One of London's biggest market-makers, who did not want to be named, said yesterday: "I have never seen the volatility in the UK equity market that we have seen in the last 48 hours." He blamed an obscure clause in the Budget which removes tax exemption for dividends held by banks for trading purposes.
The clause has prompted a scramble by tax advisers to work out the implications for City investment banks, many of whom own equity books worth hundreds of millions of pounds.
The market-maker continued: "Some of these banks have enormous books and they have to be revalued downwards. It is a material hit in some cases." Some analysts said the Budget tax changes could cost the banking sector more than pounds 1bn.
Traders have rushed to rebalance their equity and derivative portfolios since Wednesday's Budget in an attempt to reduce losses arising from long-term fixed-income contracts with building societies and insurance companies.
These contracts provide building societies and insurance companies with a guaranteed income stream, typically over five years, high enough to pay out on customer policies which guarantee returns linked to stock market performance. "They [the banks] had to buy shares to rebalance their portfolios to compensate for a fall in dividend income due to tax cuts," one source said yesterday.
The bank takes on the risk of providing this guaranteed income stream in return for a fee. To hedge its risks the bank would normally invest in a basket of FTSE 100 stocks and a series of complex financial instruments, including futures and options.
The Budget tax changes will hit the banks in two ways. First the dividend income received from the equities they hold will drop by 20 per cent. Secondly the price of futures and options contracts taken out by the bank are based on assumed income from shareholdings. The tax changes mean that the banks have been saddled with mispriced derivatives. "Undoubtedly this is a problem. They will have to revalue their derivatives books," said an analyst yesterday. It is thought this alone could cost up to pounds 400m.
The market in these guaranteed bonds has exploded in recent years with a host of new products hitting the high street, and it is now estimated to be worth at least pounds 2bn. "The key players in the market are UBS, BZW and NatWest. Other banks such as J P Morgan and Midland are involved. Together they have mopped up virtually all of the business," said one source. Each of these banks stand to lose millions of pounds, and individual losses could rise as high as several hundreds of millions of pounds, another source suggested.
The Inland Revenue's decision to clamp down on a tax scam exploited by market-makers will cost banks well in excess of pounds 100m a year. Market- makers had been buying huge amounts of shares in companies that were just about to pay dividends. When the shares went ex-dividend their price would duly fall. Not only could the bank set this price fall against future profits, but it would receive the dividend and an associated 20 per cent tax credit that could be used to reduce its tax bill at a later date.
The Inland Revenue confirmed that its reforms, which are projected to yield pounds 500m by 2001, would affect all market-makers. Any banks holding preference shares are also likely to be hit.
The Inland Revenue is understood to be determined to push these tax reforms through to deter companies marketing a range of new financial products specifically designed to avoid tax.
The tax changes will probably lead to a rise in prices of guaranteed income policies. Existing policy holders will not be affected.
How the market-making tax scam worked
The market-maker buys shares just before dividends are due to be paid to shareholders
After securing the dividend, the market maker then sells the shares, establishing a loss on the transaction. This is because the price invariably falls to compensate for the fact that the shares have gone ex-dividend. That price fall is then treated as a trading loss and written off against the bank's corporate tax bill
The market-maker receives the dividend, which up until the Budget would have been treated as exempt from corporation tax. It has thus established a fictitious loss. Furthermore, the tax credit on the dividend payment of 20 per cent, although not paid, could be offset against the market maker's future corporation tax liability, thus further reducing any tax paid
Market makers have factored these tax breaks into the pricing of equity option contracts used by building societies and insurance companies to offer investors guaranteed returns. "Guaranteed" return funds have become a popular form of saving with retail investors over the last two years. Some of these options will now have to be re-hedged through the stock market to make up the shortfall in dividend incomeReuse content