site.</footnote>

<footnote><sup>(60)</sup> The EU uses the term “Multilateral Trading Facilities” (MTF).</footnote>

<footnote><sup>(61)</sup> It has also been approved by the Hong Kong Monetary for the same purpose in August 2001.</footnote>

<footnote><sup>(62)</sup> Quoted from “Electronic commerce: Commission welcomes final adoption of legal framework Directive” available on http://europa.eu.int/comm/internal_market/en/ecommerce/2k-442.htm.</footnote>
registered in each EU country where they want to sell services. Locating their web site outside the EU will not change anything. The obligation to provide basic information to competent authorities even if they trade only online and in particular their VAT number gives an indication of what could be done if the CTT was part of the law.

The conclusion is that if EBS and Reuter headquarters migrated to the US to avoid the tax, which is not that simple and would cost them a lot of money, their customers would not avoid the tax. EBS and Reuter, or any other electronic trading platforms would have to be registered in one or every EU country.

Banks' trading rooms in the EU that use their services could also be subject to the fiscal law creating the CTT. The new "Investment Services Directive" adopted in 2004 already includes in its article 25, (paragraph 3 and 5) an obligation of reporting transactions and maintaining records (paragraph 2) for the purpose of monitoring the activities of investment firms, "to ensure that they act honestly, fairly and professionally and in a manner that promotes the integrity of the market" (article 1). The same obligation could be extended with no difficulty to fiscal issues.

Investment firms must report details of their transactions "... to the competent authority as quickly as possible as and no later than the close of the following day" (paragraph 3). "The report shall, in particular, include details of the names and numbers of the instruments bought or sold, the quantity, the dates and times of execution and the transaction prices and means of identifying the investment firms concerned" (paragraph 4). The report can be made and transmitted also by a regulated market, an MTF <sup>(63)</sup>, or a trade matching or reporting system approved by the competent authority (paragraph 5). In a recent "draft commission document" <sup>(64)</sup>, the Commission requires that "reports should be made in an electronic form"; to "ensure the safety and confidentiality of the data reported", and for that purpose "each competent authority shall publish a list of identification codes of the regulated markets, multilateral trading facilities, and entities which act as their central counterparties, ... and those codes shall be used to identify a counterparty to the transaction which is a regulated market, multilateral trading facility or other central counterparty" (op cit p 4).

We can conclude that critical technical, institutional and legal requirements for the implementation of the CTT are already in place in the EU. Foreign exchange transactions could be taxed when traded with no major changes to the present legal provisions. If banks are obliged by law to declare their transactions when they trade, they could do it directly or via the electronic platforms they already use. This will be no more costly as it is now because it will be done automatically.

But if the tax was introduced in the E.U. only, can we imagine that banks and their customers would stop trading currencies in the EU and use existing dealing sites in the USA or in Asia to trade without paying the tax? It is a real problem but one that must not be exaggerated. Buying or selling currencies in a cost-efficient way depends on a whole set of conditions that not every city and country is able to satisfy.

The first one is that the geographical location depends on its location in the universal time. One often meets the idea that there would be a unique integrated world financial market because it is possible to trade 24h a day. This representation of the market is partly misleading. Foreign exchange trading is rhythmed by the activity of the three major financial places, Tokyo, London and New York, each one located on the three continents where world wealth is produced and concentrated (See figure 2-3 below).

<footnote><sup>(63)</sup> A Multilateral Trade Facility: official term used by the EU commission to designate electronic platforms.</footnote>

<footnote><sup>(64)</sup> "Draft commission Document on the methods and arrangements for reporting transactions in financial instruments, the contents of such reports, the exchange of information between competent authorities, and the determination of the most relevant market of a financial instrument in terms of liquidity". Option A, Cooperation and enforcement". Available on the European Commission's website.</footnote>
These three cities realised 58.8% of world foreign exchange transactions in 2004, against 25.9% for the following seven places that play a minor and declining role (31.6% in 1989, see table 2-2 below). Each of these cities is located in a different time zone. The foreign exchange market awakens with Asia, reaches its full activity when Europe comes in, and again with North America that ends the 24 hours.

<figure><img src="image_8.png" /><figcaption>Fig. 2-3 : The Circadian Rhythm of the FX Market</figcaption></figure>

Source: Reuters, cited in "The Foreign Exchange Market in the United States", Chapter 3, Federal Reserve Bank of New York, New York, 1999.

<table><caption>Table 2-2 : Market Share of the Main Countries, in % of the World Foreign Exchange Market</caption><thead><tr><th>COUNTRIES</th><th>1989</th><th>1992</th><th>1995</th><th>1998</th><th>2001</th><th>2004</th></tr></thead><tbody><tr><td>United Kingdom</td><td>25.6</td><td>27.0</td><td>29.5</td><td>32.5</td><td>31.1</td><td>31.3</td></tr><tr><td>United States</td><td>16.0</td><td>15.5</td><td>15.5</td><td>17.9</td><td>15.7</td><td>19.2</td></tr><tr><td>Japan</td><td>15.5</td><td>11.2</td><td>10.2</td><td>6.9</td><td>9.1</td><td>8.3</td></tr><tr><td><strong>SUB TOTAL</strong></td><td><strong>57.1</strong></td><td><strong>53.7</strong></td><td><strong>55.2</strong></td><td><strong>57.3</strong></td><td><strong>55.9</strong></td><td><strong>58.8</strong></td></tr><tr><td>Singapore</td><td>7.7</td><td>6.9</td><td>6.7</td><td>7.1</td><td>6.2</td><td>5.2</td></tr><tr><td>Germany</td><td>n.d.</td><td>5.1</td><td>4.8</td><td>4.8</td><td>5.4</td><td>4.9</td></tr><tr><td>Switzerland</td><td>7.8</td><td>6.1</td><td>5.5</td><td>4.2</td><td>4.4</td><td>3.3</td></tr><tr><td>Hong Kong</td><td>6.8</td><td>5.6</td><td>5.7</td><td>4.0</td><td>4.1</td><td>4.2</td></tr><tr><td>Australia</td><td>4.0</td><td>2.7</td><td>2.5</td><td>2.4</td><td>3.2</td><td>3.4</td></tr><tr><td>France</td><td>3.2</td><td>3.1</td><td>3.7</td><td>3.7</td><td>3.0</td><td>2.7</td></tr><tr><td>Canada</td><td>2.1</td><td>2.0</td><td>1.9</td><td>1.9</td><td>2.6</td><td>2.2</td></tr><tr><td><strong>TOTAL</strong></td><td><strong>88.7</strong></td><td><strong>85.2</strong></td><td><strong>86.0</strong></td><td><strong>85.4</strong></td><td><strong>84.8</strong></td><td><strong>84.7</strong></td></tr></tbody></table>

Source: own calculations from "Triennial Central Bank Survey", BIS 2001 and 2004.

Increasing investment in new technology is the second reason for the strong geographical concentration of the foreign exchange market. Foreign exchange transactions require sophisticated and secure computer and telecommunications infrastructures and highly qualified staff. These very costly elements need a high volume of transactions to be
profitable. Economies of scale are becoming, as in other industries, a strong incentive for mergers and acquisitions in the banking industry and also in electronic trading companies.

Intangible external economies are the third reason for the geographical concentration. In every professional community, one needs to know what is not explicitly written somewhere, but rather hears through the grapevine. Banks also need an adequate environment. A set of law and financial professions at hand, efficient transport commuting, and for their very well-paid staff, residential areas, shopping malls, leisure facilities, and good private schools for their children.

These advantages are only encountered in big cities where the world major financial centres are located (New York, London, Frankfurt, Paris, Zurich, Hong Kong, Singapore, etc.) <sup>(65)</sup>. This is what economic theory calls a “natural monopoly”. In this respect, London enjoys a specific advantage. It has, most importantly, a number of overlapping hours with Asia and North America. Added to its historical heritage as an imperial metropolis, London, which is one of the most costly cities in the world, realised nearly a third of the world foreign exchange market. So, it would be more difficult than it looks, and probably not so profitable, to delocalise trading rooms in tax havens lost in the middle of the Pacific Ocean. If it was not the case, why are trading rooms not yet there?

For the same reasons, it would not be so simple to stop trading in London and in the E.U. in favour of New York, Tokyo or Singapore just because of a tax on currency transactions. It is theoretically possible to imagine that all transactions on European currencies could be made in New York or in Asia, but it would be difficult in practice. European customers, in particular productive and commercial firms, pension and mutual funds, want a close relationship with their bank to ask for advice and services. They don't only need quotes. Furthermore, they would have to work in Asian and American time if they had to trade with traders from American and Asian banks, and it is not realistic in the long term. In summary, technical progress has turned trading capture into a viable option for collecting the CTT.

### 2.2.3 Step 3: Confirmation

Transaction confirmation is important because it is the legal evidence that a transaction has been dealt. It includes all the relevant data that will allow the two counterparties to agree on the terms of the transaction. It also includes the settlement instructions. Confirmation is prepared by back office staff who are independent of the traders in the front office.

Confirmation is not difficult for traditional transactions such as spot, usual forward transactions and usual currency swaps, and even foreign currency options. These standard transactions can be easily automated. Their confirmation relies on electronic validation and confirmation messaging provided either by the electronic trading platform itself or by message carriers like SWIFT <sup>(66)</sup>. These systems eliminate the operational expense of processing confirmations manually and eliminate trade errors, given that trade information is entered just once rather than re-keyed multiple times throughout the trade and settlement process. Reports are then available in html, pdf and csv formats and the frequency can be real time or via schedulers with notifications upon completion. The type of customer reports can include daily activity, audit trail and liquidity provider. In this case, fiscal authorities can be informed in real time about any transactions made by a bank, or can check at random any bank without significant costs.

<footnote><sup>(65)</sup> Anecdotes sometimes reveal a lot. In an advertisement published in a reputed financial newspaper to attract more traders, Singapore announced that it had allowed clubs and discothèques to stay open later at night.</footnote>

<footnote><sup>(66)</sup> SWIFT provides an electronic confirmation matching services called SWIFT Accord.</footnote>
The problem is that electronic confirmation matching services cannot handle the non standard OTC derivatives <sup>(67)</sup> such as “non-deliverable forwards” (NDF) and some “exotic” currency option transactions, and that not every customer on the retail market has access to these services.

The combination of these two facts explains why OTC derivatives are privately negotiated transactions, usually traded and confirmed by telephone. In this case, conversations between traders are invariably recorded at the trading capture. Some firms also record back office conversations when confirmations are made by telephone.

The Foreign Exchange Committee of the FED (2004) recommends that “... following the telephone confirmation, both parties should record the date, time, telephone line, and the name of the individual with whom the trade was confirmed. In addition to the telephone confirmation, both parties should exchange and match a formal confirmation (mail, SWIFT, or other electronic) or a call back procedure should follow” (p 24). So, in any case, trading and confirming by telephone produces a paper or an electronic trail that could be used for taxation issues.

This trail contains all the necessary information because counterparties use master agreements issued by the Foreign Exchange Committee of the Federal Reserve Bank of New York, the Emerging Market Traders Association (EMTA), or the International Swaps and Derivatives Association (ISDA) among others. These master agreements list the economic terms of the transaction and many legal terms of the trade. “Data included in the confirmation should contain the following: the counterparty to the FX transaction; the office through which they are acting; the broker (if applicable); the transaction date; the value date; the amounts of the currencies being bought and sold; the buying and selling parties; and settlement instructions” (Foreign Exchange Committee, 2004, p 22).

According to the CPSS (1998), tapes of the recorded transactions are typically kept for six months, although some dealers keep them for a year, long enough to ensure that they are available on the first settlement for most transactions. The EU new legal legislation is increasing the record keeping requirements. The Directive on “Markets in financial Instruments” <sup>(68)</sup> requires in its article 13(6) that “an investment firm shall arrange for records to be kept of all services and transactions undertaken by it which shall be sufficient to enable the competent authority to monitor compliance with the requirements under this directive...”. According to the Lamfalussy Process, the Commission may adopt the implementing measures, so-called “Level 2 measures” with respect to a large number of provisions of the Directive. For this prospect, it has sought the technical advice of the European Securities Regulators (CESR) on these measures.

On 3 March 2005, the Committee of European Securities Regulators (CESR) issued a consultation paper on Level 2 implementing measures with respect to the Markets in Financial Instruments Directive (MiFiD), which concerns foreign exchange transactions and in particular foreign exchange derivatives.

It proposes that investment firms maintain records “in a manner conducive to demonstrating compliance with the requirements under the directive” (CESR, 2005). Records of telephone orders must be kept on a voice recording system for a period of at least one year. Detailed records must be sufficient to enable supervisors to reconstruct the processing of each transaction during their five-year-retention period” (we underline). They need to be retained in a durable medium”, so they can be reproduced at any time on paper.

<footnote><sup>(67)</sup> Remember that a derivative transaction is a financial contract whose value depends on the values of one or more underlying reference assets, rates or indices. Derivatives are also called “structured” or “non standard transactions”.</footnote>

<footnote><sup>(68)</sup> the directive on Markets in Financial Instruments (Directive 2004/39/EC – “MiFiD”) was adopted by the European Parliament and Council on 21 April 2004 (OJ L145/1 of 30 April 2004). The Directive will replace the Investment Services Directive 93/22/EEC.</footnote>
per. Records of the telephone conversations for the giving and/or receiving of orders have to be retained for at least one year. "Tapes, however, are not defined as a "durable medium", so any tape recordings could need to be transcribed into a "durable medium" at some points, with adequate measure to ensure no tampering during transcription" (FSA, 2005). The "durable medium" can be paper, optical, magnetic media, or other computer-based format.

In summary, every standard and non standard transaction can be monitored at the confirmation level. Even when trade is operated by telephone, the necessary data is already available in an electronic form for any control that fiscal authorities would like to do. So, there are no foreign exchange transactions that could avoid the tax. If OTC foreign exchange derivatives are not taxed when they are traded on telephone, they can be taxed when they are confirmed.

### 2.2.4 Step 4. Netting

As we have seen, netting (or clearing) is an agreed offsetting of transactions between trading partners in order to reduce a large number of individual transactions into a smaller net amount to be settled. Netting is important because it reduces settlement risks and operational costs. Clearing applies to all financial transactions: on retail markets as well as on wholesale markets, on the money market and foreign exchange markets, on bond and stock markets, on decentralised markets or on stock exchanges. Retail transactions are very numerous but their average value is small. They are called mass transactions. Wholesale transactions present the opposite features. They are not as numerous, but their average value is very high.

On the foreign exchange market, netting is realised by a clearing institution that is in general a bank for spot, forward, swaps transactions and OTC options, or an exchange for the small part of exchange-traded derivatives. Clearing institutions can restrict their activities to pure netting, but some of them are also settlement agents. One important recommendation of central banks to private banks is that all transactions, even those that will be netted, should be confirmed individually. If not, trades may be mistakenly added or removed from the net agreement, which will be difficult to detect on settlement day. This is important because it means that even netted transactions can be traced individually in order to find the origin of a potential error. For taxing issues it means that all transactions can be taxed even if they are subsequently netted.

There are two important categories of netting: bilateral and multilateral netting. Bilateral netting concerns multinational firms, investors and interbank transactions. Multinational companies make lots of internal foreign exchange transactions between their subsidiaries. Bilateral netting reduces the number of internal transactions and thus reduces operational costs and risks attached to them. Multinational banks sell bilateral netting services to the multinational companies thanks to their implantation on all continents and their links to national payment services. For instance, Citibank® Netting Services enables subsidiaries to settle their financial obligations with each other on a "net" basis, rather than transaction-by-transaction. It reduces inter-company payment transaction volumes, and automates the settlement process resulting from netting. Unfortunately, there is no estimation of the reduction of internal transactions due to this kind of netting.

Interbank bilateral netting has been common practice for more than ten years. In a 1997 survey, the BIS (1998) had found that 77% of banks already engaged in bilateral netting. "Across all currencies, 29% of the gross settlement flows in the 1997 survey were subject to bilateral netting, up from 24% in the 1996 survey. Overall, bilateral netting reduced total settlement flows by 15% in 1997 up from 13% in 1996". That is not much but is already significant. When we only take into account the 29% of settlement flows to which
bilateral netting is applied, the power of reduction of bilateral netting is impressive. In 1997, settlement flows are reduced by half.

We can reasonably hypothesise that since 1997, the percentage of settlement flows subject to bilateral netting must have increased thanks to technical progress. It has also increased because of mergers and acquisition in the banking industry. In Switzerland for instance, two large banks, prior to their merger, had similar types of businesses and nearly the same daily turnover in the national settlement system. After the merger and the consolidation of their two accounts in the national settlement system, the turnover of the new institution was roughly the same size as that of one of the pre-merger banks. The total volume and value of payment processed in the settlement system decreased by around 25% (BIS 2000). This reflects the potential for clearing offered by banking concentration, where interbank transactions become intrabank transactions which do not involve external exchanges of payment messages and tend to be cheaper to process. This evolution means that collecting the tax at the settlement step only captures a decreasing part of transactions.

Multilateral netting is more recent. In 1997, only 23% of the banks surveyed by the BIS engaged in multilateral netting, reducing transactions by less than 1%. More importantly, settlement flows were reduced by 71%. But the two multi-currency netting banks that existed at that time, Echo and Multinet, never succeeded in attracting a significant market share. The banking industry did not wish to invest in several different initiatives to reduce settlement risk and preferred to concentrate their effort on one project, the CLS bank, which was launched five years later. But the demonstration had been made that there was a dramatic potential to reduce the volume of transactions.

Norway gives an illustrative example of the reduction of flows due to netting in modern payment systems. The daily value of transactions on the retail and wholesale market for every transaction operated by banks is reduced from an average of NOK 66 billions before clearing, to NOK 8.6 billions to be settled, i.e. a reduction of 87%. "This netting effect means that banks on average, only require liquidity equivalent to 13% of the value of total payments in the clearing in order to cover their payments". (Norges Bank, 2004, p40).

Today, electronic trading platforms have developed multilateral netting facilities, or offer a direct electronic access to private and public clearing institutions that on their side have improved their performance. For instance FXall, Currenex and their competitors provide direct access to clearing and settlement banks. FXall allows the customer to choose between gross settlement, bilateral netting and CLS. Netting between counterparties is calculated automatically by a module integrated into the trading software. Only confirmed trades can be netted before settlement.

Forex transactions that have not been cleared internally or bilaterally (around 80%) are sent to clearing houses or other interbank clearing institutions specialised in cash transactions. Traditionally, there used to be a clear division of labour between clearing and settlement. LVTS in Canada, CHIPS <sup>(69)</sup> in the USA, and Paris Net Settlement in France are examples of multilateral domestic clearing institutions that combine all trade between their customers to calculate a single net payment, several times a day or once at the end of the day. In the European Economic Area (EEA) <sup>(70)</sup>, Euro1 provides multilateral netting for cross-border transactions in euros. But now, clearing is even more integrated to settlement. On the forex market, the Continuous Link Settlement Bank (hereafter CLS), provides multilateral netting in each pair of currencies and then proceeds to the settlement <sup>(71)</sup>.

<footnote><sup>69)</sup> Clearing House Interbank Payments System.</footnote>

<footnote><sup>70)</sup> The European Economic Area is constituted by the EU member states plus Iceland, Liechtenstein and Norway.</footnote>

<footnote><sup>71)</sup> CLS will be analysed in details below in the settlement section.</footnote>
#### 2.2.4.1 The role of Euro 1

In Europe, “Euro 1” is the most important private cross-border clearing institution specialised in large value euro transactions. It was founded in 1998 by the “Euro Banking Association”, a cooperative association between EU-based commercial banks and EU branches of non-EU banks, created in 1985 by 18 commercial banks and the European Investment Bank with the support of the European Commission. The “Euro Banking Association” is an umbrella organisation intended to be a forum for exploring and debating issues related to euro payments. It has set up the EBA Clearing Company which operates the “Euro 1” system. They are located in Paris and operate under French law. Euro 1 is an equivalent to CHIPS in the USA in the sense that it supports the creation of a “single payment area” allowing euros to circulate between member states at low cost, in a similar way as the dollar between the states of the USA. With around 180 000 transactions per day in March 2005 with a daily value of €172 billion, Euro 1 has become the most important private clearing institution in the euro area. In 2002, it accounted for around 32% of the total value of foreign exchange trade in euros (ECB, 2003).

To achieve its mission, Euro 1 must rely on detailed information about the transactions it must process, which is provided by a message carrier, in this case, SWIFT. Payment messages sent by participants for the purpose of being processed by Euro 1 must carry the tag "EBA" in field 103 of the message header. Messages with this tag are partially copied to the clearing computer via SWIFT’s “FIN-Copy” service, a dedicated software program (see Figure 2-4).

<figure><img src="image_9.png" /><figcaption>Fig. 2-4 : Message routing and real-time processing</figcaption></figure>

Source: EBA website, http://www.abe.org/

Payment messages are processed on an individual basis. Processing consists of checking the sending and receiving participants’ positions and, if possible, adjusting their position. Should the adjustment lead to a breach of the sending participant’s debit cap or
the receiving participant's credit cap, the payment message will not be processed, but instead put into an on-hold queue.

Upon processing of a payment message, the clearing computer generates a release message to the FIN-Copy service, and the original payment message is forwarded to the receiving participant. The system revisits a participant's on-hold queue each time a payment message in relation to that bank is processed to check whether the adjusted position allows for further processing of payment messages that are held in the participant's on-hold queue.

Euro 1 settles at the end of the day in central bank money at the European Central Bank. After the cut-off time (4 p.m. Central Eastern Time, CET), banks with debit positions will pay their single obligation into the EBA settlement account at the European Central Bank (ECB) through TARGET. After all amounts due have been received, and upon instruction from the EBA Clearing Company, the ECB will pay the banks with credit positions, also through TARGET.

This procedure means that only net debit positions are settled through TARGET on the accounts of the ECB. In other terms, it is not the individual transactions that are settled one by one through TARGET during the day, but only their net amount at the end of the day.

This is not without consequence for tax issues. If the tax is levied only at the point of settlement on the accounts of the ECB, only the net amount will be taxed, which can be much less than the gross amount due to the power of reduction of the clearing process.

One solution is to levy the tax when the transactions are routed individually to Euro 1 by SWIFT. It is indeed possible, because each transaction is tagged to signal SWIFT that the transaction is destined for Euro 1. In fact SWIFT messages include various information: the identity of the sending and receiving banks, the nature of the transaction (for instance a forex transaction), the currency, the exchange rate and of course the amount of the transaction. It could then include easily another field to be filled about the fiscal status of transaction, i.e. whether the CTT has been paid or not.

Suppose that a US bank sends a SWIFT message to its correspondent bank in the euro area, for instance Crédit Lyonnais, to order a credit transfer in euros to Deutsche Bank. If Crédit Lyonnais uses Euro 1 to process the order, it is therefore possible that SWIFT Fin Copy sends a copy of the message to Euro 1 for clearing issues and one to the Banque de France for taxing issues.

### 2.2.4.2 The launch of CLS

Today, multilateral netting facilities on the foreign exchange market like Echo and Multinet have been replaced by a major innovation launched on 9 September 2002: the Continuous Link Settlement Bank (CLS Bank). The CLS Bank is a global clearing and settlement system for settling both sides of forex deals simultaneously in order to eliminate the forex settlement risk.

The settlement risk is precisely defined as the risk that one party to a forex transaction will pay the currency it sold but not receive the currency it bought. This is due to the fact that the two legs of the transactions are settled in two different countries that are often located in two different time zones. For this reason they cannot usually be synchronised because one of the two national payment systems is closed.

Suppose that Crédit Lyonnais in France buys dollars and sells euros to Citibank in the US. The two traders will trade through EBS trading platform for instance that relies on SWIFT for the routing of message orders (see Figure 2-5 on the following page). Although the media makes a lot of fuss about the globalisation of finance and hot money that travels all around the world, the interesting point is that SWIFT messages are the only elements
that will travel across the ocean. Euros will stay in France and the US dollars will stay in the USA. Crédit Lyonnais will transfer euros via the French payment system on the account of a bank which acts has the correspondent in France of Citibank. This correspondent bank, also located in France for simplification's sake, will receive the funds in lieu of Citibank and will then credit a loro account. A loro account is the term used by a correspondent to describe an account held on behalf of a foreign bank (in the example Citibank). Citibank will regard this account as its nostro account. Crédit Lyonnais has a nostro account in its US correspondent which will be credited by the amount of dollars transferred by Citibank.

<figure><img src="image_10.png" /><figcaption>Fig. 2-5 : Settlement of a Forex Transaction Via Correspondent Banks</figcaption></figure>

This very old system is cost efficient because banks don't have to open branches or subsidiaries in every country where they would be submitted to the national legislation. It is also very safe because transfers of funds are totally dematerialised. But it has also some shortcomings such as the exposure to settlement risk.

Although the operating hours of the euro and the US dollar payment systems now overlap, the payment of the two currencies are normally not made simultaneously. US dollar large-value payments are often made towards the end of the business day in the United States, 10 to 15 hours after the payment from Crédit Lyonnais has been finally settled in France. The unsynchronised settlement of the two payments exposed Crédit Lyonnais to the risk that Citibank will not make the US dollar payment as agreed.

The exposure to settlement risk was in fact much longer than the mere difference of tie zone and extended to several days because of the processing time at all level of both settlement circuits, including the internal processing procedures of Crédit Lyonnais and
Citibank, those of their respective correspondent banks for the two currencies and the op-
erating rules of the interbank systems used to transmit the payment instructions.

The CLS project was initiated by a group of major foreign exchange participants, known as the G20 banks, to address this problem of forex settlement risks. Central banks have supported the development of CLS and by November 2002, 67 major financial institutions located in 17 countries had joined the system and had become CLS shareholders (72). Some 22 banks, i.e. one third of the shareholders, are located in the euro area. CLS was granted a specific banking licence in 1999 in New York, limiting its field of activity. CLS is a single-purpose private bank whose sole activity is to engage in forex settlement activities. CLS is a settlement agent that does not at any point become a counterparty of the participants.

To reduce settlement risk, the CLS system combines two major advantages. First, trades are settled on a Payment versus Payment basis (PVP system). The settlement of one side of the transaction occurs if – and only if – the other side of the transaction is also settled. The debiting of one currency ad the crediting of the other currency occurs simultaneously. The second advantage is that CLS members pay their final position on a net basis, which reduces dramatically the amounts they have to pay, and the risks attached to them.

To combine these two advantages, the CLS system establishes a clear distinction between trade settlements, realised on a gross basis on the books of CLS bank according to the PVP principle, and the funding of the resulting positions of each members, that is the final transfer (payment) of currencies between members and CLS Bank, realised on a net basis on the accounts of open by CLS Bank on the books of the relevant central banks. This distinction can be better understood with a full description of the CLS daily timeline (See figure 2-6 below and comments extracted from M. Bronner, 2002).

<figure><img src="image_11.png" /><figcaption>Fig. 2-6 : CLS Settlement Process Timeline</figcaption></figure>

Source: CLS Group

CLS members can submit settlement instructions to CLS Bank or cancel them by mutual agreement before 6:30 Central Eastern Time (CET) on the settlement day. "At

<footnote n="72">72) To be entitled to open an account at CLS, commercial banks must become CLS shareholders. Shareholders are settlement members, and as such can submit instructions for the settlement of forex trades directly to CLS.</footnote>
6:30, the system calculates the theoretical multilateral net positions in each currency that would result on the participants' account with CLS bank after execution of all of the foreign exchange transactions submitted for settlement on that day. Participants have to make pay-ins (73) for currencies in which their theoretical multilateral position is negative. For that purpose, CLS Bank sends each participant its pay-in schedule for the day. The pay-in deadlines are 8:00, 9:00 and 10:00 for Asian Pacific currencies and 8:00, 9:00 and 10:00, 11:00 and 12:00 for the other eligible currencies".

The start of the settlement process occurs at 7:00 and, under normal circumstances, transactions are settled and pay-outs are completed by 12:00. All transactions must be settled across the participants' multi-currency accounts by 9:00 and the rest of the time is used to complete pay-ins and pay-outs."

Pay-ins and pay-outs are made in central bank money in each currency via a Real-Time Gross Settlement (RTGS) payment system. "The operating hours of the CLS system correspond to the overlapping operating hours of the RTGS systems used to make pay-ins and pay-outs. The earlier cut-off time for Asian Pacific currencies handled by the CLS system corresponds to the close of markets in that area." In the EU, for the funding of euro positions, CLS Bank has opened an account with the ECB Payment Mechanism, the ECB component of TARGET, the RTGS managed by the ECB for EU payments.

The importance of CLS for the settlement of large-value euro transactions should not be underestimated nor overestimated. The ECB has analysed the probable medium-term impact of CLS on the number and value of payments settled in individual large-value payment system operating in euro (ECB, 2003). Before the start of CLS, TARGET was estimated to account for 62% of the total value of forex trades in euro, compared with 32% for EURO 1. The remaining 6% were settled via smaller euro large-value payment systems.

The settlement members of CLS have indicated that the value of forex trades involving the euro that they intend to settle through CLS would amount to 55% of the total value of the forex market in euro. If one assumes that the settlement of forex trades would be transferred in equal measure from TARGET and EURO 1 to CLS, the value of payments settled in TARGET would shrink by a maximum of 12% and in EURO 1 by 37%. This significant impact could increase in the future because the number of CLS members and third party users is bound to grow, bringing in more trades.

But there are also limits to the expansion of CLS and the question remains about its possibility to become a business standard. This in turn has implication for the CTT case. The first limit of CLS is that it does not cover an exhaustive number of currencies, but only the most important ones. If it is not a problem for the introduction of the CTT inside the EU per se, it means that for the present moment, CLS cannot be used to collect the tax for the majority of developing countries.

The second point is that even for the major currencies, CLS market share is still limited. In 2005, less than half of total forex settlement took place in CLS (D. Sawyer, 2004). This means that some important banks and non bank financial corporations have chosen to settle outside CLS, particularly in the UK.

At the start, 7 major currencies were eligible to be settled in CLS, namely the US dollar, the euro, the Japanese yen, the pound sterling, the Swiss franc, the Australian dollar and the Canadian dollar that accounted for around 80% of the total interbank foreign exchange market. In September 2003, the number of eligible currencies was increased to eleven with the Danish and Norwegian krone, Swedish krona, as well as the Singapore dollar. At the end of 2004, the South African rand, the Hong Kong dollar, the Korean won

<footnote n="73">73) The transaction to pay off a negative position is called a pay-in. The transaction to pay off a positive position is called a pay-out.</footnote>
and the New Zealand dollar have been added increasing the number of eligible currencies to 15. The inclusion of additional currencies such as the Mexican peso, Chilean peso, Israeli shekel and Turkish lira is being reviewed. But there are fixed costs to CLS and to its settlement members attached to the introduction of new currencies that may weaken the business case for adding them, not to say strict legal and technical criteria. Extending the currency coverage may not be an endlessly on-going process.

The present 15 currencies account for around 95% of total turnover in the global
forex market according to the BIS Triennial survey. Despite this progress, in April 2004,
CLS market share for all kind of transactions related to the 15 eligible currencies is approx-
amately 40%, and over 60% for the sole inter-bank transactions. The importance of CLS
market share for each currency varies greatly (See figure 2-7).

<figure><img src="image_12.png" /><figcaption>Fig. 2-7 : CLS Value Against the BIS Survey by Currency</figcaption></figure>

Source: CLS Brief Issue June 9 2005.

CLS settles between 50% and 70% of the transactions in Swiss franc, Danish and Norwegian krone, and New Zealand and Singaporean dollars. But CLS settles only a minor share of major currencies: around 40% of the transactions in US dollars and euros, and 30% of the transactions in pounds sterling or Japanese Yen. It is not possible to rely on CLS as the major place to collect the tax.

Furthermore, some important banks and non banks still do not settle inside CLS.
Participation in the CLS system can take two main forms, as a member or as a third-party
user. A settlement member's foreign exchange transactions are settled directly across its
accounts at CLS bank, while those of a third-party user (which has no direct relationship
with CLS Bank) are settled by a settlement member on its behalf.

In December 2004, 296 institutions were settling through CLS Bank. Of these, 58 commercial or investment banks are CLS Bank Members, and an additional 238 banks, brokers, funds and corporates are using CLS Bank services as Member customers (“third parties”). Around 80% of the third-parties are also banks. This means that the most important gap in CLS coverage is in the area of non-bank financial and non-financial corporations. Only about 30 non-bank financial institutions were participating in CLS at the end of 2004, meaning that very few hedge funds and other investment funds were using CLS user members.
If we compare this information with the BIS Triennial Survey results, this means that the great part of transactions settled through CLS are interbank transactions, but that the growing share of foreign exchange trading between banks and their financial customers is not captured by CLS. The cost of using CLS may offset the elimination of settlement risk for many of these funds that have a risk appetite. For non-financial corporations, joining CLS as a third-party user is beneficial only if these corporations have a high volume of foreign exchange transactions. The conclusion is that the CTT cannot ignore CLS but must not focalise on it as the only channel to levy the CTT.

### 2.2.4.3 How to collect the tax at CLS?

From a tax point of view, it is very important to make a clear distinction between the settlement process realised on a gross basis and the funding process realised on a net basis. As explained above, the settlement process identifies each transaction individually to apply the PVP principle. But the actual payment is done in real time, through the national payment system of the relevant currency, after a multilateral netting process, in order to reduce as much as possible banks' liquidity needs.

The multilateral netting process, which reduces actual payments to a fraction of their gross amounts, is very powerful and increases with the number of participants and the transactions they make. "For example, if bank A sells USD 100 to bank B against euro and buys USD 100 from bank C against Japanese yen, its US dollar position is squared and it does not have to make any US dollar payments. For this reason the value of payments that banks need to make to settle their FX transactions is substantially lower in CLS than in traditional settlement mechanisms" (ECB Monthly Bulletin, January 2003).

According to Risk Magazine, (2003) CLS netting reduces gross payments amounts by around 85%, and the use of in-out-swaps (74) by a further 10%. "At a recent peak after the US Thanksgiving holiday, the system handled around 74,000 trades with a gross payment value of around $800 billion. The final net payment amount was under 3% of the gross payment total" (Risk Magazine, 2003) (75).

The lesson is clear: the tax cannot be collected when transactions are paid through the national payment system of the relevant central bank, because more than 90% of the gross amount would not be taxed. The tax must be collected at the settlement stage through the inner CLS system, when each leg of a transaction is matched on a PVP basis. This means that each transaction settled through CLS has to be identified individually at the early stage. This is of course technically possible, because the identification of each transaction is at the root of the CLS system.

In this perspective there are in fact several possibilities to collect the tax. The first is the most obvious. CLS must identify each transaction on a gross basis, for each currency and for each settlement member, in order to match them and to calculate how much each settlement member owes to the other ones. For this purpose, each settlement member holds a multi-currency account at CLS Bank, with a sub-account for each currency approved to be settled through the system. So there cannot be any technical difficulty to tax

<footnote n="74">74) Banks balance their CLS liquidity in a certain currency to meet payment commitments by the use of a same-day zero-price currency swap, where one leg of the swap takes place inside CLS bank, and the other outside. For further details on in-out-swaps and the problem they pose see ECB Monthly Bulletin, January 2003, p 60-61, in particular Box 2.</footnote>

<footnote n="75">75) CLS ran simulations in 2001 on the forecasts provided by 51 future participants. These showed that the average amount of pay-ins in each currency was between 8% and 18% of the gross amount of transactions in the same currency. According to F. Diehl, from central treasury department of BNP Paribas, in November 2003, the daily net amount to be paid (total pay-ins) was around USD 40 billion for a gross amount of USD 400 billion. In and out swaps reduced further the net amount by 70%. Only USD 12 billion had finally to be paid. The overall reduction from the gross to the net amount was thus 97%.</footnote>
transactions each time the euro is involved, or to tax all transactions if the CTT is adopted by all countries whose currency is settled through CLS.

The same is true for CLS user members and third party services. User members have to be CLS shareholders and can submit instructions directly to CLS. However, they do not maintain accounts with CLS and therefore have to settle their transactions via a settlement member. Both settlement members and user members can provide CLS settlement third party services to other banks or corporate customers that are not participants in the CLS system. Again, their transactions must be settled via a CLS settlement member. So in the end, all kind of transactions can be perfectly identified and controlled through the accounts of the settlement members and the CTT can be collected without difficulties and extra costs.

Concerning the legal aspects they are solutions to the potential difficulties. Officially, CLS service is provided by CLS Bank International, a US-incorporated special-purpose bank, with a sister operations company (CLS Services Ltd) in the United Kingdom. Its parent company (CLS Group Holdings AG, incorporated in Switzerland) is currently owned by 69 of the world's largest financial institutions, mainly commercial banks. The Federal Reserve of New York is the lead overseer that coordinates oversight of the CLS system. But it works in conjunction with the other G10 central banks and other central banks whose currencies are or soon will be eligible for CLS. For instance, the Governing Council of the European Central Bank approved the inclusion of the euro in the CLS system on 10 July 2002. The ECB is the overseer in respect to the settlement of the euro, and each central bank of the EU has the right to monitor the transactions that involve the euro and are settled by banks which act as settlement members of CLS on its territory (CPPS, 2003, p 80).

Central banks play an operational role in CLS. They provide accounts and in most cases, settlement services for CLS. CLS can only work if central bank settlement systems can be used for the payment of pay-ins and pay-outs of each settlement member. The ECB has strengthened its contingency arrangements for TARGET to care of possible operational failure scenarios. Any disruptions in the executing of pay-ins and pay-outs can lead to the rejection of transactions in the currency involved and in other currencies.

In the EU, decisions and recommendations were taken in coordination with the European banking industry to facilitate the euro pay-ins and euro pay-outs via the TARGET system. In France, for instance, a special high-priority transfer for executing pay-ins was created in TBF, the French component of TARGET.

All this means that without the active collaboration of the relevant central banks, CLS cannot work at all. If the CTT was part of the EU law, the ECB would have to verify that the tax has been paid on all transactions involving the euro, and it could do so as part of its oversight duty. In the event of a conflict, it could deny the use of TARGET for the funding of pay-ins and pay-outs in central bank money. This would have a major impact on CLS because the euro is the second most settled currency in CLS, with a settlement value of 25% of all forex trades in November 2002. The share of the British pound is 11%, and the Swiss franc, 3%. The US dollar has a leading role with a share of 47% (ECB, 2003). Because of large investments made, CLS needs volume to be profitable and could not survive if the euro, and all EU currencies, which must total around 40% of CLS activity, left CLS.

The second possibility is to use SWIFT. The involvement of SWIFT in CLS is related to the provision of the network infrastructure. SWIFT provides a communication service called SWIFTNet InterAct, which supports the exchange of request and response messages between two CLS members and allows them to browse remote data sources and to communicate with CLS. SWIFT has also a "CLS Third Party Service". After a third
party and a counterparty have struck a deal, the third party will choose to settle through a CLS member. The standard SWIFT service consists in delivering copies (76) of foreign exchange confirmation (Message Type 300) sent by third parties to their chosen CLS member (See figure 2-8).

<figure><img src="image_13.png" /><figcaption>Fig. 2-8 : SWIFT "CLS Third Party Service"</figcaption></figure>

Source: "SWIFT CLS Third Party Service", available on SWIFT website, www.swift.com

The enhanced service provides the matching status to CLS members of their third parties' MT 300. If third parties subscribe also to SWIFT Accord™, they will be able to view the matching status of their confirmations that are to be settled by the CLS Bank. Again, if SWIFT Copy is able to send a copy to a CLS member, it should also be able to send a copy to the relevant central bank for taxing issues.

The third possibility is to rely again on electronic trading platforms such as Reuters, EBS for interbank transactions and FXAll or Currenex for bank-to-customer transactions. These electronic platforms have developed full integration of their software with CLS's in order to achieve full straight-through-processing from trade to settlement. It is thus possible to assess the flow of transactions traded on these platforms that are settled through CLS.

For interbank transactions, there is the example of Reuters' "Dealing Matching" a software module integrated to Reuters trading platform "Dealing 3000". It allows matching and settling trades electronically directly through CLS or any other settlement institutions like the Hong Kong Monetary Authority (HKMA). The basic principle is to define a "settlement group". A "settlement group" includes all counterparties that have pre-agreed on Standard Settlement Instructions (SSI) before trading. The "settlement group" is a thus a central data store that each bank regularly actualises. Figure 2-9, taken from REUTERS, illustrates the example of a bank A that has struck a deal in euro with a counterparty

<footnote n="76">76) The copies are sent by FIN Copy™, a mechanism specifically designed to transmit messages for the clearing, netting and settlement of payments.</footnote>
"KSAGBANK".

Bank A has displayed the "Payment/Standing Instructions" dialogue box, then has chosen the "Settlement Groups" tab, and selected "CLS" from the "Settlement Group" drop-down list. "KSAGBANK" is selected from the subscriber list, and then the appropriate payment instruction which is automatically translated in a SWIFT' format message type. KSAGBANK will follow the same procedure vis-à-vis Bank A.

<figure><img src="image_14.png" /><figcaption>Fig. 2-9 : Bank a Has Struck a Deal With a Counterparty ,,KSAGBANK“</figcaption></figure>

Source: REUTERS Dealing 3000 Matching.

This functionality applies to spot and also forward transactions for all CLS currencies. This shows that due to the importance of Reuters and EBS (who offers the same kind of service) it is possible to have a reasonable idea of the gross volume of transactions settled in CLS. If it was not possible for EU fiscal authorities to have direct access to CLS data, this alternative source of information could be used. This example illustrates again the importance of SWIFT as a conveyor of critical data throughout the different steps of the forex process flow.

In the case of bank-to-customer transactions, we observe the same characteristics. FXAll allows its customer to choose between gross settlement, bilateral netting and CLS (See Figure 2-10). For CLS participants, FXAll provides seamless messaging by sending third-party notifications for all customers. FXAll supports the CLS Custody Mapping (the "C"- trigger) and adds settlement instructions to the confirmation and notification messages. Matching is available on the settlement instructions as well as the economic details.
<figure><img src="image_15.png" /><figcaption>Fig. 2-10 : FXall Settlement Methods</figcaption></figure>

Source: "A guide to achieving best practice in foreign exchange through automation". FXAll, 2004. www.fx-all.com

All these case studies show that there are several possibilities that can be mobilised alternatively or in combination to tax transactions settled through CLS. However, as we have seen, CLS is only one important but not unique way to settle forex transactions. For the present moment, the majority of market activity is still outside CLS, and this may be the case for a long time yet. Traditional settlement procedures, i.e. correspondent banking, must still be taken into account for collecting the tax.

### 2.2.5 Step 5. Settlement

As we have seen previously, all transactions must be settled, either directly after transactions have been confirmed and matched, or indirectly after transactions have been netted bilaterally or multilaterally through CLS. This settlement is realised at the settlement system usually but not exclusively managed by the central bank of the relevant currency. The settlement is realised on a gross basis without netting, i.e. transaction by transaction each one being clearly identified, and in real time, i.e. continuously and without any delay. For these reasons it is called Real Time Gross Settlement System (RTGS).

Not only forex transactions, but all kinds of financial transactions, on the money market, equity market, corporate and bond markets, are in the end settled through the RTGS. Not only large-value transactions linked to these markets, but also retail transactions, such as cheques, credit cards and other kind of payments are settled through the RTGS. On Figure 2-11, one can see a hypothetical example of linkages between individual banks, clearing and settlement systems and the RTGS, which is the heart of the payment system.

Figure 2-11 shows that each clearing and settlement systems settles at pre-definite closing-times, for instance 09:00h for ACH, 10:00h for clearing of exchange-traded derivatives, etc..., while individual banks can settle at any time during the day. Individual private banks can have direct access with the RTGS to conclude interbank transfers. In this last case, the advantage for the bank is that settlement is realised immediately, but it costs more. Differed net systems are slower but cost less. There is an exchange between immediacy and cost that depends on the nature of the transaction.

Private banks and clearing and settlement systems are the only economic agents who have direct access to the relevant RTGS, but they have to be resident in the country and duly licensed. Non-bank financial institutions and non-financial firms cannot settle their transactions through RTGS directly, but rather indirectly through the intermediation of banks and clearing systems. Non resident banks and systems are usually not allowed to access the national RTGS. This is due to the fact that national central banks want to protect the integrity and safety of their national payment system (77).

<footnote>(77) To allow a foreign bank with no branch or subsidiary in the country to open an account at the central bank and to use the central bank money could endanger the central bank and the whole financial system. This foreign bank would not be liable to national banking laws and regulations, especially prudential ones, and its</footnote>
Settlement is the actual transfer of funds between the payer's bank and the payee's bank. In general, the settlement of interbank funds transfers uses central bank money materialised by the transfer of balances on the books of the central bank. Settlement is declared final and irrevocable when the transfer of value has been recorded on the books of the central bank.

The central bank plays a key role in the payment system. “The widespread use of central bank money as a settlement asset reflects its overall qualities of safety, availability, efficiency, neutrality and finality” (CPPS, 2003b, p 2). The central bank is usually a solid institution that cannot fail, to the contrary of a commercial bank, and this minimises the systemic risk, i.e. the profound banking and financial crisis that could disrupt the whole economy if the settlement institution failed. In case of crisis, central banks are lenders of last resort because they have the power to create money.

<figure><img src="image_16.png" /><figcaption>Fig. 2-11 : Hypothetical Example of Linkages Between Settlement Systems</figcaption></figure>

Source: "Real Time Gross Settlement Systems, CPSS, BIS, Basle 1997

In normal periods, central banks provide intra-day liquidity to commercial banks to facilitate daily settlements. To decide if it can lend money, the central bank needs to know precisely the net position of each commercial bank that has opened an account on its books, minute by minute. To achieve this task, the central bank needs to be informed in real time about the daily activity of each commercial bank. Again, SWIFT plays this crucial role of providing the necessary information in real time to the central bank.

Let's now turn to the analysis of the types of transactions settled by the RTGS. At the domestic level, there is an interrelationship between differed net systems for interbank funds transfer like CHIPS in the US, CHAPS in the UK, or PNS in France, in which participants' net settlement positions are settled over an RTGS system at one or more designated times.

The second type of interrelationship concerns Securities Settlement Systems (SSS) in which securities (equities and bonds traded on exchanges) are exchanged simultaneously with cash by applying a Delivery Versus Payment (DVP) principle. In this case, the RTGS settles the cash leg of the transactions of securities. The settlement can be continuous or differed according to the nature of the SSS. The same principles apply to the clear-

<footnote>failure could lead to a systemic crisis.</footnote>
ing of exchange-traded derivatives. The Automated Clearing House (ACH) system covers the clearing of retail means of payments, such as cheques and credit cards. All domestic transactions have in common that the two legs are located, matched and settled in the national territory.

At the international level, one finds forex transactions clearing and settlement sys-
tems such as Euro 1 or CLS in the EU, or even international SSS such as Euroclear or
Clearstream. As we have seen previously, all international transactions have in common
that only one leg is settled in the national territory, the other being settled abroad. This is
exactly the case for forex transactions that involve two currencies, with each one being
settled in the relevant country. This is particularly clear when correspondent banking is
used, because correspondent banks are necessarily situated in one of the two countries
whose currencies are traded. But the existence of CLS does not change this particularity.
As explained above, the novelty introduced by CLS is the simultaneity of payment, (PVP)
like in a domestic transaction, but the two legs are still settled in two different countries.

It means that in each country, it will be impossible to match one leg of the transac-
tion with the other leg which is located in another country. For Rodney Schmidt (2001) and
P.B. Spahn (2002), this peculiarity establishes the principle to levy the tax at the settle-
ment site when the national RTGS processes the transfer of funds: the absence of one leg
is the mark of a forex transaction that will be detected as such by the RTGS. The law in fa-
vour of the CTT that has been adopted in Belgium relies on this principle.

This proposition is very powerful. The main advantage is the following. Customers
and banks can buy or sell euros everywhere in the world, and these euros will be finally
settled inside the euro zone. Taxing forex transactions in euros when they are settled via
the RTGS of EU country member seems to circumvent all the difficulties linked to the glob-
alisation of finance. As we will see now, this proposition is true, provided that we analyse
in detail how the European RTGS work practically, and provided that complementary ways
of taxing forex transactions are involved in conjunction.

2.2.5.1 The role of TARGET, the European RTGS

In the EU, the launch of the euro, the single monetary policy and the subsequent in-
tegration of financial markets have introduced a novelty: the creation in 1999 of a pan-
European RTGS, called TARGET (78). The existence of this pan-European RTGS intro-
duces some more complexity because it changes the geography of European finance and
the way national payment systems settle transactions. Some euro denominated transac-
tions traded in an EU member state can settle domestically while some others can settle in
another EU member state via TARGET (See figure 2-12 for the French case).

<footnote><sup>78)</sup> TARGET stands for Trans-European Automated Real-time Gross Settlement Express Transfer.</footnote>
<figure><img src="image_17.png" /><figcaption>Fig. 2-12 : Country Example: Integration of Infrastructure in France</figcaption></figure>

Source: CPSS (2005). "General Guidance Consultative Report". CPSS BIS, Basle.
Three types of transactions can be handled by TARGET.

1. Payments directly connected with central bank operations in which the Eurosystem is involved on either the recipient or the sender side.

2. The settlement operations of large-value netting operating in euros (Euro1 for instance).

3. Interbank and commercial payments in euros.

It is mandatory for the first two types of transactions to be settled through TARGET (CPSS, 2003).

### 2.2.5.2 The geographical coverage of TARGET

One particularity is that the three EU members (Denmark, Sweden and the United Kingdom) which have not adopted the euro are connected to TARGET and can settle euros transactions in their own countries. Switzerland, which is not member of the EU, also has a formal euro settlement arrangement (euroSIC). EuroSIC members have direct access to the German RTGS system and subsequently a direct access to TARGET. The new EU members also have access to TARGET although they have not yet adopted the euro (79). And the scope is even broader because Hong Kong private banks can settle euro transactions in Hong Kong (EURCHATS).

This is an important point because if the project is to tax euro transactions at the settlement site, then it is obligatory that all European countries that settle transactions in euro together apply the tax. If it was not the case, it would be possible for banks and firms to settle their euro transactions in the UK, for instance.

How is possible that TARGET may process euro payments to countries that have not adopted the euro as their currency? This is because all EU central banks had to start making preparations for TARGET since 1995 before knowing if their country would adopt the euro. The Governing Council of the ECB adopted a special agreement for the three countries that finally did not join the euro area (see box 2-3 below). Under the terms of the agreement, these three Member States have a deposit in euros with the Eurosystem that allows their central banks to settle euro transactions in central bank money on the accounts opened by private banks on their books. This deposit allows the three central banks to provide the necessary but limited amount of intraday liquidity to their credit institutions. For instance, intraday liquidity provided by the Bank of England (as a non-euro area national central bank) to members of CHAPS Euro is limited to € 3 billion. But if this amount is not sufficient, banks established in the UK can get access to euro loans on the continent and send the liquidity directly via TARGET, in their capacity as direct members of TARGET (80).

<footnote n="79">79) In 2004, the Polish central bank decided to connect to TARGET before Poland joined the euro area. Nardowy Bank Polski chose to connect its own national euro system to TARGET via a bilateral link established with the Italian central bank, Banca d'Italia. The connection took place on 7 March 2005. This option differs technically from other central banks connected via the Interlinking.</footnote>

<footnote n="80">80) "However, members are able to raise additional liquidity within the euro area and transfer this through TARGET to CHAPS Euro." (Bank of England, 2004, p 57).</footnote>
Box 2-3 : Connection of Euro RTGS Systems of Non-Euro Central Banks to Target

The TARGET Agreement (and its transposition into national RTGS rules) provides a mechanism whereby non-euro area NCBs can connect to TARGET, but must adhere to the rules and procedures stipulated in the TARGET legal documentation and implement the modifications and specifications appropriate for the non-euro area NCBs. Via the TARGET Agreement any changes made to the TARGET Guideline are also directly applicable to the non-euro area NCBs (see the section entitled “Legal framework” in Annex 3).

As for the provision of intraday liquidity, the non-euro area NCBs are allowed to offer only limited amounts of intraday liquidity in euro to their credit institutions on the basis of a deposit in euro held with the Eurosystem. Safeguards have been established in order to ensure that non-euro area credit institutions will always be in a position to reimburse intraday credit in good time, thus avoiding any need for overnight central bank credit in euro. This arrangement is a unique one, as it is the first time a central bank has allowed central banks belonging to other currency areas to provide settlement facilities in its currency. A policy statement issued by the ECB in November 1998 made it clear that central bank money in euro can only be provided by central banks belonging to the Eurosystem and indicated that the facility offered to non-euro area central banks was an exception.

Source: TARGET Annual Report, 2003, p 47, ECB, Frankfurt.

This shows how much the EU national payment systems are integrated and the ne-
cessity of including all EU members, even if the euro was the only currency subjected to
the tax.

<figure><img src="image_18.png" /><figcaption>Fig. 2-13 : Share of 2003 Cross-Border TARGET Payments by TARGET Component (a)</figcaption></figure>

Source: Payment Systems Oversight Report, Bank of England, 2004.

If the UK was not part of the CTT agreement, banks from the rest of the EU could quite easily transfer euros in the UK to avoid the tax. The same is true for Denmark and Sweden, even if their market is much smaller (See figure 2-13 above). In addition, an aggravating factor is the importance of the British market for euro transactions. It is the second-largest market in terms of value and volume, after Germany and before France (See figure 2-14 below). One cannot simply ignore it.
<figure><img src="image_19.png" /><figcaption>Fig. 2-14 : Daily Values Settled by Euro Payment Systems Located Outside the Euro Area (EUR bln., logarithmical scale)</figcaption></figure>

Source: ECB, Swiss Interbank Clearing and Hong Kong Internet Clearing Ltd.

The conclusion is that applying the CTT to the euro implies that at least the 15 EU Member States that settle in euro levy the tax. But it would be better if the pound sterling, the Swedish krona and Danish krona were also submitted to the tax. Because, if not, it would boost these currencies, particularly the pound sterling, as international currencies to the detriment of the euro. The same argument applies to a lesser extent to the new member-states though they cannot settle in euros. They are not part of the euro area for the moment, but will join it in the near future and can be connected to TARGET in the meantime, like Poland.

In political terms, if the message is that the EU wants to make a special contribution in financing for development and the global common good, then no one will understand why these countries stayed outside the system.

Hong Kong (EuroCHATS) and Germany/Switzerland (EuroSIC) are typical of the emergence of new arrangements for the settlement of local payments in foreign currency, in this case the euro (see bos 2-4). They create new problems because they neither fit perfectly in the traditional category of “correspondent banking” nor in the category of “payment system” (CPPSS, 2005b, p 24). “The main common characteristic of these arrangements is that they do not settle in central bank money but across accounts held with a commercial bank and that they are based on clearly defined and transparent rules for payment activities” (CPPSS, 2005b, p 24).
Box 2-4 : New Dimension in Correspondent Banking

In Hong Kong, the US dollar and euro clearing systems USD CHATS (Clearing House Automated Transfer System) and Euro CHATS were introduced in 2000 and 2003 respectively, in order to enhance the safety and efficiency of settling these foreign currencies in the local time zone. These systems are almost exact replicas of the Hong Kong dollar RTGS system (HKD CHATS). The key functions of both systems are to enable PVP settlement of foreign exchange transactions between HKD, USD and euros and DVP securities settlement in the respective currencies through a linkage with the Central Moneymarkets Unit (CMU). Both systems settle in commercial bank money. The Hong Kong Monetary Authority (HKMA) has appointed the Hongkong and Shanghai Banking Corporation (HSBC) as the settlement institution for USD CHATS and Standard Chartered Bank (Hong Kong) Limited as the settlement institution for Euro CHATS. Both institutions provide intraday liquidity to the direct participating banks by means of repos as well as overdraft facilities. The operator of both systems is HKICL,²⁷ the same as that of HKD CHATS.

In 1999, Swiss financial institutions established a cross-border solution in order to facilitate their cash management in euros. This solution involves a fully licensed bank in Germany, Swiss Euro Clearing Bank (SECB). To process euro transactions SECB uses the euroSIC platform in Switzerland, which is often referred to as the euro payment system of Switzerland. Some consider SECB/euroSIC to be a payment system and others see it as a "quasi-system" or as correspondent banking. In terms of design, euroSIC is a replication of the Swiss franc RTGS system Swiss Interbank Clearing (SIC), so that it provides to a great extent the same functionalities. SIC and euroSIC are technically operated by Swiss Interbank Clearing AG.²⁸ SECB is the settlement institution and shares the role of settlement agent with the operator SIC AG. SECB is also the liquidity provider in euroSIC. It extends intraday and overnight credit to the participants of euroSIC against collateral. SECB provides a link to the euro area as it is a direct participant in RTGS<sup>plus</sup>, through which access to TARGET is established.

Source: "New Development in Large-Value Payment Systems". CPSS (2005b), BIS, Basle.

Switzerland is a special case. It is the only European country with a developed and sophisticated financial infrastructure that settles in euro without being member of the EU. Furthermore, it practises secretive banking and because of this is often considered a tax haven.

The strong financial links between Switzerland and Germany have lead to the creation of EUREX through the merger between the Swiss derivatives stock exchange (SWX) and the German derivatives stock exchange (Deutsche Terminbörse) in December 1996. Both parties agreed to develop and implement a single platform for their derivatives markets and trade a harmonised product range. To settle the cash leg of these transactions, it was necessary to develop a link to TARGET to settle payments in euros. To this purpose, the Swiss Euro Clearing Bank (SECB) was established in Frankfurt am Main. SECB operates euroSIC, a payment system linked to RTGS<sup>plus</sup>, the German RTGS system connected to TARGET. "Thus, for Swiss financial market participants, euroSIC constitutes a link to the other payment systems and provides efficient cross-border gateway for payments to and from other European payment systems" (CPSS, 2003).

Although euroSIC was originally created to satisfy the securities transactions needs, it has enlarged the scope of its activities. It now processes primarily transactions of private companies and individuals, but also interbank payments, which largely consist of the euro leg of foreign exchange transactions, money market transactions, and securities transactions. It has consistently increased the volume and value it processes and, in the first eight months of 2004, handled a daily average of 9,500 transactions with a value of €2.9 billion per day. This places euroSIC in fourth position in the ranking of off-shore euro settlement systems, far behind the British CHAPS Euro (daily average of €128 billion), the Danish Kronos (€12.4 billion), and the Swedish Euro RIX (€7.4 billion) (see also Table 2-5 at the end of this chapter for more comparisons).

But even if the present activity is modest, euroSIC would create a leak in the system if it was not submitted to the CTT. It is possible to tax the euro leg of the forex transactions because, as explained above in Box 2-4, the liquidity in euros is provided by the Swiss
Euro Clearing Bank, (SECB), which to the contrary of what its name may suppose, is a fully licensed bank in Germany. EuroSIC operates on the basis of the software developed for SIC, the Swiss RTGS, and runs on the same platform. But SECB, who owns euroSIC, is a German bank and a direct participant in RTGS<sup>plus</sup>, the German RTGS and as such comes under the supervision of the Deutsche Bundesbank.

If the CTT was adopted by Germany, SECB would have to collaborate on the levying of the tax, otherwise the Bundesbank or any other EU central bank could deny it access to TARGET and its advantages, such as the intraday liquidity in euro that the Bundesbank provides. This is a different case from the offshore euro systems of the three EU members because there is no special agreement by which the Swiss central bank has an important deposit in euros.

The case of EuroCHATS in Hong Kong is different. At the end of 2004, there were 23 direct and 21 indirect participants in EuroCHATS, including 11 indirect participants from outside Hong Kong, most of them from neighbouring countries. In 2004, the system handled an average of 37 transactions a day with a total value of over €923 million, which puts it at the bottom of the ranking of offshore euro payment systems <sup>(81)</sup>. But it may grow, because Hong Kong is a small territory that has specialised in finance and plans to become an Asian financial hub for neighbouring countries, and in particular mainland China. If commercial trade and financial trade between China and East Asian countries with the EU grow in the near future, then the use of euros in those transactions will grow. It has become necessary to settle in real time, i.e. In Asian time, the euro leg of those transactions and to synchronise them with US$ transactions in Hong Kong. This is why the Central Monetary Unit has created cross-border linkages between the CMU (Central Money-markets Unit, the main Central Custodian Deposit (CSD) in Hong Kong) and International Central Custodian Deposits (ICSD) such as Euroclear and Cleastream and national CDS of the region (See figure 2-15). The establishment of those outbound two-way links allows investors in Asia to hold and settle international securities directly through CMU members, most of which are banks in Hong Kong. The interlinking of those private securities settlement systems and private euro and dollar payment systems is unique for the moment but shows there is a potential for the development of offshore private payment systems. Settlement in euros is bound to increase.

<footnote><sup>(81)</sup> The value of euro transactions is also very small in comparison with the value settled in US$ via the US dollar RTGS system, dollar CHATS, with $5.51 billion in 2004.</footnote>
<figure><img src="image_20.png" /><figcaption>Fig. 2-15 : CMU Linkages with ICSD</figcaption></figure>

Source: HKMA

Direct participants to Euro CHATS have to open accounts at Standard Chartered Bank in Hong Kong, the settlement institution. Standard Chartered Bank is one of the world's most international Banks. It employs 38,000 people in 950 locations in more than 50 countries in the Asia Pacific region, South Asia, the Middle East, Africa, the UK and the Americas. It is also one of the biggest banks in the world, and is in the top 25 FSTE-100 companies, by market capitalisation. It is headquartered in London and listed on the London Stock Exchange, but it is also listed on the Stock Exchange of Hong Kong where it has been established for more than 150 years. It was authorised to issue bank notes in Hong Kong up until the end of 19th century and is still one of three banks to print Hong Kong bank notes.

With these characteristics one understands easily why Standard Chartered Bank was appointed by the Hong Kong Monetary Authority as the settlement institution for euro transactions. Standard Chartered Bank has enough liquidity in euros not only to allow the settlement of transactions on the accounts opened by direct members but also to provide interest-free intraday credit. How does it work?

Suppose that two banks (Bank X and Bank Y) have agreed to settle a euro/Hong Kong dollar forex deal by Payment-versus-Payment (PvP) in Hong Kong (See figure 2-16). Bank X and Bank Y have opened accounts at the Hong Kong Monetary Authority (HKMA) and Standard Chartered Bank. On settlement day, the seller of Hong Kong dollars (Bank X) sends a PvP payment transaction to Bank Y via HKMA, the RTGS for the Hong Kong dollar. The seller of the euros (Bank Y) also initiates a mirror PvP via EuroChat. The Cross Currency Payment Matching Processor (CCMP) (82) will then communicate with the two RTGS to match and confirm the transaction. After successful matching, and if Bank A and B have sufficient funding, HKMA and Euro CHATS will transfer the funds to their respective counterparty simultaneously.

<footnote>(82) the CCMP plays the same role as SWIFTAccord.</footnote>
<figure><img src="image_21.png" /><figcaption>Fig. 2-16 : PvP Facility</figcaption></figure>

Source: adapted from HKMA, 2002.

Standard Chartered Bank in Hong Kong in one way or another needs to have a direct link with the EU payment system and finally TARGET in order to fund the settlement of euro transactions in Hong Kong. It is the same problem as euroSic in the Swiss/German case which needs Swiss Euro Clearing Bank, a German bank, to get access to TARGET. This is realised by Standard Chartered Bank's headquarters in London, which provide the necessary amount of euros through internal transactions. As a British bank, Standard Chartered UK is a direct member of TARGET and subject to the supervision of the Bank of England.

This means that if the UK was part of the CTT agreement, Standard Chartered Bank would have to pay the tax on the amount of euros that were used as the euro leg of transactions settled in Hong Kong. Standard Chartered Bank in London could decide to provide voluntarily the data concerning the volume and value of transactions via SWIFT-Copy to the Bank of England. But if it refused to cooperate, the EU could decide to impose a lump sum tax based on statistics concerning the volume and value realised by Euro CHATS published by the Hong Kong Monetary Authority.

### 2.2.5.3 How does TARGET work?

TARGET is a decentralised system that has created a link between the 15 domestic RTGS of the EU member countries (pre-expansion), the ECB payment mechanism (EPM) and the interlinking system. The interlinking system connects the national RTGS and the EPM by means of common procedures that allow cross-border payment orders to move from one system to another. The role of the interlinking component is to convert the presentation of payment data from the national standard into the interlinking standard and vice versa (See figure 2-17).
<figure><img src="image_22.png" /><figcaption>Fig. 2-17 : TARGET Cross Border Processing...</figcaption></figure>

Source: "Information Guide for Institutions using TARGET", ECB 2003.

Payment transactions are settled one by one on a continuous basis, with intraday finality and in central bank money. A transaction between France and Germany will be first presented by a bank to the French RTGS managed by the Banque de France and then routed to the Bundesbank through the intermediary of TARGET. The Bundesbank will be informed that a payment is coming from France, check that the beneficiary is located in Germany, debit the interlinking account of the Banque de France and deliver a positive acknowledgement to the Banque de France. The Bundesbank will credit the funds on the account that the beneficiary's bank has opened at the Bundesbank. The Bundesbank will also send the payment message through the German RTGS to the commercial bank of the final beneficiary. This commercial bank will then credit the funds to the account of its customer. If the receiving bank is not a participant in the German RTGS system, the Bundesbank will reject the payment message. We can observe that SWIFT, which already plays a critical role for the settlement of transactions internal to the French RTGS system (See figure 2-12), plays also a critical role for the interlinking of the French RTGS with the German RTGS (See figure 2-17).

TARGET is the preferred system for the processing of large-value payments in euros but its share in low-value payments is also increasing. On an international stand-point, in 2003 TARGET processed a slightly higher amount of transactions in value terms than FEDWIRE, the state-owned US RTGS (see Table 2-5 at the end of the chapter). Creating the CTT in the EU has solid grounds.

In 2004, TARGET's share of the global traffic (domestic and cross-border) of all large-value payment systems operating in euro rose to 88% in terms of value, and remained unchanged at 58% in terms of volume. TARGET is the dominant system in Europe. The difference between terms of value and volume shows the impact of large-value transactions such as interbank transactions although TARGET accepts any kind of payment with no value limit. Customers' orders of any kind are handled by TARGET. They have a lower value but are more numerous.

In 2004, the daily average of payments processed by TARGET as a whole (i.e. both domestic and cross-border) represented a daily value of €1,714 billion of which 33.0% was cross-border <sup>(83)</sup>. In terms of volume, inter-member state traffic represented 23%. This shows that despite European integration, domestic financial transactions are still pre-emin-

<footnote><sup>(83)</sup> In 2004, TARGET processed a daily average of 65,040 inter-Member State payments with a total value of €564 billion. All these data come from ECB, 2004.</footnote>
ent. The use of TARGET for intra-member state payments varies considerably among the different EU country members. In some countries (such as France and Spain), TARGET is used mostly to process especially high value payments; in others (such as Germany and Italy), it is also heavily used for low-value payments <sup>(84)</sup>.

Of the cross-border TARGET payments, 95% in terms of value were interbank transactions with the remaining 5% being customer payments. In terms of value, TARGET traffic is overwhelmingly interbank, although the value share from customers is growing slowly. Interbank transactions have a high unit value because they are "related to money market transactions, securities settlement transactions, foreign exchange transactions and liquidity transfers resulting from the centralisation of liquidity management by multi-country banks" (ECB, 2004, p 11). But in volume terms, the share of customer transactions (51%) superseded interbank transactions (49%) for the first time <sup>(85)</sup>. This shift reflects the further migration of commercial payments from correspondent banking to systems such as TARGET (ECB, 2004). This is confirmed by the fact that 65% of TARGET payments were for values less than €50,000 <sup>(86)</sup>.

TARGET is therefore a heterogeneous system reflecting the ongoing diversity of European countries. This situation will change with the launch of TARGET 2 which is due to begin in January 2007. "In TARGET 2, it will no longer be necessary for each national central bank to maintain a national RTGS system of its own. All central banks will be able to share one technical platform, the Single Shared Platform (SSP), thus supporting the RTGS services that they offer to their banks. However, the settlement account relationship and the intraday credit provision will continue to belong to the business relationship between each central bank and its national banking community" (CPSS, 2005, p 41). So, there will be a greater centralisation, standardisation and harmonisation of settlement in central money in Europe.

What will be the probable changes for the CTT perspective? Not many. The positive aspects are the following. The settlement of individual euro payments in central bank money will be maintained. There will be a greater transparency as users will be offered consolidated account information and liquidity management services with a broad range of optional tools. One important innovation and a potential negative aspect for the CTT, is that TARGET will include mechanisms that incorporate mutually offsetting payment flows. This netting mechanism will operate when transactions are in the queue. It creates the same kind of problems raised by EURO1 and CLS. The CTT must be collected before transactions are offset, when they are first presented to TARGET, because if not the volume base of the CTT will be reduced by the offsetting mechanism.

#### 2.2.5.4 What conclusions can we draw from the present TARGET characteristics?

In principle, TARGET is the appropriate institution that can observe one-legged financial transactions and conclude that it is a forex transaction subject to the tax. But in reality, there are some limits and difficulties to be taken into account. The limit is that an important part of forex transactions (and perhaps the major part) are netted before being routed to the RTGS. Only forex transactions that are addressed individually by banks directly to the RTGS on a gross basis can be identified and taxed individually when settled.

The difficulties are that not only forex transactions give birth to unmatched transactions. International financial transactions on bonds and securities, money market transactions and cash management and other types of cross-border transactions are character-

<footnote><sup>(84)</sup> The German and Italian TARGET components combined processed more than two thirds of intra-member state payments (ECB, 2004).</footnote>

<footnote><sup>(85)</sup> In 2003, interbank transactions (51%) were still higher than customer transactions (49%).</footnote>

<footnote><sup>(86)</sup> Payments over € 1 million only accounted for 12% of the traffic, and payments above € 1 billion for less than 0.1%.</footnote>
ised by the fact that only leg of the transaction is settled via TARGET. If for instance a Ger-
man firm has a plant in France and makes frequent payments in euro from Germany to
France for ordinary operational motives, it will be registered as a one-legged transaction
and could be taxed in the same way as a forex transaction. If the firm had all its plants in
Germany, it would not bear any risk of paying the tax.

Taxing all international financial transactions is not a problem in itself and is a nor-
mal extension of the CTT to all financial transactions. But taxing the ordinary internal trans-
actions of productive firm is clearly not the objective of the CTT. These limits and practical
difficulties justify our initial proposal to use extensively all the existing opportunities to levy
the tax at each step of the forex transaction flow, with the idea in mind of an electronic tag
that would inform the settlement institution about the fiscal status of the transaction: Has
the CTT been already paid or not? If the settlement order is routed by Euro1 or CLS then
the CTT must have been already paid. If the settlement order is routed individually by a
private bank, then the CTT has to be collected by the RTGS during the settlement pro-
cess.

To overcome the problem of confusion between forex and non forex transactions, the RTGS must be able to clearly identify the nature of the transaction. Is this presently possible, or not? To answer these questions, one must analyse carefully how RTGSs work in the EU context. The starting point is again SWIFT. SWIFT is really the nervous system of the national payment system.

Through the communication network, banks and clearing institutions forward their payment instructions to the payment system in order to achieve the exchange of funds. As we have seen, the same channels can also be used for the provision of information on the clearing and settlement process to the participants.

To initiate a funds transfer the sending bank dispatches a payment message which is subsequently routed to the central bank and to the receiving bank as the system processes and settles the transfer. In fact, the payment message is routed only after SWIFT has requested and received from both parties a confirmation message of the transaction (message-type 300). The majority of RTGS have adopted the so-called V-shaped message flow structure, but some have adopted the so-called Y-shaped structure (87) (See figure 2-18).

<footnote><sup>87)</sup> There exist also L-shaped and T-shaped message flow structures. For more details, see CPSS, 1997.</footnote>
<figure><img src="image_23.png" /><figcaption>Fig. 2-18 : Message Flow Structure</figcaption></figure>

Source: CPPS, 2005b.

The V-shaped structure is the simplest way to process a payment message. The full message containing all the relevant information (including the details of the beneficiary) is passed to the settlement institution (in general the central bank although it can be SWIFT or a private settlement bank), and is sent to the receiving bank only after the transfer has been settled by the central bank. The settlement occurs if the sending bank has sufficient covering funds in its central bank account. If not, the central bank can lend money to the sending bank for a few minutes or hours, providing that the sending bank has not yet reached the credit limits that the central bank has allowed to it. If the limits set against the sending bank are about to be breached, the fund transfer order is queued.

In this case, the settlement institution sends a message to the sending bank about the status of the payment order, the sending bank's account balance and the details of the incoming queued payment. The information provided makes it easier for the sending bank to control the payment process interactively in real time <sup>(88)</sup>. The sending bank can provide liquidity, change the position of payments in the queue, or their priority, or revoke the payment. The central bank can change the sender limits.

In the Y-shaped structure, the payment message is transmitted directly by the sending bank to the receiving bank. The central processor (usually SWIFT) filters the message in order to take a subset of information that is necessary for settlement from the original message and copy this core subset <sup>(89)</sup> to the settlement institution (the original message being kept in the central processor). Upon receipt of the core subset, the settlement institution checks that the sending bank has sufficient covering funds on its account and informs SWIFT of the status of the transfer, for instance queued or settled. Once settled, the full message containing the confirmation of settlement is rebuilt by the SWIFT and sent to the receiving bank. The business information exchanged between the sending and receiving bank (such as the identity of the beneficiary) is therefore not known by the settlement agent. Like in the V-shaped structure, SWIFT provides a number of query and reporting

<footnote><sup>(88)</sup> SWIFT Net InterAct is the software that provides this interactive exchange of instructions between the settlement institution and the counterparties. This was already the case in CLS.</footnote>

<footnote><sup>(89)</sup> This copy is done by SWIFT FIN Copy which plays a critical role in private settlement systems such as Euro 1 or CLS.</footnote>
features which enables participants to obtain information to facilitate their liquidity management.

The main difference between the V-shaped and the Y-shaped relies in the difference of information that is delivered to the central bank. On its website, SWIFT clearly explains that “commercial information does not need to be copied to the central institution” (SWIFT, 2004). The objective is clearly to hide some information from the central bank. This raises the possibility that some useful information to collect the CTT could escape to the knowledge of the central bank. It cannot be the identity of the sending bank and the amount of the transaction because the central bank must know if the sending bank is not breaching its limits. But all the rest of the information such as the identity of the ordering institution, the nature of the transaction (forex transaction, or payment of salaries) may be hidden to the central bank and this can create difficulties to collect the tax. Some of them can be resolved. If the identity of the ordering institution (whether customer or bank) is unknown to the central bank as well as the final beneficiary, one solution is that the CTT would be paid in full by the sending bank that would then arrange to be partially or fully reimbursed by the ordering institution and/or the receiving bank and final beneficiary.

But other problems remain such as the nature of the transaction. TARGET is not destined and equipped to apply the PVP or DVP principles. It is designed to enable a single payment message to be passed from one RTGS to another (CPSS, 1997, p 35-36). TARGET does not match and confirm transactions. It is the duty of SWIFT and other netting institutions. It is therefore critical that the content of the message that the central bank receives allows identifying a forex transaction.

In fact, we can observe that the majority of national European RTGS have adopted a Y-shaped structure while international settlement institutions like CLS, Euro CHAPS or TARGET have adopted a V-shaped structure (see table 2-5 at the end of the chapter).

This means that if a French bank A buys yen against euro from a French bank B (the two banks being located in Paris), Bank A will send euros to bank through the French national payment system whether directly (via TBF the French RTGS) or indirectly (via PNS) to settle the euro leg of the transaction. In this classical case of correspondent banking, all that TBF knows is that it has debited Bank A's account by a certain amount of euros to credit the account of the receiving bank (bank B), but TBF does not necessarily know who is the final beneficiary, and if the transfer of euros is the leg of a forex transaction or the cash leg of a security transaction, or one leg of a money market transaction. This is because TBF has adopted a Y-shaped structure. Only SWIFT possesses the complete information set included in the message.

The danger is that all domestically traded forex transactions risk passing unnoticed by the central bank, i.e. around 34% of euro transactions (90). To implement the CTT, it is therefore necessary to demand that in case of a domestic forex transaction, the full message (or at least the necessary data) be transferred to the relevant central bank. It is technically possible. In one of its last report, the BIS (2005) notices that in a Y-shaped structure, “SWIFT intercepts the message (sent by the sending bank) copies the entire content (or a subset) of the message and sends this copy to the settlement institution” (we underline). There is clearly room to manoeuvre in the definition of the content of the subset of information sent to the central bank, and it must be technically possible to include the necessary data allowing the identification of a forex transaction. A regulation by national central banks of the Member States or by the ECB could decide that the necessary data should be included in the subset.

<footnote n="90">⁹⁰) According to the BIS (2005, p 6, table B.2.), in 2004, 38% of global turnover at the world level was local transactions, versus 62% for cross-border transactions. For the euro, the share of local transactions is around 34% (calculated from table E.1., statistical annex, BIS, 2005).</footnote>
Suppose now that the French bank A has dealt with the Luxemburg branch of the French Bank B. The euros will be sent through TARGET or EURO1. If it is settled by TARGET, the two central banks involved, French and Luxemburgian, will process the settlement. As TARGET uses a V-shaped message structure, the full message will be sent by SWIFT to both central banks. The critical question is then the following: what is the content of the messages sent via TARGET (or via private clearing and settlement institutions). Do we have the guarantee to find the data necessary to collect the tax?

#### 2.2.5.5 The critical importance of SWIFT Message-Types used in TARGET

There are two main SWIFT message-types relevant for a forex transaction. One (MT103) is initiated by the customer (a non-financial firm) and is sent to a bank which processes the order. The other is for interbank transactions (MT 202). The format specifications establish the status of the specification (or field), which is mandatory (M) or optional (O) <sup>(91)</sup>. The field tag allows identifying the specification, and the field name describes the content of the specification <sup>(92)</sup>.

When two customers do not belong to the same corporate firm, and do not have a direct account relationship in the currency of the transfer, then the ordering customer has no other choice than to ask a bank to process the payment. It means that a bank will receive the MT 103 and will "cover" the customer transfer by sending its own message, an MT 202 (General Financial Institution Message) to the bank of the receiving customer that includes the details of the MT 103 <sup>(93)</sup>. The two message-types, MT 103 and MT 202, are linked between them (See figure 2-19).

<figure><img src="image_24.png" /><figcaption>Fig. 2-19 : Cross Border Euro Customer Payment Through TARGET</figcaption></figure>

Source "TARGET Information Guide", ECB, 2003.

<footnote n="91"><sup>91</sup> Optional does not usually mean that banks have the freedom to choose to provide the information or not. It means that if information is not already provided in the mandatory field, then it has to be provided in the optional field.</footnote>

<footnote n="92"><sup>92</sup> The two last columns concern the possible options and their technical transcription.</footnote>

<footnote n="93"><sup>93</sup> This payment method is called « cover » in the technical vocabulary. When more than two financial institutions are involved in the payment chain, and if the MT 103 is sent from one financial institution to the next financial institution in this chain, then the payment method is called "serial". See SWIFT, 2005.</footnote>
### 2.2.5.6 Data included in a message when a customer makes a forex transaction

The Message-Type (MT 103 core) is used in case of a "single customer credit transfer". It includes various situations such as the payment of salaries, pensions, securities and foreign exchange transactions initiated by an "ordering customer", i.e. a non-financial firm, and sent by a bank (the sender). It is sent directly or through a correspondent to the receiving bank of the beneficiary customer. The format specifications of MT 103 are worth studying because one finds all the data necessary for the collection of the CTT (see Table 2-3, MT 103 format specifications).

There exists two other versions: a MT103 +, which is subset of MT 103 that limits the number of fields and options to enable full STP, and a MT103 REMIT which to allow financial institutions to offer their customers the possibility to send more information to the beneficiary customer. The MT 103 + includes all the fields and options critical for the CTT. This shows once again that the CTT can benefit from technical progress and creates no additional cost. The MT103 REMIT presence proves that if necessary, it is possible to increase the information content of the message. If all participants agree on the presence of this extended information, by subscribing to a Message user Group (MUG), it can then be transformed into STP data.

Let's turn to the analysis of the content of MT103. First, the transaction and the parties involved are clearly identified with the "Sender's Reference" (tag M20), the "Ordering Customer" (tag 50a), the "Sending Institution" (tag 51A), the "Ordering Institution" (tag 52a), the "Sender's Correspondent" (tag 53a), the "Receiver's Correspondent" (tag 54a) and the "Beneficiary Customer" (tag 59a).

The sender's reference clearly identifies the message with a reference given by the bank that sends the message of its ordering customer. This reference must be quoted in any related confirmation or statement. It is then possible to track the message.

<table><caption>Table 2-3 : MT 103 Format Specifications</caption><caption>MT 103 Single Customer Credit Transfer</caption><thead><tr><th>Status</th><th>Tag</th><th>Field Name</th><th>Content/Options</th><th>No.</th></tr></thead><tbody><tr><td>M</td><td>20</td><td>Sender's Reference</td><td>16x</td><td>1</td></tr><tr><td>O</td><td>13C</td><td>Time Indication</td><td>/8c/4!n1!x4!n</td><td>2</td></tr><tr><td>M</td><td>23B</td><td>Bank Operation Code</td><td>4!c</td><td>3</td></tr><tr><td>O</td><td>23E</td><td>Instruction Code</td><td>4!c[/30x]</td><td>4</td></tr></tbody></table>

Table Continues on the next page...
<table><thead><tr><th>Status</th><th>Tag</th><th>Field Name</th><th>Content/Options</th><th>No.</th></tr></thead><tbody><tr><td>O</td><td>26T</td><td>Transaction Type Code</td><td>3!c</td><td>5</td></tr><tr><td>M</td><td>32A</td><td>Value Date/Currency/Interbank Settled Amount</td><td>6!n3!a15d</td><td>6</td></tr><tr><td>O</td><td>33B</td><td>Currency/Instructed Amount</td><td>3!a15d</td><td>7</td></tr><tr><td>O</td><td>36</td><td>Exchange Rate</td><td>12d</td><td>8</td></tr><tr><td>M</td><td>50a</td><td>Ordering Customer</td><td>A or K</td><td>9</td></tr><tr><td>O</td><td>51A</td><td>Sending Institution</td><td>[1!a][34x]<br>4!a2!a2!c[3!c]</td><td>10</td></tr><tr><td>O</td><td>52a</td><td>Ordering Institution</td><td>A or D</td><td>11</td></tr><tr><td>O</td><td>53a</td><td>Sender's Correspondent</td><td>A, B or D</td><td>12</td></tr><tr><td>O</td><td>54a</td><td>Receiver's Correspondent</td><td>A, B or D</td><td>13</td></tr><tr><td>O</td><td>55a</td><td>Third Reimbursement Institution</td><td>A, B or D</td><td>14</td></tr><tr><td>O</td><td>56a</td><td>Intermediary Institution</td><td>A, C or D</td><td>15</td></tr><tr><td>O</td><td>57a</td><td>Account With Institution</td><td>A, B, C or D</td><td>16</td></tr><tr><td>M</td><td>59a</td><td>Beneficiary Customer</td><td>A or no letter option</td><td>17</td></tr><tr><td>O</td><td>70</td><td>Remittance Information</td><td>4*35x</td><td>18</td></tr><tr><td>M</td><td>71A</td><td>Details of Charges</td><td>3!a</td><td>19</td></tr><tr><td colspan="5">----&gt;</td></tr><tr><td>O</td><td>71F</td><td>Sender's Charges</td><td>3!a15d</td><td>20</td></tr><tr><td colspan="5">----|</td></tr><tr><td>O</td><td>71G</td><td>Receiver's Charges</td><td>3!a15d</td><td>21</td></tr><tr><td>O</td><td>72</td><td>Sender to Receiver Information</td><td>6*35x</td><td>22</td></tr><tr><td>O</td><td>77B</td><td>Regulatory Reporting</td><td>3*35x</td><td>23</td></tr><tr><td>O</td><td>77T</td><td>Envelope Contents</td><td>9000z</td><td>24</td></tr></tbody></table>

M = Mandatory O = Optional

Source SWIFT 2005.

The EU has adopted several regulations to promote equal treatment between national and cross-border transactions in euro inside the EU (94) and for anti-money laundering purposes (95). The 2001 Regulation obliges banks to charge equal fees for national and cross-border payments. One mean to achieve these goals is to promote full STP as a mean to achieve equal treatment, competitiveness and transparency.

As a consequence, it is mandatory since 2003 in the EU, that ordering and receiving customers, sending and receiving banks, and any intermediary bank in between are

<footnote n="94">⁹⁴) See Directive 97/5/EC of the European Parliament and of the Council of 27 January 1997, Regulation (EC) n° 2560/2001 of the European Parliament and of the Council of 19 December 2001 for cross-border transactions.</footnote>

<footnote n="95">⁹⁵) See Directive 91/308/EC of the Council of 10 June 2001, and Directive 2001/97/EC of 4 December 2001.</footnote>
clearly identified by a correct IBAN code <sup>(96)</sup> for customers and a BIC code <sup>(97)</sup> for banks. This information are also mandatory in the STP version MT103+. This distinguishes European and non-European transactions because these data are not always present in other parts of the world.

Our point is that it also serves the cause of tax issues in the EU, because it will facilitate the identification of the counterparties who will have to pay the CTT without new legal dispositions and extra-costs.

The new EU Member States and EEA countries have also accepted this European validation rule among other countries. By May 2005, all of them had completed the implementation of the presence of a correct IBAN in MT 103 STP message.

Time indication (O 13C) can also help identifying the transaction. The time indication is necessary if for instance the payment is destined to CLS (code CLSTIME) for which time scheduling is very strict. There may also be the code "RNCTIME", the time at which a TARGET payment has been credited at the receiving central bank, and "SENDTIME" the time at which a TARGET payment has been debited at the sending central bank (expressed in CET). This shows that SWIFT message-types are adapted to European features or to CLS and that TARGET can trace credit transfers.

Instructions (O 23E) can be joined, among them one (code CORT) which specifies that the "payment is made in settlement of a trade, e.g., foreign exchange deal, securities transaction" (SWIFT 2005, p 134). The presence of this instruction proves that it is perfectly possible to include a tag that clearly identifies the transaction as a foreign exchange transaction and even a securities transaction if one wants to extend the transaction tax to securities. These instructions are optional for the present moment but could become mandatory by an amendment to the EU directive on cross border credit transfer. The amendment could specify three options: one to identify the euro leg of a forex transaction, one to identify the euro leg of a security transaction, and one to identify the euro leg of a money transaction.

The same is true for field 26T (Transaction Type Code). "This field identifies the nature of, purpose of, and/or reason for the individual transaction, e.g., salaries, pensions, dividends" (SWIFT, 2005, p 136). This field is also very important because it proves that it is perfectly possible to resolve the potential problem mentioned above, i.e. the confusion between forex transactions and ordinary transactions of corporate customers that have nothing to do with forex transactions.

If this field was mandatory, then TARGET would be able to distinguish between unilateral transactions (transactions with only one leg) in order to tax forex transactions only. It is clearly possible because SWIFT notes that the codes from the Eurostat list "Code list for Balance of Payment Collection Systems" may be used in this field because "the information given is intended both for regulatory and statutory requirements and/or to provide information to the beneficiary customer on the nature of the transaction" (SWIFT 2005, p 136). Once again, this shows that SWIFT standards are flexible and already fitted to EU requirements.

This is for transactions in euros. But what happens when the credit transfer is

<footnote><sup>(96)</sup> The IBAN, the International Bank Account Number, is defined in the official ISO (International Standardization Organisation) 13616 Standard. It provides a unique and automatically processable identification of the bank, branch and account number at an international level. The European IBAN nom was developed by the ECBS (the European Council for Banking Standards) to convert any non-harmonized national account number into a European account number. The customer can thus be identified by the IBAN of the account that it has opened in any bank.</footnote>

<footnote><sup>(97)</sup> The Bank Identifier Code (BIC) is the ISO bank code as defined by SWIFT. It is mandatory for TARGET system participants to use the BIC attributed to them. The list is published by SWIFT on its website. For further details on IBAN and BIC, see ECBS's website, http://www.ecbs.org</footnote>
destined for a country that does not use the euro as the national currency? In this case, there is a more direct and simple possibility to identify a foreign exchange transaction. When a customer instructs a payment for a beneficiary located in a country outside the euro area, then the instructed amount (field 33B) and the settled amount (field 32A) <sup>(98)</sup> will be denominated in two different currencies. In this case, field 36 (exchange rate) is mandatory and not optional. This happens when the ordering customer is located in the euro zone, and the beneficiary customer receives its funds in pounds sterling, Swedish krona, or Norwegian krona, for instance; or in a currency of a new Member State; or in a currency of some other small countries or territories (See box 2-5).

What is interesting in box 2-5, is that field 33B and 36 are new and were incorporated in MT103 design to satisfy the EU demands for more transparency and are called the “EU validation”. It seems as if, involuntarily, the EU had created beforehand the necessary fields to implement the CTT <sup>(99)</sup>. In another document (MT103, “Frequently Asked Questions”), SWIFT explains that:

> "Transparency is increasingly becoming a regulatory requirement. Especially in the European Union (EU), the European Commission and European Parliament are mandating more transparency in cross-border customer transfers. The MT 103 provides the framework to achieve this with a number of new, dedicated fields (e.g. instructed currency and amount, regulatory reporting fields, charging fields, exchange rate, etc.)".

Another useful characteristic is that the same MT103 has been adopted by institutions like EURO1, allowing full compatibility with TARGET. One can also infer that the same data can be found in the messages sent by private clearing and settlement institutions in the EU because they are subjected to the same regulations. In short what is true for TARGET is in great part true for other large-value institutions in the EU, and probably for CLS transactions, as long as EU currencies are concerned.

<footnote n="98"><sup>98</sup> The mandatory field 32A (Value Date/Currency/Interbank Settled Amount) specifies the value date, the currency and the settlement amount to be booked/reconciled at interbank level. This information must be of course present in the MT 202 exchanged by the sending bank and the receiving bank on behalf of their respective customers.</footnote>

<footnote n="99"><sup>99</sup> Field 23E (Instruction code) and 26T (Transaction Type Code) that are also critical for the CTT (see above) are also new fields introduced at the request of the EU and were discussed as others in the “Heathrow Group”, that gathered private bank, SWIFT and EU representatives to conceive the new MT103.</footnote>
Box 2-5 : MT 103: Specific Validation Within EU Countries

32 countries are concerned.

EU validation will be applied on all versions of the MT 103, and is a guarantee that the message contains the instructed currency and amount field 33B.

This validation will apply whatever form of communication (e.g. clearing system, correspondent banking) is used and whenever a MT 103 message is sent between BIC destinations whose country codes belong to the following list:

<table><tr><td>AD</td><td>Andorra</td><td>IS</td><td>Iceland</td></tr><tr><td>AT</td><td>Austria</td><td>IT</td><td>Italy</td></tr><tr><td>BE</td><td>Belgium</td><td>LI</td><td>Liechtenstein</td></tr><tr><td>BV</td><td>Bouvet Island</td><td>LU</td><td>Luxemburg</td></tr><tr><td>CH</td><td>Switzerland</td><td>MC</td><td>Monaco</td></tr><tr><td>DE</td><td>Germany</td><td>MQ</td><td>Martinique</td></tr><tr><td>DK</td><td>Denmark</td><td>NL</td><td>The Netherlands</td></tr><tr><td>ES</td><td>Spain</td><td>NO</td><td>Norway</td></tr><tr><td>FI</td><td>Finland</td><td>PM</td><td>Saint Pierre et Miquelon</td></tr><tr><td>FR</td><td>France</td><td>PT</td><td>Portugal</td></tr><tr><td>GB</td><td>United Kingdom</td><td>RE</td><td>Réunion</td></tr><tr><td>GF</td><td>French Guyana</td><td>SE</td><td>Sweden</td></tr><tr><td>GI</td><td>Gibraltar</td><td>SJ</td><td>Svalbard and Jan Mayen Islands</td></tr><tr><td>GP</td><td>Guadeloupe</td><td>SM</td><td>San Marino</td></tr><tr><td>GR</td><td>Greece</td><td>TF</td><td>French Southern Territories</td></tr><tr><td>IE</td><td>Ireland</td><td>VA</td><td>Vatican City State</td></tr></table>

Note: Some countries requested SWIFT to apply the technical validation due to reciprocity agreements and do not consider that they are bound by all requirements of the EC directive on cross-border credit transfers".

Source: "Why do we move from MT100 to MT103?" on SWIFT website.

Finally, we can observe that EU regulations are accepted by Switzerland and by some tax haven territories such as Liechtenstein and Monaco, but not others such as Guernsey and Jersey, Isle of Man, and Mayotte that are also linked to EC members (the UK and France). Of course these countries would reconsider their acceptance of EU directives if the CTT was adopted by the EU, but it shows that the EU has a sufficient power of persuasion to get some transparency measures adopted by some of these small tax havens. If there was a sufficient political commitment on the part of the EU, these tax havens are so dependent on Europe that they would have to accept the CTT.

The presence of field 33B in the SWIFT message is also particularly interesting in the perspective of an enlargement of the CTT to other countries and continents. It proves that the technical basis already exists for the whole EU and not only for the sole euro area, and also for a universal treaty and not only for the EU.

Another very important point is the presence of field 36 (exchange rate): We have precisely here the technical instrument necessary to implement the two-tier CTT when a customer orders a foreign exchange transaction. If the exchange rate included in the message is outside the band on the date and time of the transaction, then the surcharge is applied to the ordering or beneficiary institution according to pre-agreed rules. This validates technically the Spahn proposal in a very simple way.

Another interesting feature is that SWIFT messages establish very clearly and simply the link between bank-to-customer transactions (the retail market) and interbank transactions (the gross market), because SWIFT needs to calculate the transactions
charges that it will receive. And this gives the solution about how to integrate the tax in the inner payment process of the transaction. Let me present an example given by SWIFT it-self about the possible usage rules regarding transaction charges. Suppose that a bank A in the euro zone wants to send €1000 to a bank B in the UK.

Examples: Transaction A

* Pay the equivalent of EUR 1000,00 in GBP to a beneficiary in the United Kingdom

* Exchange rate is 1 EUR for 0.61999 GBP

* Transaction charges on the Sender's side are EUR 5,00 (=GBP 3,1)

* Transaction charges on the Receiver's side are GBP 4 (=EUR 6,45)

Source: SWIFT 2005, p 126.

There are three charging options: the first is that the ordering customer pays all the charges (charging option "OUR"), the second is that the ordering customer and the beneficiary shares the charges (charging option "SHA"), the third is when the beneficiary pays the charges (charging option BEN). By default, the EU has decided that the option "OUR" prevails. We present this first charging option to show how the MT 103 is affected (See figure 2-20 next page).

The instructed amount (field 33B) is €1000 equivalent to £619.99 credited to the beneficiary but €1011.45 will be debited from the ordering customer equivalent to £623.99 (field 32A) which is the settled interbank amount. The exchange rate, 0.61999 appears in field 36 of the message. If one applies the same rules to collect the tax, one possibility is to increase the sender's charges by the amount of the tax. If the tax is 0.1%, it would cost €1 for an instructed amount of €1000 (to compare with SWIFT charges of €5). The sender's charges would be €6 instead of €5, i.e. an increase of 20%. But it is also technically possible to share the tax between the sender and the receiver. In this case it would cost €0.50 each. Sender's charges would amount to €5.50, a 10% increase, and receiver's charges would amount to €4.5, a 7.8% increase. The third possibility is that the receiver pays the full amount of the tax. Charges would amount to €7.45, a 15.5% increase.

This hypothetical exercise shows again that everything is already in place for the collecting of the tax with a full array of options. All is needed is the inclusion of the tax inside the transaction charges.
<table><caption>Fig. 2-20 : Example: Charging Option is OUR</caption><thead><tr><th colspan="3">a) Amount debited from the ordering customer's account:</th></tr></thead><tbody><tr><td>Instructed Amount</td><td>EUR</td><td>1000,00</td></tr><tr><td>+ Sender's charges</td><td>EUR</td><td>5,00</td></tr><tr><td>+ Receiver's charges</td><td>EUR</td><td>6,45</td></tr><tr><td>= Debit Amount</td><td>EUR</td><td>1011,45</td></tr></tbody></table><p>b) MT 103 extract:</p><table><thead><tr><th>Field Tag</th><th colspan="2">Content</th></tr></thead><tbody><tr><td>33B</td><td>EUR</td><td>1000,00</td></tr><tr><td>71A</td><td></td><td>OUR</td></tr><tr><td>71G</td><td>GBP</td><td>4,00</td></tr><tr><td>36</td><td></td><td>0,61999</td></tr><tr><td>32A</td><td>GBP</td><td>623,99</td></tr></tbody></table><p>c) The subsequent MT 950 shows one debit entry for GBP 623,99, ie, field 32A.</p><p>d) Amount credited to the beneficiary:</p><table><tbody><tr><td>Interbank settlement amount</td><td>GBP</td><td>623,99</td></tr><tr><td>- Receiver's charges</td><td>GBP</td><td>4,00</td></tr><tr><td>= Credit amount</td><td>GBP</td><td>619,99</td></tr></tbody></table>

Source: SWIFT 2005, p 127.

We can now turn to interbank transactions, using MT 202 to check that we also find the necessary data.
### 2.2.5.7 Data included in a message in case of interbank transaction (MT202)

Interbank transactions use "MT 202 General Financial Institution Transfer" messages. These messages are used by sending banks to receiving banks to order the movement of funds to the beneficiary institution. Their format specifications are the following (see Table 2-4, source SWIFT 2005).

<table><caption>Table 2-4 : MT 202 Format Specifications</caption><caption>MT 202 General Financial Institution Transfer</caption><thead><tr><th>Status</th><th>Tag</th><th>Field Name</th><th>Content/Options</th><th>No</th></tr></thead><tbody><tr><td>M</td><td>20</td><td>Transaction Reference Number</td><td>16x</td><td>1</td></tr><tr><td>M</td><td>21</td><td>Related Reference</td><td>16x</td><td>2</td></tr><tr><td>O</td><td>13C</td><td>Time Indication</td><td>/8c/4!n1!x4!n</td><td>3</td></tr><tr><td>M</td><td>32A</td><td>Value Date, Currency Code, Amount</td><td>6!n3!a15d</td><td>4</td></tr><tr><td>O</td><td>52a</td><td>Ordering Institution</td><td>A or D</td><td>5</td></tr><tr><td>O</td><td>53a</td><td>Sender's Correspondent</td><td>A, B or D</td><td>6</td></tr><tr><td>O</td><td>54a</td><td>Receiver's Correspondent</td><td>A, B or D</td><td>7</td></tr><tr><td>O</td><td>56a</td><td>Intermediary</td><td>A or D</td><td>8</td></tr><tr><td>O</td><td>57a</td><td>Account With Institution</td><td>A, B or D</td><td>9</td></tr><tr><td>M</td><td>58a</td><td>Beneficiary Institution</td><td>A or D</td><td>10</td></tr><tr><td>O</td><td>72</td><td>Sender to Receiver Information</td><td>6*35x</td><td>11</td></tr></tbody><tfoot><tr><td colspan="5">M = Mandatory O = Optional</td></tr></tfoot></table>

Source SWIFT 2005.

This information is critical to levy the tax. Field 20 specifies the reference assigned by the sender to unambiguously identify the message. Field 21 (related reference) is especially important. This field contains a reference to the related transaction initiated by the customer. In this case, the field will contain the field 20 sender's reference of that MT 103. This means that it is perfectly possible to identify a forex transaction ordered by a customer (but not necessarily the identity of this customer).

"In all other cases, field 21 will contain a reference to the related transaction which is meaningful to the beneficiary institution, e.g., the common reference in an MT 300 Foreign Exchange Confirmation, field 21 of an MT 202 General Financial Institution Transfer, an MT 205 Financial Institution Transfer Execution or an MT 400 Advice of Payment" (SWIFT, 2005, p 26, we underline).

Again, we can verify that thanks to field 21, it is technically possible to make a clear distinction between forex transactions and financial transactions that are not related to forex transactions. If the reference to MT300 forex confirmation is present, then we can be sure that it is a forex transaction; otherwise it will be another type of transaction.

Field 13C, (time indication) is optional but can be useful because it specifies one or
several time indication(s) related to the processing of the payment instruction as in MT103. It can then give information about the settlement institutions involved. For instance the "CLSTIME" code can be used to specify the time (expressed in CET) by which the funding payment must be credited, with confirmation to the CLS Bank's account at the central bank. Its simple presence indicates a forex transaction is settled through CLS. "RNCTIME" is the time at which a TARGET payment has been credited at the receiving central bank and "SNDTIME" the time at which a TARGET payment has been debited at the sending central bank. It is therefore possible to say precisely when a forex transaction has been settled through TARGET and collect the tax at this precise moment.

Field 32A (Value date, Currency Code, Amount) concerns the currency and amount to be transferred between banks. It is mandatory and important for the CTT and was already present in MT103. Its presence shows that it is perfectly possible to calculate the CTT for forex transactions involving the euro at the interbank level and not only at the customer to bank level.

Field 52A (ordering institution) is optional. It specifies the identity of the ordering institution when different to the sender of the message. The identity is given by the BIC code. It can be used to indicate a national clearing system code such as the Canadian Payments Association Payment Routing Number, the Bank Code of Hong Kong, Fedwire (the US RTGS), or CHIPS (the US private-owned settlement institution), etc. It would be better to have this information, and the EU could decide to make its presence mandatory. But the CTT can be levied even in its absence. By default, the sending bank will have to pay the tax and then will arrange with its customer (the ordering institution) for reimbursement or incorporate the tax directly into its fees.

Fields 53a and 54a are used in case of correspondent banking, but are absent if the sending bank and the receiving bank are two branches of the same global bank for instance. In this case, the two banks have a direct account relationship. But if they are independent, they must specify the counterparty identity with a BIC identifier. Field 53a specifies the account or branch of the sending bank or its correspondent through which the sender will pay the receiving bank. Field 54a specifies the branch of the receiving bank or the correspondent bank at which the funds will be made available to the receiving bank. These fields are useful because correspondent banking is the traditional way to settle a forex transaction and is still important even after the launch of CLS. The presence of these fields allows the central bank to monitor the activity of correspondent banking of European banks and complete its information about forex transactions.

Field 56a (intermediary) is used when a bank, or more usually, a national clearing institution is used as an intermediary between the sending and the receiving bank. For instance the code "//RT" means that an incoming SWIFT payment is being made via real-time gross settlement and the code "//SW" means that the incoming payment comes through the intermediary of the Swiss clearing institution SIC. The code is binding for the receiver if an RTGS is used as an intermediary. This information will be useful to help identify forex transactions coming through foreign clearing or settlement systems and not directly from a sending bank.

Field 57a (account with institution) is almost the same. It identifies the financial institution, which can be a national clearing or settlement institution, which will pay or credit the receiving bank when it is necessary that the payment be made via these institutions or when the receiving bank cannot be identified by a BIC code.

Field 56a and Field 57a guarantees that in any case an intermediate payer or receiver of the transaction is identified. This information helps to establish the payment chain from the ordering institution through to the final receiver. It will be useful to identify transactions that are traded outside the EU but settled inside the EU through intermediaries.
Field 58a (beneficiary institution) specifies the bank that has been designated by the ordering institution as the ultimate recipient of the funds being transferred. It is mandatory information. It means that all banks in the EU receiving funds as the result of a forex transaction can be identified as such and subject to the tax if the share or beneficiary option charges are chosen.

Field 72 (sender to receiver information) specifies additional information for the receiver. An interesting feature is the following: "In order to comply with the EC-Directive on cross border credit transfers, the optional code word "EXCH" may be used to transport an exchange rate." (SWIFT 2005, p 40)

This indication proves two important things:

1. When the EU decides to impose a rule, financial institutions have no choice but to follow and find a technical solution.

2. If it is possible to integrate the exchange rate at which the transaction is made inside the message ordering the settlement, then it proves again that the technical instrument to implement the two-tier CTT is already in place and need not be created as we have seen previously in the MT103 case.

There are nevertheless some difficulties due to the reluctance of the European banking industry to implement the "cross-border credit transfer" regulation adopted in 2001, which stipulates that the IBAN and BIC are mandatory in SWIFT messages in order to improve STP and reduces money laundering practices. The various ECB reports (2001, 2003c) on the creation of a "Single Euro Payments Area" (SEPA) testify how difficult it is to convince private banks to realise the necessary investments to upgrade their internal process to achieve the requirements of EU legislation and a full STP.

The provision of IBAN and BIC to the customer has become mandatory with the regulation, but the regulation does not make the use of BIC and IBAN mandatory in payments systems (see ECB, 2003c, p 14). It is an absurdity that can be only be explained by undue concessions to the banking industry. The use of IBAN and BIC should be made mandatory in the use of all payment systems not only for tax issues, but also for anti-money laundering issues.

As far as TARGET is concerned, MT103 and MT103+ are the only message-types accepted for customer cross border transfers. But MT103 can be filled out manually, thereby allowing the absence of the IBAN and BIC of the beneficiary. This drawback seems to be on the way to resolution. According to the ECB (2005, p 18), the use of MT103 and especially its STP version MT103+ is growing strongly recently and these forms require the presence of the IBAN and BIC of the beneficiary's institution.

"In 2004, the share of MT103+ in TARGET inter-Member State customer payments increased from 27% in the first quarter to 40% in the fourth quarter. In the first quarter of 2003, however, the share was only 5%" (ECB, 2004, p 18). Pan-European STP is progressing to the benefit of the CTT project.

We hope that this detailed analysis of SWIFT messages have convincingly proved that it is possible to collect the two-tier CTT in the EU without any supplementary investment by simply using what already exists.

Two final arguments will be presented to demonstrate, we hope definitively, that the CTT is enforceable: The first concerns the creation of a European single market for securities transactions. The EU has dedicated a lot of effort to promote this objective together with the SEPA. What is of interest for the CTT is first that securities are still subject to transaction taxes in a few European countries, and second that the objective is to create a pan-European settlement system for securities. Securities transaction taxes (STT) are in this context, collected at the point of settlement. For sure, it is of interest for the CTT, the STT cousin.