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LONDON (Reuters) - Bankers are confident they can persuade the European Union that its proposed financial trading tax poses enough risks to struggling economies and banks to warrant being watered down.
Their campaign against the tax, which will be imposed by 11 of the EU's 27 countries, focuses on how much it would boost the cost of funding for governments and companies, erode returns earned even by long-term investors, and hurt funding markets which are crucial to the health of the financial system.
Advocates of the financial transaction tax say it is small enough and covers enough assets not to distort markets while ensuring banks, which received taxpayers' cash during the financial and euro zone crises, make a contribution to the public coffers as governments try to rein in budget deficits.
Their arguments have struck a chord with public opinion, particularly in those European countries where unemployment has been rising, social welfare has been cut and wages have stagnated or fallen due to government austerity measures.
But bankers say the impact of the levy will be felt far beyond the financial sector if the EU sticks to its plan to tax buyers and sellers at each stage of every trade that is either transacted by someone in one of the countries imposing the tax or involves an asset issued by an institution based there.
"I think that the impact is so dramatic, I would be astounded if it passes in its current form," Remco Lenterman, chairman of the FIA European Principal Traders Association said.
"I would almost theorize that if they pass and implement it in its current form, they would have to cancel it after a three- to six-month period as markets would become so dysfunctional that you would have to revert back."
The European Commission declined to comment. Financial regulation is often changed in the process of negotiations.
Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia, and Slovakia have said they will levy the tax. The Commission says revenues from the tax are expected to total up to 35 billion euros a year, or 1 percent of the total tax revenues of the participating countries.
It is still unclear how the tax would be collected in EU countries which won't levy it - a group that includes Britain, which has the region's biggest financial center.
Bankers are stepping up lobbying of the European Commission and countries which will impose the levy to explain how a tax of 0.1 percent on stocks and bonds and 0.01 percent on derivatives could have such a seismic impact.
One of their oft-cited examples is how much the tax would add to the cost of a transaction which involves one investor selling a bond and another buying it.
Because such a trade typically involves dealers and brokers as intermediaries between investors, the tax could be levied 10 times, with the same dealer or broker sometimes being taxed twice -- once for buying the bond and again for selling it on -- as well as each time a position is hedged to mitigate risk.
Banks therefore expect the tax to depress trading volumes, which will hurt the profits they make from such business. And they expect to pass higher trading costs on to clients.
"They say this is a tax on the financial sector but we pass on the tax to clients," said a London-based banker responsible for derivatives trading who spoke on condition of anonymity.
"Investors end up paying the tax, either through a direct charge or because market-makers are not market making anymore so bid/offer spreads widen and transaction costs rise."
That is unlikely to sway the European Commission or those who signed up for the tax given one of their intentions was to deter financial trading which does not contribute to the efficiency of markets or to the economy.
The Commission has said the levy targets transactions which take place between financial institutions but that it would not be "disproportionate" if some of the costs were passed on to consumers.
But rising trading costs are expected to prompt investors to demand higher returns. The impact this could have on government and corporate borrowing costs, and therefore the economy, may end up being persuasive.
For example, a Bank of America Merrill Lynch study published in March said the tax could add as much as 8.5 billion euros to the combined cost of annual debt interest payments of Germany, France and Italy in the first year.
It would also affect corporate bonds.
Consulting firm London Economics said the per-transaction impact of the tax, as a percentage of bond returns, would average between 6.2 and 12.8 percent for corporate borrowers from the countries which impose the levy.
"Our view remains that the tax is highly unlikely to be implemented in anything like its current form," the Bank of America Merrill Lynch research note on the tax's impact said.
"(We) think such a tax would increase borrowing costs noticeably, increase financial risks and crimp the availability of finance to the 'real economy', as well as damaging monetary policy transmission mechanisms."
The Commission's own report on the potential impact of the trading tax estimates it could shave 0.28 percent off gross domestic product in the long run. But it said that imposing the tax "will not negatively impact growth or jobs".
Still, bankers say a potential drag on growth is the last thing highly indebted euro zone countries need as they try to revive economic activity and, either avoid international bailouts, or exit such bailouts.
"I will eat my hat if this tax comes in as proposed on January 2014," said David Lewis at Astec Analytics, which specializes in information on securities borrowing and lending.
"For politicians it's gold, but it's the wrong thing at the wrong time. In the current economic environment we should be freeing up the market, reducing costs and making things easier".
Politics is expected to determine when and by how much the financial trading tax is eventually amended.
Five bankers and six financial industry bodies contacted by Reuters pinpointed the German parliamentary elections, scheduled for September, as a key watershed.
"It is ... unlikely that the proposal - in its current form - will survive," said Judith Hardt, secretary general of the Federation of European Securities Exchanges.
"Some lobbyists in Brussels say that part of the initiative is driven by the upcoming German elections. Some assume that the urgency of getting results quickly will diminish after the elections."
Writing by Swaha Pattanaik, editing by Giles Elgood