occasional paper series no. 1 · july 2000 · ecb occasional paper series no. 1 • july 2000 5...

E U R O P E A N C E N T R A L B A N K

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No. 1

THE IMPACT OF THE EUROON MONEY AND BOND

MARKETSBY

JAVIER SANTILLÁN,MARC BAYLE AND

CHRISTIAN THYGESEN

July 2000

OCCASIONAL PAPER SERIES

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No. 1


MARKETSBY


CHRISTIAN THYGESEN

July 2000

© European Central Bank, 2000

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All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

ISSN 1607-1484

3ECB Occas i ona l Pape r Se r i e s No . 1 • J u l y 2000

Foreword 5

Introduction 6

Executive summary and main conclusions 7

I The euro money market 11

I.1 The interbank unsecured and repo marketsI.1.1 Consequences of the Eurosystem’s operations for the market 12

I.1.1.1 Number of bidders participating in MROs 13I.1.1.2 Bidding behaviour 13

I.1.2 Main developments in the unsecured and repo markets 14I.1.2.1 Trading volumes 14I.1.2.2 Degree of integration 16I.1.2.3 Cross-border transactions 18

I.1.3 Functioning of the market 19I.1.3.1 Liquidity, volatility and bid-ask spreads 19I.1.3.2 Market participants and the process of cash management

centralisation 21

I.2 Derivative segments 22I.2.1 Futures markets 23I.2.2 Interest rate swap market 24

I.3 The market for Treasury bills and other short-term securities 25I.3.1 Primary markets 26I.3.2 Amounts outstanding 28I.3.3 Secondary markets 29I.3.4 Microstructure of the market and liquidity 32I.3.5 Changes in the use of short-term paper as collateral in monetary policy

operations 33

II The euro bond market 35

II.1 The demand side: developments in investment behaviour 36II.1.1 Investment diversification 37

II.1.1.1 Geographical diversification within the euro area 37II.1.1.2 Diversification into other asset classes 39II.1.1.3 Changes in the use of indices 40II.1.1.4 Remaining impediments to diversification and integration 40

Contents

ECB Occas i ona l Pape r Se r i e s No . 1 • J u l y 20004

II.2 The supply side: developments affecting issuer behaviour 42II.2.1 Government bonds 42II.2.2 Supranational and government agency issues 45II.2.3 Corporate bonds 46II.2.4 Asset-backed and structured products 48

II.3 Developments in secondary markets 49

II.4 Bond-related derivatives markets 49II.4.1 Futures 49II.4.2 Swaps 50II.4.3 Bond repos 51II.4.4 Credit derivatives 51

II.5 Market participants 51

III Infrastructure of the market 53

III.1 General framework 53III.1.1 Trading in the euro securities market 54III.1.2 Matching, netting and clearing houses in the euro securities market 55III.1.3 Settlement in the euro securities market 56III.1.4 Legal environment 57

III.2 Barriers to integration 57III.2.1 Availability of cross-border settlement on a DVP basis 58III.2.2 Lack of a uniform legal framework 59III.2.3 Lack of common practices concerning settlement procedures 60III.2.4 Lack of harmonisation in the collateralisation process between

central bank and interbank operations 60III.2.5 Heterogeneity in fiscal regimes and regulation 62III.2.6 Need for a clearing house 62

IV List of annexes

Annex 1 Glossary 65

Annex 2 The ESCB market surveys 69

Annex 3 Evolution of the bid-ask spreads in the Italian MID (“MercatoInterbancario di Depositi”) since the introduction of the euro 71

References 73

European Central Bank Occasional Paper Series 77


Foreword

This is the first issue in the Occasional PaperSeries of the European Central Bank (ECB).This new communication tool is aimed atpresenting policy-relevant topics to a wideaudience, including other policy-makers,academics, the media and the general public.

Occasional Papers will be longer than articlesin the ECB Monthly Bulletin and will thereforeallow for a more elaborate analysis. They willbe able to serve as a future source ofreference and make public material used bythe ECB and the Eurosystem. OccasionalPapers will always contain work carried outby ECB staff and will be published in thename of the authors. They are, as it were,part of the background to the decision-makingprocess. The ECB as an institution need not,therefore, subscribe to (all) the viewsexpressed by the authors. In other words,there will always be a disclaimer.

By contrast with ECB Working Papers,Occasional Papers are not intended topresent original contributions to economictheory. Of course, authors may, and oftenwill, use old and new economic theories andempirical methodologies to present theirresults or to underpin their conclusions. Theanalysis aims to be both sound andcomprehensive.

ECB Occasional Papers will be published onour website and will also be available inhard copy. This new series fills a gap inour publications framework. The publicationof Occasional Papers is yet anotherdemonstration of the ECB’s policy of beingas open and transparent as is both possibleand responsible. I am confident in the hopethat these Occasional Papers will find theirway to many interested readers.

Dr. W. F. Duisenberg


Introduction

The Eurosystem has a keen interest in thedevelopment of financial markets and, inparticular, in full advantage being taken of allthe potential benefits resulting from theintroduction of the euro.

In the second half of 1999, with the aim ofmaking a first assessment of the level ofintegration and efficiency of the euro areamoney and bond markets after theintroduction of the euro, the EuropeanCentral Bank (ECB) and the national centralbanks (NCBs) of the European Union carriedout within the Market Operations Committee(MOC) an analysis of the functioning of thesemarkets, based on a set of studies on moneyand bond markets. Moreover, an analysis bothof the infrastructural developments and ofbarriers to market integration in the euroarea has been conducted by the SecuritiesSettlement Systems Policy Division of theECB and discussed in the Payment andSettlement Systems Committee. The moneymarket study was co-ordinated by ElisabethPauly of the Banque de France and JavierAritzegui of the Banco de España, and thebond market study by Jos Heuvelman of DeNederlandsche Bank. The groups preparingthese studies included representatives fromsix NCBs (the Banca d’Italia, the Banco deEspaña, the Banque de France, the DeutscheBundesbank, the Nationale Bank van België/Banque Nationale de Belgique and DeNederlandsche Bank) and from the ECB, andwere finalised in December 1999. This Paperwas prepared by Javier Santillán (Sections Iand II) and Marc Bayle and Christian Thygesen

(Section III) of the ECB.1 This Paper draws toa large extent on these studies and has beencomplemented by data collected by the ECBand other sources, in order to provide amore complete picture. Its aim is to presentan overview of the euro area money andbond markets as they stood around a yearafter the introduction of the euro, and topoint out a number of fields in which furtherintegration can be achieved. The contributionof this Paper to the discussion of financialmarket developments in the euro area islimited in several respects: first, its approachis descriptive rather than analytical; second,it only looks in a thorough way at the bulk ofthe money market, while the treatment ofthe bond and the repo markets is lessdeveloped, and other parts of the financialmarkets, for instance the equity market, arenot covered at all; third, the period ofobservation is much too short to derivedefinitive conclusions; and, fourth, while theimpact of the introduction of the euro hasobviously been a major catalyst for change,no systematic attempt is made to distinguish,within the developments identified, betweenthose resulting from the introduction of theeuro and those which would have taken placein any case.

1 The comments received from Denis Blenck, Peter Bull, VítorGaspar, Gert Jan Hogeweg, Lex Hoogduin, Klaus Löber, ArnaudMarès, Francesco Papadia, Daniela Russo, Antonio Sáinz deVicuña, Jean-Louis Schirmann and the anonymous referees ofthe ECB Occasional Paper Series as well as the comments andtechnical support provided by Maria Encío and Marco Laganá,are gratefully acknowledged. Any remaining errors are the soleresponsibility of the authors. The views expressed by the authorsdo not necessarily reflect those of the European Central Bank orthe European System of Central Banks.


The Eurosystem has a keen interest in thedevelopment of financial markets and, inparticular, in full advantage being taken of allthe potential benefits resulting from theintroduction of the euro. A key requirementfor the efficient achievement of the primaryobjective of the European Central Bank(ECB), namely the maintenance of pricestability, is for monetary policy impulses tobe transmitted in a smooth and homogeneousway throughout the euro area by means ofefficient and integrated money and bondmarkets. This Paper mainly aims to contributeto the debate as to whether or not the levelof integration of the euro money and bondmarkets is appropriate. It may also provide apreliminary contribution to other broaderdiscussions, such as the gains in efficiency ofthe euro area financial system in relation toEconomic and Monetary Union (EMU).

The first two chapters of this Paper describedevelopments in money and bond marketssince the introduction of the euro. A thirdchapter analyses the market infrastructureand the barriers restricting the integration ofthose markets, as well as some possibleactions to improve the situation. Two maincaveats to the discussion stem from the factthat, on the one hand, the period ofobservation is too short for a definitiveassessment of the structural developmentshighlighted in the Paper, and, on the other,no systematic attempt is made to makea distinction, within the developmentsidentified, between those resulting fromthe introduction of the euro and thosewhich would have taken place in any case.Still, the evidence collected suggests that theeuro is having profound effects on theEuropean financial markets, with pervasiveconsequences not only on their functioning,but also on their contribution to the overallefficiency of the economic system.

The euro money market

As far as the euro money market isconcerned, the situation prevailing at the startof Stage Three of EMU in the various

Executive summary and mainconclusions

segments of the market varied with regard totheir potential integration, owing to both thedifferent nature of the instruments exchangedand institutional peculiarities. Accordingly, thegains in terms of integration, efficiency andliquidity achieved in each of the marketsanalysed here during the first year of StageThree of EMU also varied. In the cash andderivative money markets, the introductionof the euro and the new monetary policyframework triggered major developments,leading to a much more advanced degree ofunification and standardisation. This is exactlywhat one would have expected from theintroduction of a common currency.

In broad terms the money market performedits main function efficiently, namelyredistributing the liquidity allocated by theEurosystem to its counterparties in monetarypolicy operations throughout the euro area.Hence, as far as the wholesale market forinterbank liquidity is concerned, there wereno significant distortions which could haveprevented the monetary policy transmissionmechanism from working smoothly, and atleast some of the potential efficiency gainsderived from the increased scale of the moneymarket have already been achieved. Signs of agood degree of integration were apparentfrom several sources, including marketparticipants’ responses to the market surveysconducted by the European System of CentralBanks (ESCB); the smooth and balancedpattern of the use by the Eurosystem’scounterparties of its standing facilities, whichshowed no geographical distortions; and theefficient arbitrage of short-term interestrates. The significant increase in cross-bordertransactions in the euro money market sincethe start of Stage Three of EMU points in thesame direction.

Liquidity improved in the unsecured and reposegments of the money market comparedwith the situation prevailing in the formerdomestic markets. As a rule, contract sizesrose sharply. The unsecured and swapsegments melted quickly into a single marketmainly on account of the success of euroarea indices (the EONIA and the EURIBOR)


and the efficient functioning of TARGET.Although less integrated, the repo marketalso underwent significant developments,while the market for short-term securitieslagged behind in terms of both integrationand the degree of development. This mayhave been caused by differences in thedevelopment of the infrastructure supportingthe different market segments. In 1999 tradedvolumes in the unsecured and repo marketsexpanded globally compared with 1998. Bycontrast, the volume of foreign currencyswaps declined owing to the disappearanceof cross-currency trading among the eurolegacy currencies. However, the jointexpansion of unsecured and securedtransactions exceeded the decrease in thetrade in foreign currency swaps. The growthof the unsecured segment of the market wasparticularly concentrated in overnighttransactions. For longer maturities, repotransactions seemed to be preferred tounsecured transactions. Euro-denominatedmoney market derivatives such as swaps andfutures experienced a process of quickstandardisation and integration and theirdepth increased substantially, while over-the-counter transactions diminished.

In the market for short-term securities,privately issued securities overtook the short-term government paper market. The issuanceand the amount outstanding of Treasury billsdeclined, but this decline was more thanoffset by the increase in the amountoutstanding of euro-denominated privatesecurities. The markets for short-termsecurities within the euro area remain ratherfragmented. In these markets, the behaviourof investors, who are barely active in thesecondary market, tends to restrain liquidity.However, some signs of integration in theprivate paper segment of the market havebeen observed.

The joint effect of the single monetary policyand the consolidation and merger processunder way in the European banking sectorhas fostered the concentration andreorganisation of cash management and, morebroadly, of money market activities. In the

money markets some major players, whichhad previously focused on their domesticmarket or on the most active Europeanmarkets, naturally extended the scope of theiractivities to the whole euro area.

The euro bond market

As far as the euro bond market is concerned,technical aspects of the start of Stage Threeof EMU, such as the re-denomination andre-conventioning of bonds denominated inthe euro legacy currencies into euro-denominated bonds, worked smoothly andwere hardly seen as an issue by marketparticipants.

While the pace of EMU-driven developmentsin the bond market can be expected to beslower than in the case of the money market,evidence available so far indicates that verysignificant changes took place or were underway just a year after the start of Stage Three.Major changes in the European bond marketwere expected as a result of the combinationof economies of scale and increasedhomogeneity. Such changes included supply-side innovation, in the form of innovativecompetition with regard to issuing techniquesand some aspects of secondary marketorganisation, and increased diversification ofbonds’ portfolios through the euro areadriven by investor demand.

Indeed, the combination of these factors gaverise to significant results in several fields: themarket became bigger and more integratedand the average size of individual issuesincreased; the sovereign bond segmentbecame more homogeneous and signs ofincreased integration were perceived in othersegments; private issuer activity overtook thatof sovereign issuers, which had traditionallydominated the bond market; the process ofincreased diversification of investors’portfolios initiated before the start of StageThree of EMU intensified; some signs ofincreased opportunities for access to thecapital markets by new sectors of theeconomy formerly absent from them (in


particular small and medium-sized enterprisesand high-growth corporations) wereobserved; and secondary market liquidityimproved. The trading volumes of euro-denominated bond futures contracts haveincreased dramatically since the beginning of1999. The euro-denominated issuance ofinternational bonds in 1999 was higher thanUS dollar denominated issuance. However,despite the substantial progress made in thefirst year of Stage Three when compared withthe US corporate bond market, that of theeuro area still lags behind with regard toliquidity and market completeness, and somemarket segments remain underdeveloped,particularly those for lower credit ratings andnon-rated debt. The overall size of the marketis still relatively small in comparison with theUnited States.

Overall, the euro bond market is starting tobecome an important source of finance forthe private sector and, in particular, forcorporations, thus complementing thegrowing role played by the short-termsecurities market in this same respect.Virtuous interaction between many of theabove-mentioned factors could ultimately beexpected to bring about a reduction in thecosts of financing through the euro capitalmarket.

As in the case of money market activities,most financial intermediaries active in thebond market carried out the internalreorganisation of their bond trading desks toadapt them to a euro area-based approach.

The euro money and bond marketinfrastructure

This Paper describes the main features of theinfrastructure of the euro money and bondmarkets and identifies and analyses the mainbarriers to the integration of the markets.Most of the barriers identified do not seemto be specific to these markets, but concernthe integration of the euro securities marketinfrastructure more generally. It is alsoacknowledged that the infrastructure alone

cannot explain the varying degrees ofintegration in the different markets. Time willbe needed to change business practices andto agree on and implement new partnerships,as well as to take full advantage of the newpossibilities available.

Special attention is paid to thesecurities trading, clearing and settlementinfrastructure, which is still predominantlydomestic with very few truly euro areastructures. So far, the euro area hasbecome a “domestic” market without its“domestic infrastructure”. A more harmonisedinfrastructure would also ensure a levelplaying-field for market participants providingequal access to all euro area collateral.

In particular, this Paper identifies someactions aimed at enhancing the integration ofthe securities market infrastructure and,therefore, at increasing the integration ofeuro money and financial markets.

First of all, the development of cross-bordersettlement structures either in the form ofefficient links between securities settlementsystems (SSSs) or through cross-bordermergers is still under development. The firststep would be the establishment of linksbetween the systems which should be able toensure the synchronised intraday settlementwith finality of both the securities side andthe payment side of securities transactions(intraday delivery versus payment – orDVP – links).

A fully compatible and more standardisedlegal framework and documentation forthe interbank and central bank repomarkets would help to integrate further themarket for collateralised operations. Thehomogenisation of practices in securitiesmarkets (including fiscal regimes andregulation) should also be encouraged.

The effect of the lack of harmonisation inthe SSSs’ procedures – in particular fortransactions involving repos and debtinstruments – should be further documentedand analysed, and the areas in which the


further harmonisation of clearing andsettlement procedures is necessary shouldbe identified. In the same vein, the effect ofthe lack of harmonisation between centralbank procedures for collateralisation shouldbe analysed further and initiatives toharmonise practices may be necessary.

Finally, market integration should benefitfrom the emergence of a more efficientclearing function in the euro area. The optimalsolution seems to be for a global clearing

house providing services to all the SSSs andfocusing its activity on the clearing ofoperations other than intraday operations.

It will be up to the market participants andservice providers to come up with the mostefficient solutions for the integration of theinfrastructure and, thus, of the markets.Increasing awareness of the issues at stakeand describing and analysing the possiblesolutions represent ways of promoting thiscommon aim.


Before Monetary Union, much curiosity anddifferent points of view surrounded the effecton financial markets of the introduction ofthe euro. As regards the money market,attention focused, in particular, on questionssuch as how smoothly the money marketwould integrate after the start of Stage Threeof Economic and Monetary Union (EMU),whether money markets would perform theirrole efficiently in the monetary policytransmission process, and to what extentEMU would affect the efficiency of the euromoney market compared with that of thepredecessor money markets. The question ofmoney market integration is seen as aprecondition for the smooth and homogeneoustransmission of the monetary policy impulsesthroughout the euro area which, in turn, fulfilsa necessary condition for the efficientachievement of the primary objective of theEuropean Central Bank (ECB), namely themaintenance of price stability. Indeed, anintegrated money market is necessary for thedistribution of liquidity among creditinstitutions throughout the euro area and,thus, for the conduct of the single monetarypolicy. In turn, the integration of the moneymarket interacts virtuously with thefunctioning of large-value payment systems ingeneral, and TARGET in particular, therebycontributing to the fulfilment of therequirement of the Treaty establishing theEuropean Community to ensure the smoothfunctioning of payment systems.

A definitive answer to these questions willonly come after some time, with the gradualaccumulation of empirical evidence on theeffects of the introduction of the euro. Thissection aims at providing some evidence bydescribing the developments which havetaken place in the money market since theeuro was introduced.

The most significant segments of the moneymarket are examined here, namely theunsecured deposit market (where creditinstitutions exchange short-term liquiditywithout the guarantee of collateral2 ); therepo market (in which market participantsexchange short-term liquidity against

I The euro money market

collateral), the swap market (in which fixedinterest rate payments are exchanged forfloating interest rate payments), the futuresmarkets for short-term instruments, and themarkets for short-term securities, includingTreasury bills, commercial paper (CP),certificates of deposit (CDs) and other assets.

As will be seen, at the start of Stage Three ofEMU, the condition of the various moneymarket segments differed greatly with regard totheir potential integration, owing to the differentnature of the instruments exchanged, as well aspeculiarities regarding market participants andother institutional factors.

The gains in terms of integration, efficiencyand liquidity achieved in each of the marketsanalysed following the introduction of theeuro depend on a number of factors such as:the degree of proximity of each marketto monetary policy implementation; thestructure of the market (i.e. mainly interbankversus a customer-oriented structure,centralised versus an over-the-counter –OTC – or non-centralised structure); itsrelative complexity (i.e. the number andnature of instruments traded and marketparticipants); infrastructural developments;and a number of regulatory, institutional andhistorical features.

In the cash and derivative money markets,the introduction of the euro and the newmonetary policy framework have eithertriggered or accelerated some majordevelopments, leading to a high degree ofunification and standardisation. Some of thedriving forces underlying such processes werealready in place in 1998, in view of theprospective transition to Stage Three of EMU,but the introduction of the euro clearlyfostered them. Signs of integration in themoney market are evident from severalperspectives: a first indirect indication isfound in the pattern of the use by marketparticipants of the Eurosystem’s lending anddeposit facilities since the start of Stage

2 Annex 1 contains a glossary explaining the technical terms usedin this Paper.


Three. Simultaneous recourse to bothfacilities has occurred only exceptionally,barring the very early days of Stage Three,which can be seen as an indicator that thereare no major integration-related problems inthe euro money market (see Section I.1.2.2);on the prices side, the dispersion ofshort-term interest rates (EONIA) prevailingamong euro area countries has been minimalsince early 1999. Interviews with marketparticipants in the context of the marketsurveys3 of the European System of CentralBanks (ESCB) showed that, by the end of 1999,the prevailing feeling was that the moneymarkets were fairly well integrated, especiallyin the unsecured and swap segments.Although less integrated, the repo marketalso underwent significant developments,while the market for short-term securitieslagged behind, remaining more fragmentedand less developed.

Overall, the money market efficientlyperforms its function of distributing liquidityamong the various regions of the euro areaor, more relevantly, among the thousands ofMonetary Financial Institutions active in theeuro area. Hence, as far as the wholesalemarket for interbank liquidity is concerned,there were no significant distortions which

could have prevented the monetary policytransmission mechanism from workingsmoothly. However, at least some of thepotential efficiency gains derived from theincreased scale of the money market in termsof enhanced liquidity and depth havealready been achieved. Thus, the ECB canconcentrate its attention on estimating theamount of liquidity needed, at the aggregatelevel, in the euro area as a whole.

However, as shown in this study, theintegration and standardisation of the moneymarket are not yet complete, and furtherevolution can be expected. The solution tosome of the problems will require the activeinvolvement of market participants andauthorities. This is particularly the case forthe repo market, which, by virtue of its verynature, suffers from all the impediments tounification still in play at the different phasesof negotiation and settlement. Indeed,advances in the infrastructure and legalframework require the contribution of boththe public sector and the private sector. Inparticular, the implementation of an efficientlink between SSSs, the unification of legaldocumentation and the homogenisation ofpractices in the bond market are needed toenhance integration further.

1.1 The interbank unsecured and repo markets

This section focuses primarily on the majorchanges brought about by the introduction ofthe euro and by the implementation of asingle monetary policy on the interbankunsecured and repo markets. Specifically, theconsequences of the Eurosystem operationsfor these segments of the money market aredealt with in Section I.1.1. Section I.1.2describes developments in the unsecured andrepo markets such as the evolution of tradingvolumes, the degree of integration and cross-border transactions. Section I.1.3 describesthe functioning of the market.

1.1.1 Consequences of theEurosystem’s operations for themarket4

Since the start of Stage Three of EMU, theEurosystem has been providing liquidity to itscounterparties on the basis of the globalrefinancing needs of the euro area,independently of the liquidity situationprevailing in each country. This implies that,normally, the amounts allotted to banks in

3 Several market surveys of both a quantitative and a qualitativenature were conducted by the ESCB in the context of the studiesreferred to in the Foreword, see Annex 2 for details.

4 Some discussions on the effects of the single monetary policy onthe money market in various euro area countries can be foundin Ayuso et al. (2000); Banque de France (1999); and DeutscheBundesbank (2000); a general, although preliminary review maybe found in Santillán (1999).


individual countries do not exactly matchtheir refinancing needs. The local liquidityimbalances resulting from this situation havecontributed to a significant increase in cross-border transactions in the euro moneymarket since the start of Stage Three. Withinthis general framework, two specific featuresmay improve understanding of the context inwhich money market integration has beendeveloping since the start of Stage Three,namely the number of bidders participating inthe Eurosystem’s tenders and the biddingbehaviour of the Eurosystem’s counterparties.

1.1.1.1 Number of bidders participating inMROs

Overall, the number of bidders participating in themain refinancing operations (MROs) decreasedin 1999 compared with the sum of thoseparticipating in the regular operations conductedin the second half of 1998 by the national centralbanks (NCBs) currently forming the Eurosystem.Several factors explain such a development:

• Organisational changes implemented bysome banks located in the euro area,whereby their cash management and theiroperations with the Eurosystem areconcentrated at a single location (this isdiscussed further in Section I.1.3.2).

• New infrastructure requirements, such asthe condition of having access to a real-time gross settlement (RTGS) system orthe Eurosystem’s tendering systems, havein some cases discouraged small ormedium-sized banks from participating inthe Eurosystem’s operations.

• The ongoing restructuring process inthe banking sector, i.e. mergers andacquisitions, is tending to reduce thenumber of potential bidders.

• Uncertainty about the amount that eachcounterparty will actually receive in the MRO inthe fixed rate tenders conducted until21 June 2000 may also have deterred somecounterparties from participating in the tenders.

The lower number of bidders alone hasincreased the need to redistribute liquidityamong euro area market participants, even ifthe number of those participating in themonetary policy operations remains verylarge in comparison with the situationprevailing in the United States, for instance.

1.1.1.2 Bidding behaviour

Compared with the second half of 1998, animportant increase in the amount bid bycounterparties took place in all euro areacountries in 1999, resulting in lower allotmentratios in MROs compared with thoseprevailing in the tender operations conductedby individual euro area NCBs prior to StageThree. In some countries the increaseobserved in the amount of bids posted bycounterparties was more than 200%.

To a small extent the increased bids werethe result of greater refinancing needs on thepart of banks. These, in turn, have essentiallyincreased for two reasons, namely thesignificant increase in the level of reserverequirements in some countries (such asFrance and the Netherlands) and the fact thatsome refinancing facilities were discontinuedwith the changeover to the euro. In Germany,in particular, the discount facility existingbefore Stage Three provided approximatelyone-third of the liquidity needed by thebanking sector.

The most important factor, however, inexplaining the increase in the bid amountwas a change in bidding behaviour ofthe Eurosystem’s counterparties.5 Thiswas affected, in turn, by a number ofconsiderations:

• In fixed rate tenders (used throughout1999 for MROs), participants have to guessthe allotment ratio (i.e. the ratio betweenthe actual allotment and the bids

5 No systematic discussion is attempted here of the issue ofbidding behaviour and the overbidding phenomenon. Bindseiland Mercier (1999) or Nautz and Oechsler (1999) providediscussions of this issue.


submitted) in order to forecast the amountof liquidity they will actually receive. Suchratios fluctuate depending on the biddingput up by the other participants and theECB’s allotment decision.

• Active players in the money market try totake advantage of any spread arisingbetween the MRO rate and the expectedovernight (EONIA) rate. The higher thespread expected, the higher the amount ofthe bids will be.

• The amount of collateral available hasexpanded in Stage Three, also on accountof the possibility of its cross-border use.

For these reasons, the connection betweenthe financing needs of counterparties and theamount allotted to them by the central bankhas become looser, therefore increasing therole of the market in redistributing liquidityamong euro area credit institutions.

1.1.2 Main developments in theunsecured and repo markets

Among the various segments of the euromoney market, the interbank, unsecureddeposit market has achieved the highestdegree of integration and, since the start ofStage Three of EMU, has performed animportant role in ensuring the smoothredistribution of liquidity among euro areacredit institutions irrespective of theirgeographical location. The significantpeculiarities of the various domestic interbankdeposit markets at the end of 1998 nearlydisappeared in the few weeks following theintroduction of the euro.

In addition to the catalytic effect of the singlemonetary policy and the harmonisation ofmarket practices associated with it, there aretwo main reasons for this rapid integration:

i) The immediate and full success of euroarea indices, i.e. the EONIA and theEURIBOR, which were broadly acceptedby all market participants.

ii) The good functioning of the settlement ofcross-border payments, mainly performedthrough TARGET, which has allowed banksto trade safely throughout the euro area.

In this context, the unsecured market becamehighly liquid and deep, with very big dealsizes, tight bid-ask spreads and equal interestrates at the different locations, with theexception of minimal differences, normallywell within the bid-ask spreads.

1.1.2.1 Trading volumes

As explained at the beginning of Section I,some figures, including those upon which thissection is based, were collected through amarket survey and, therefore, must be seenas being indicative only. However, a cleartrend of growing trading volumes in both theunsecured and repo markets was identified,whereas the use of foreign currency swapsdecreased (see Annex 2 for details of theESCB market surveys). Although discussionhere focuses on developments in the securedand unsecured segments of the moneymarket, it is also worth considering foreigncurrency swaps, as they are an importantinstrument to which bank treasurers resortto fund banks’ activities.

In 1999 (second quarter data), tradedvolumes in the unsecured and repo marketsexpanded by more than 20% globallycompared with 1998 (fourth quarter data).Specifically, the unsecured market increasedby 16% and the repo market by 24% (seeChart 1). By contrast, foreign currency swapsdeclined by 24% in the same period,owing to the disappearance of cross-currencytrading among the euro legacy currencies.Nevertheless, it should be noted thatcurrency swaps funding still represents 23%of the total of the euro money market and iscomparable, in terms of size, with the repomarket.

The shares of each of the three instrumentsin the total (see Chart 2) followed differentpatterns: foreign currency swaps decreased


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20

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60

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1401998 1999

unsecured market repo market swap against foreigncurrencies

Chart 1Activity in the euro area deposit, repo and foreign currency swap markets(1999 (Q4) compared with 1998 (Q2) 1))

Source: ESCB market surveys.1) Relative size of average daily transactions. Basis 100: volume of transactions in the unsecured market in Q4 1998.

from 32% to 23%, while the share ofunsecured deposits grew from 48% to 53%and that of repos grew from 20% to 24%.

All in all, the expansion of the unsecured andsecured transactions exceeded the decreasein the foreign currency swaps (see Table 1 inAnnex 2 for details). While the expansion ofunsecured transactions was clearly related tothe single monetary policy, the expansion ofthe repo market is also linked to the need tolimit credit exposures and reduce capital

needs. The involvement of new marketparticipants in this segment of the market,owing to the introduction of the euro, can beseen as a supportive factor.

The growth of the unsecured segment of themarket was concentrated at the shortermaturities, indeed in overnight transactions,which represented by far the largest shareof unsecured operations (see Chart 3 andTable 1 in Annex 2). The overnight maturityhas increased significantly since the beginning

Chart 2Deposit, repo and foreign currency swap markets as a share of total activity in theeuro area(1999 (Q4) compared with 1998 (Q2))

Source: ESCB market surveys.

currency

swap 32%

repos24%

currency swap23%

deposit48%

deposit53%

repos20%

in 1998 in 1999


of the year, with a 40% jump in volumecompared with the previous year. By contrast,turnover at longer maturities, from one weekup to one year, declined markedly andrelatively low volumes are being traded atthe longer end.

For longer maturities, repo transactions seemedto be preferred to unsecured transactions (seeChart 3), as they provided greater security.Repo operations for maturities over one dayhave increased significantly since the end of1998: they represented 34% of all money marketoperations in the second quarter of 1999compared with 24% in the fourth quarter of1998. This change was particularly visible atmaturities of one month and three months(with growth of 23% and 42%), even if dailyturnover remained, overall, relatively modestcompared with that at shorter maturities. Atthe longer end, liquidity was generally morereduced.

1.1.2.2 Degree of integration

One first, indirect sign of the integration ofthe money market emerges from the use bymarket participants of the Eurosystem’s creditand deposit facilities since the start ofStage Three of EMU, where no significantimbalances (i.e. the use of the credit facilityin one or more countries and of the depositfacility, simultaneously, in other countries,which would indicate problems in thedistribution of liquidity within the euro area)have been observed among euro areacountries.6

6 Simultaneous resort to both facilities has taken place within thesame country to a very small extent, indicating minor inefficienciesin the functioning of the “local” markets on given days, ratherthan an integration-related problem (see ECB (1999b)).

Chart 3Deposit, repo and foreign currency swap markets as a share of total activity in theeuro area(breakdown by maturity, 1999 (Q2) compared with 1998 (Q4))

currencyswap 16%

repos13%

deposit71%

currencyswap 12%

repos13%

deposit75%

in 1998 in 1999

Other maturities

deposit32%

in 1998 in 1999

currencyswap 42%

repos24%

deposit34%

currencyswap 34%

repos34%


Overnight transactions


However, the integration prevailing in theunsecured segment of the euro money marketfrom the early stages of Stage Three wasrather higher than that prevailing in the repomarket. While the available information forthe euro money markets is scarce on theprices side, the EONIA (euro overnight indexaverage) provides a clear indicator forovernight developments. The dispersion ofthe EONIA prevailing among euro areacountries has been very small since early1999. Only a few weeks after the startof Monetary Union, the differences in theaverage interest rates recorded by the56 banks of the various countries of the euroarea participating in the EONIA paneldecreased, with some exceptions, to 2 to4 basis points, i.e. below the usual bid-askspread. Furthermore, after a similarly shortperiod, less than half of the daily variance ofinterest rates registered by the banksparticipating in the EONIA panel could beexplained by differences between rates indifferent countries (see the contribution ofinter-country variance in Chart 4), while therest was explained by differences betweenindividual credit institutions within eachcountry.

In the context of the ESCB market surveys,market participants agreed that the repomarket was not as fully integrated within the

Chart 4EONIA rate variance: contribution of inter-country variance to total variance(percentage)

euro area as was the unsecured market.Evidence of this was found in the hierarchyprevailing for the general collateral rates(“general collateral” is collateral which, owingto its homogeneous features, is broadlyaccepted); while the French and Germansecurities were rather “expensive”, theopposite was the case for the Belgian, Spanishand Italian ones. The most frequently invokedreasons for this situation were the following:

• Differences in the yield of the underlyingbonds, especially on account of theirdifferent degrees of liquidity. In particular,the impact of “specials” (i.e. collateralother than general collateral) trading,which is largely done in German Bundsand, to a lesser extent, in French OATs,was often mentioned by counterparties toexplain their higher price in the repomarket in comparison with other collateral.

• The lack of harmonisation of repoagreements throughout the euro area, withthe coexistence of domestic contracts, theTBMA/ISMA contract and the EuropeanMaster Agreement.

• Some difficulties in the cross-bordermanagement of collateral which can leadto a preference for deals on domesticassets. For example, it appears that the

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securities leg of repo trades is not as wellintegrated as cash settlement, which cangive rise to some friction in transactions(see Section II.2 for a discussion of trading,clearing and settlement issues).

Other factors mentioned include nationalpeculiarities or investment guidelines limitingholdings of foreign securities, the differenttax treatment of bonds,7 and the unevendistribution of collateral throughout the euroarea.

As a consequence of the factors describedabove, practices in various repo markets havenot evolved significantly compared with StageTwo. Furthermore, some peculiarities, suchas the trading of variable rate contracts inFrance, continued to be confined to localmarkets. A widespread sentiment was thatthe introduction of the euro did not promptmarket participants to undertake uniformchanges to the internal organisations withregard to their repo activity. It can be notedthat some market participants developedfor the first time repo departments, whilebanks well established in the repo marketsometimes reorganised their desks. However,no single model of organisation emerged, asrepo desks were either integrated in cashmanagement centres, specialised according tocountries, or integrated in bond marketactivities.

1.1.2.3 Cross-border transactions

The introduction of the euro led toa significant increase in cross-bordertransactions among euro area countries, interms of both volume and market share, asdomestic transactions accounted for only 40%of the total activity of the largest marketparticipants in 1999. This trend was especiallynoticeable in the unsecured and currencyswap segments of the money market (seeChart 5 and Table 1). It should be mentionedthat only in the repo market did domestictransactions increase more rapidly than cross-border transactions.8

The main factors explaining suchdevelopments include:

• The simplification of cross-bordertransactions brought about within theeuro area by the disappearance of thecosts associated with foreign currencysettlement, and the smooth functioning ofTARGET.

• The need to redistribute central bankmoney among financial centres.

7 Particularly in Spain, where a drying-up of liquidity takes placein the 30-day period preceding the government bonds’ couponpayment.

8 While such a fact seems to be well documented from the datagathered through the ad hoc ESCB market surveys, there is nocomplete information on the borrowing side of money marketactivities.

Chart 5Share of activity in the money market by type of market counterparty(1999 (Q2) compared with 1998 (Q4))


in 1998 in 1999

domestic54%

euro area25%

other21%

euro area39%

domestic40%

other21%


• The development of arbitrage activity bymarket participants, as the integrationprocess enhanced the emergence of asingle money market yield curve. As aconsequence, quotation spreads among thevarious euro area countries narrowed veryquickly in the first few months of 1999 toan average of 2 to 4 basis points, whichrepresents the minimum price below whicharbitrage is not undertaken. It should benoted, nevertheless, that larger pricediscrepancies occasionally appeared, at theend of either reserve maintenance periodsor individual days when cross-bordersettlement procedures encountered someproblems.

• The emergence of market participants witha euro area scope of activity, whobroadened their activity to adapt to thenew situation.

1.1.3 Functioning of the market

1.1.3.1 Liquidity, volatility and bid-askspreads

According to market participants, liquidityimproved in the unsecured and reposegments of the money market comparedwith the situation prevailing in the formerdomestic markets. This was particularly thecase at the short end of the money marketyield curve, mainly as a result of increased

Table 1Activity in the euro money market: deposit, repo and foreign currencyswap markets as a share of the total(breakdown by type of market counterparty, 1999 (Q2) compared with 1998 (Q4) (as a percentage))

cross-border transactions in the newenvironment.

No systematic comparison of the bid-askspreads (i.e. the differentials prevailing in themarket between the bid and the offeredprices) currently prevailing in the euro moneymarkets and those prevailing before StageThree has been performed.9 However,available indicators on the evolution of bid-ask spreads confirm the impression ofimproved liquidity insofar as there is usually apositive correlation between both variables.Some information regarding unsecuredoperations may be drawn from intraday dataon the Italian MID (“Mercato Interbancariodi Depositi”), a screen-based market forinterbank deposits: in this market spreadsnarrowed, on average, from 3 basis points in1998 to 1.5 basis points in 1999.10 In the repomarket bid-ask spreads seemed to be eitherunchanged (as in the case of France andGermany) or narrowing to only a few basispoints (in Belgium, Finland, Ireland, Spain andthe United Kingdom).

There is no uniform opinion as regardsinterest rate volatility. Market participants’assessments were conditioned by the

9 See Biais, Hartmann and Manna (2000) for an empirical analysisof the microstructure of the euro money market. Some of themain theories can be found in Stoll (1978), Copeland and Galai(1983), Glosten and Milgrom (1985) and Amihud andMendelson (1986). O’Hara (1995) provides a good synthesis ofmarket microstructure theory.

10 See Annex 3 for more details.

Type of counterparty Money market transactions through

unsecured swaps repos currency swaps

1998 1999 1998 1999 1998 1999

Domestic 68% 48% 42% 43% 23% 15%

Euro area 21% 38% 33% 33% 39% 50%

Other 11% 14% 25% 24% 38% 35%



different situations prevailing in each countryprior to Stage Three: French banks underlinedthe higher level of overnight rate volatility inStage Three, whereas Spanish and Italianbanks saw reduced volatility; data from theMID would confirm reduced volatility in thefirst half of 1999 for the Italian market.11

As a rule, contract sizes rose sharply. Only twoexceptions to this rule were reported, namelyFinland, where repo transactions remainedessentially “tailor-made”, i.e. adapted to theneeds of the parties to each transaction asopposed to the usual standardised approach,and Portugal. Traders in Germany and France,for example, reported that contracts in nationalcurrencies were replaced, one for one, witheuro contracts, thus multiplying (by 2 and6 respectively) the usual value of transactions.Overnight transactions in the unsecured marketof €500 million to €1 billion are common anddeals over €1 billion are not unusual. On therepo market contracts for €50 million to€100 million have become normal and evendeals of €1 billion are not exceptional. Still,while the market has the capacity to handlethese larger transactions, in order to reducesettlement risks large deals are often split upinto several transactions.

The evolution of the differential between theinterest rate of the unsecured transactions andthat of the repo transactions, i.e. the “depo/repo spread”, showed a diverging pattern in thevarious euro area countries compared with thesituation in 1998: it declined in Spain, did notchange in Germany and increased in France, theNetherlands and Italy. In the Netherlands andItaly spreads often used to be negative in StageTwo. No clear-cut explanations for thesediverging trends were obtained from marketparticipants, apart from the fact that repo marketdevelopments are primarily driven by cash insome countries, while in others they are drivenby the underlying collateral.

However, the cost of managing the collateralmay play a role in explaining the evolution ofthe depo/repo spreads. The factors explainingthe relative advantages and costs involved inthe use of collateral for transactions in the

interbank market include the reduction ofrisk achieved by the cash lender, theopportunity cost incurred by the collaterallender (i.e. cash borrower), and the costs ofmanaging the collateral borne by both partiesin the transaction, i.e. settlement, markingto market, coupon treatment, legalarrangements, etc. These various factors mayhave a different importance in differentcountries. Spanish banks explained thereduced depo/repo spreads in Spain by therelatively low allotments received by them inthe Eurosystem’s refinancing operations, as aconsequence of which the share of availablecollateral held by the Banco de Españadiminished and, correspondingly, that held bythe market increased. In turn, this situationboosted the liquidity of the repo market,thereby contributing to reducing the depo/repo spread. In other countries, in which cashlenders were able to include in the price thecost of managing the collateral, this cost mayhave contributed to narrow and even negativedepo/repo spreads. Most market participantsmentioned difficulties in repo settlement asa factor affecting market prices, particularlyfor overnight transactions (Italy andthe Netherlands) and/or in cross-bordertransactions (Belgium, France and Finland).12

Moreover, differences in the quality of thecollateral – which is less relevant for theshortest maturities – and differences in thesettlement of the underlying securities alsoplay a role in the repo rates hierarchy (seeSection I.3).

Finally, it is worth noting that, according tothe figures provided by market participants,the share of foreign collateral used forrepo transactions rose significantly in 1999compared with 1998, from 5% to 23% of thetotal. Analogously, an increase in the use ofnon-domestic collateral in the Eurosystem’srefinancing operations was observed in thecourse of 1999 in some euro area countries

11 In terms of the daily percentage coefficient of variation, it fellfrom1.84 in 1998 to 1.04 in 1999.

12 In Germany some market participants mentioned a smoothsettlement process as one of the reasons behind the developmentof the Bunds’ cross-border trading.


(for instance, between 40% and 50% of thecollateral used for the Eurosystem’s creditoperations by French counterparties was non-domestic).

1.1.3.2 Market participants and theprocess of cash managementcentralisation

The unification of the euro financial marketstriggered two kinds of developments withrather opposite effects on the number ofparticipants in the secured and repo interbankmarkets. On the one hand, a wider range ofcounterparties emerged, such as Germanregional banks and non-euro area participants(notably from Asia and northern Europe).These banks, which had previously focusedon their domestic market or on the mostactive European markets (notably the DEMmarket), tended to extend the scope of theiractivities to the whole euro area. On theother hand, the consolidation and mergerprocess accelerated, fostering a concentrationof cash management and money marketfunding activities in one or two centres. Allin all, major banks seem to have reinforcedtheir competitive positions, benefiting from alarger and more liquid market and from anongoing process of internal rationalisation.For their part, small and medium-sized banks,which were generally less well equipped tosettle cross-border transactions and less ableto obtain credit lines in other euro areamarkets, barely changed their businessrelationships, remaining mostly confined totheir domestic markets. As a consequence ofthese factors, and as a result of differences incredit ratings, this category of banks hasnormally paid a small spread in interbanktransactions. In France, for instance, suchspread was estimated to be between 2 and3 basis points on average. Thus the generalview is that the segmentation into a “two-tier” market, which already existed beforethe introduction of the euro, was somewhatreinforced, with large banks active in the euromoney market for cross-border, large-sizedeals and ensuring the funding of smaller,domestically oriented banks.13 These latter

banks, however, were not confronted with aworsening of funding conditions.

Overall, a concentration has taken place,which has enhanced the need for moreefficient cross-border transactions. Thisfact is a driving force leading to a morestandardised and competitive market. Thismove was strongest in the most integratedsegments of the market, such as the interbankmoney market and the overnight interestrate swap (OIS) market, where marginsnarrowed significantly, prompting someparticipants to discontinue their activity.To some extent, the trend towardsstandardisation and concentration is similarto the one observed in the foreign exchangemarket although, for the time being, thedegree of standardisation has not yet reachedthat prevailing in the foreign exchange market.The possible development of electronictrading, however, could further booststandardisation in the money market.

There is a general consensus that theintroduction of the euro triggered a processof centralisation of funding activities in thesingle currency by market participants. Twodifferent patterns of centralisation may bedistinguished: while some banks centralisedtheir interbank funding activities in euro at asingle centre (a common pattern among non-EU banks), other banks maintain subsidiariesor branches in various euro area countries.In those cases, payments to be made in othereuro area countries are routed to therelevant branch. In the latter cases, only thesettlement of the resulting credit or debitpositions among the various branches maygive rise to TARGET transactions. Hence thistype of bank is less dependent on thefunctioning of TARGET, and its nationalcomponents, than those banks withcentralised cash management.

13 Data from the Italian MID confirm such a tendency: theparticipation of members in transactions showed a concentrationin the Herfindahl index growing from 0.58 in the second half of1998 to 0.65 in the first half of 1999. Concentration in the repomarket might be higher owing to the barriers faced by smallparticipants in terms of the capacity required to manage thecollateral.


Furthermore, the distribution of the activityof individual branches in the domestic andnon-domestic markets and their biddingbehaviour in the Eurosystem’s refinancingoperations may not be related to their ownliquidity needs, but to the consolidatedposition of the group. In this context, banksface different alternatives as regards theirfunding practices and inter-branch fundallocation:

i) They must choose either intrabank fundallocation mechanisms or the money marketto redistribute liquidity within their branchsystem.

ii) They must decide to which segment(i.e. unsecured, repo or others) of the moneymarket to resort. This decision often entailschoosing which branch will trade in themarket. Performing cross-border transactionsthrough branches, instead of doing it withother counterparties, may be preferable,e.g. on the grounds of credit riskconsiderations.

The choice between these alternatives islikely to be driven by risk and costconsiderations.14 On the one hand, banks maytend to reduce their market activity byimproving their intrabank fund allocation

mechanisms when market conditions are lessattractive, as is often the case on the lastdays of the Eurosystem’s reserve maintenanceperiods, owing to higher interest ratevolatility and wider spreads. On the otherhand, some market participants pointed outthat, in some cases, banks might refrain fromcarrying out cross-border transactions duringthe last hours of the day (and perhaps alsoon the last days of the reserve maintenanceperiods), on account of fears of possibledelays in the settlement process. These kindsof problems, which also arise in cross-borderfund transfers to or from branches acting onbehalf of the headquarters, might in somecases reduce branch activity.

In conclusion, while a comprehensive processof internal reorganisation was undertaken byeuro area banks regarding their treasurymanagement (and also by non-euro areabanks with regard to their funding activitiesin the euro) following the introduction of theeuro, the completion of such a process is stilllikely to take some time, not least on accountof the ongoing and future developments inthe field of securities settlement systems. Inthe same vein, developments in the field ofelectronic trading (through centralisedplatforms) were still at an early stage (seeSection III).

1.2 Derivative segments

14 Again, data from the Italian MID may give some indication inthis respect. In the first half of 1999 the share of the Italianbranches of other EMU countries’ banks in total borrowingactivity was significantly lower on the last day of the reservemaintenance period (22% of the market) than on other days(31%). No such difference was evident in Stage Two: in thesecond half of 1998, both on the last day of the reservemaintenance period and on other days, the share was steadilyaround 40%. It should be noted that the reduced share offoreign banks’ branches in Italy on the last day of the reservemaintenance period may also be related to their lowerinvolvement in tax payments.

Since the start of Stage Three, euro-denominated money market derivatives haveexperienced a process of quick integrationand standardisation, and their depth hasincreased substantially. In such context, theuse of FRA instruments (forward rateagreements) and some other OTCinstruments (“over-the-counter” transactions,i.e. those carried out in non-organisedmarkets) diminished in favour of morestandardised products, i.e. swaps and futures.Owing to the success of exchange-tradedfutures, OTC instruments, except interestrate swaps (IRSs), are now confined tospecific operations, such as structuredproducts, and their global amount outstanding

has become marginal. By contrast, futuresand swap markets benefited from theintroduction of the euro: the data show anexpansion of more than 60% in the interestrate swaps market.


1.2.1 Futures markets

Activity in the euro futures markets increasedsignificantly in the first half of 1999 comparedwith the situation prevailing in the marketsfor the euro legacy currencies in 1998. Openpositions (i.e. the gross amount of positionsheld by market participants) on three-monthfutures euro contracts15 increased by 16%between the end of 1998 and the end of thefirst half of 1999. Such a development tookplace at the expense of OTC transactions,which decreased in that period, with theexception of IRSs.

The EURIBOR three-month futures marketquickly became very liquid and deep, whichwas also reflected in tight bid-ask spreads.This contract inherited the success of theformer “Eurodem” LIFFE contract andbenefited from the greater concentration andthe higher level of activity prevailing in themoney market following the introduction ofthe euro. The new contract is traded in theLIFFE market in London, in the GermanEurex, and in the French Matif. LIFFEEURIBOR trading is by far the most dominant,representing more than 80% of the total dailytrading volume. The EURIBOR imposed itself

as a single reference in the cash market, atthe expense of the EURO LIBOR. Therefore,the EURIBOR contract replaced all formerthree-month contracts, i.e. the Eurodem, theEurolira, the PIBOR and the MIBOR.

In order to provide an illustration of theliquidity in the euro short-term futuresmarkets, Chart 6 shows the ratio betweenthe volumes traded in three-month eurocontracts in LIFFE, Matif and Eurex, and anequivalent for the US dollar market, namelythe volumes traded in three-month US dollarcontracts in the two relevant markets: CME(Chicago Mercantile Exchange) and SGX(Singapore Exchange). As can be seen, theliquidity in the euro market is around 50%that of the US dollar market.

The success of the euro money markets’futures contracts must be linked to thestandardisation of the euro wholesalemarkets and to the harmonisation of the eurocash market, with the EURIBOR as the mainreference.

Chart 6Ratio between traded three-month euro futures contracts and three-monthUSD futures contracts 1)

Source: Bloomberg.1) One-month moving average of weekly data. All the usual quarterly future maturities traded on the dates in the x axis have been

considered (starting from March 1999). The USD futures contract figures include data from the CME and SIMEX markets.

15 Including EURIBOR, EURO LIBOR, PIBOR, EURODEM,EUROLIRA and MIBOR contracts. (See Annex 1 on terminologyfor an explanation.)

Jan. June Nov. Mar. 1999 2000

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1.2.2 Interest rate swap market

The interest rate swap market alsoexperienced significant changes following theintroduction of the euro. According to datacollected for these surveys, average daily IRStransactions in the euro area grew by 72%in 1999 (Q2) compared with 1998 (Q4).Moreover, all euro area national central banksnoted that the swap market had becomedeeper and more liquid as a consequence ofits full unification, and a single yield curveemerged for the whole euro area. Bid-askspreads narrowed and are now set between1 and 2 basis points. The average transactionsize increased to €50 million, and hugeamounts (such as €5 billion) are notexceptional. The market appears to beextremely flexible and standardised. As aconsequence of the growing size of the market,some smaller market participants might beconsidering the possibility of discontinuing theirmarket-making activity in this area.

The main reasons for the success of the euroswap market seem to be the following:

• Swaps are now commonly used, instead ofgovernment paper, for hedging positions

in fixed income instruments such ascorporate paper. This is particularly the casesince the start of Stage Three, as a singleswap curve has emerged vis-à-vis a non-unified government paper curve. In such acontext, the swap curve has become thebenchmark for money market instruments.

• Arbitrage is widely performed on swaps,thanks to the liquidity, flexibility and depthof this market.

• High liquidity and depth has attracted moreparticipants, so the swap market is set in a“virtuous liquidity circle” “liquidity callsliquidity”.

• A factor not related to the introduction ofthe euro is that market participants areshowing an increasing interest in off-balance-sheet instruments: the use ofEONIA swaps presents the opportunity toreduce all short-term interest rate risks toan overnight basis. Swaps spare capital asthey do not consume large amounts ofcredit limits. As a consequence, swaps haveincreased at the expense of depositmarkets for funding.


Table 2Activity in the interest rate swap market: average daily transactions

Notional amount in EUR millions

1998 1999 Growth as aQ4 Q2 percentage

1 week 2,153 4,636 115

2 weeks 1,952 4,397 125

1 month 4,276 7,957 86

3 months 4,588 7,906 72

6 months 3,104 4,263 37

9 months 763 1,858 144

1 year 1,144 2,461 115

> 1 year 5,602 7,002 25

Total 23,582 40,480 72

Domestic counterparties 12,438 13,636 10

Euro area counterparties 8,063 21,156 162

Other 3,081 5,688 85

Total 23,582 40,480 72


The introduction of the euro also had animpact on the characteristics of the swapmarket, notably:

• Like other segments of the euro moneymarket, the swap market became a cross-border market as the bulk of transactionsbecame euro area-oriented from thebeginning of 1999 onwards (althoughvolumes of domestic transactions wereglobally stable).

• The bulk of activity in the euro swapmarket seems to be concentrated in largeand medium-sized banks. Mainly onaccount of the high average size of thetransactions, smaller banks have somedifficulty in entering this market.

• A change in the swap indices used. LIBORindices were almost abandoned, as the

“old contracts” were progressively turnedinto EURIBOR-based contracts. Newcontracts are now referenced mostly withthe six-month EURIBOR and the EONIA.However, the EONIA represents thelargest part of the euro swap market,owing to its acceptance as the euroreference on the interbank market.16

• The average maturity of swap contractshas decreased slightly since the start ofStage Three of EMU following a trendwhich was also observed in the cashmarket: in 1999 61% of swaps (comparedwith 54% in 1998) had a maturity of lessthan six months. The short-term interestrate swap segment is therefore the mostliquid, although activity is still substantialat longer maturities. In particular, swapsover one year still represent a significantproportion of the market (17%).

1.3 The market for Treasury bills and other short-term securities

This section discusses developments in thesegments of the money market not dealt within the previous section, namely the marketfor short-term securities. This marketincludes government securities (Treasurybills) and private securities, i.e. mainlycommercial paper (CP, i.e. short-termsecurities issued by corporations) and bankcertificates of deposit (CDs, i.e. short-termsecurities issued by banks). The analysis drawson two sources: the quantitative andqualitative data gathered through ESCBmarket surveys conducted in the context ofthe preparation of the studies referred to inthe foreword, and the ECB’s database.

The pace of developments in short-termsecurities markets in 1999 was generally slowerthan that observed in the other segments of themoney market, even if some significant changeswere also observed. Two main features shouldbe highlighted. First, compared with the fastintegration observed in the euro unsecuredinterbank and interest rate swap markets, theshort-term securities markets remainedrelatively fragmented and mostly domestically

oriented. This situation also contrasts, to someextent, with developments in the euro bondmarkets (see Section II). Second, regardingissuing activity, a changing trend was observedin the euro area, whereby privately issuedsecurities overtook the short-term governmentpaper market. This is discussed further inSection I.3.1.

As regards the slow degree of integrationobserved in short-term securities markets,several explanations can be provided. Forinvestors, the rationale for diversifying bondportfolios is much stronger than for theirholdings of money market instruments.Financial intermediaries do not usually holdshort-term paper for investment purposes,but as a secured surrogate for cash. Moneymarket funds are usually much moredomestically and retail-oriented than bondfunds. As a consequence, the demand forcross-border investment in short-termsecurities tends to be smaller, and this

16 It should be noted that EONIA swaps are settled at maturityplus one day since the EONIA is not known until 7 p.m. (whilethe LIBOR was known at 11 a.m.).


weakens the forces pushing for furtherintegration.

In addition, infrastructural problems, inparticular the lack of a harmonised tradingenvironment and the segmentation of clearingand settlement systems, differences in fiscaltreatment and the lack of uniform legaldocumentation, also explain the relativelyslow pace of integration of euro area short-term securities markets.

I.3.1 Primary markets

In order to provide as complete a picture aspossible of the evolution of developments in1999, two complementary sources of data areused in this and the following two sections,namely a market survey conducted by the ESCB,and the ECB’s securities database.17

Activity in the primary markets showed arelatively steady increasing trend in 1999,although not a very significant one (increasingby 11.8% as a whole in terms of net issuance).However, a diverging pattern was observedbetween public and private sector issuers:while the issuance of Treasury bills wassubdued, the issuance of private securitieswas relatively steady (see Chart 7). This trendwas reflected in a continuously increasing

share of the participation of private paper inthe global short-term securities market (seeSection I.3.3). During the first half of 1999 asignificant increase in the issuance of bothCP and, especially, CDs was observed; inrelative terms, the share of gross newissuance by instrument has shifted in favourof bank CDs (see Chart 7 and Tables 3 to 5).

Several factors explain developments in theissuance of Treasury bills, CP and bank CDs.The slowdown in the issuance of public paperwas due to the combination of a reduction ingovernment deficits in many euro areacountries and Treasuries’ efforts to increasethe average maturity of their liabilities, inorder to take advantage of lower interestrates. As a result, a reduction in the issuanceof short-term government instruments tookplace (-17% overall; during the first half of1999 sharp declines took place in Belgium,France, Portugal and Spain), in parallel withan increase in the issuance of long-term paper.

Chart 7Gross issuance of euro-denominated short-term securities by issuer sector 1) in 1999(EUR billions)

Source: ECB.1) Values refer to the gross issuance of euro-denominated securities issued by euro area residents.

non-financial corporations140

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0Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.

central government Monetary Financial Institutions

17 The two sources are complementary since the ad hoc ESCBmarket survey provides a non-exhaustive, but rather reliablecomparison of developments in the first half of 1999 with thosein 1998 for individual countries and data on activity in thesecondary market, while the ECB’s database provides a completepicture for 1999 on a euro area basis. Hence, wherever data forindividual countries are quoted in this section, the source is theESCB market survey. The same applies to secondary marketdata. In the charts based on the ECB’s database, securitiesissued by MFIs (Monetary Financial Institutions) are basicallyCDs and those issued by non-financial corporations are essentiallyCP. For a description of the ECB’s database see ECB (2000b).


Chart 8Gross issuance of euro-denominated short-term securities by issuer sector


Beyond this overall reduction, the supply ofTreasury bills is unevenly distributed amongeuro area countries. At the start of StageThree, only four markets – the Belgian,French, Italian and Spanish ones – weresignificant and relatively mature, hadsubstantial amounts outstanding, conductedregular auctions and had primary dealershipsystems. With regard to the German market,although there are regular quarterly auctionsfor “Bubills”, the outstanding volumes andissuance remain comparably small. This is oneof the factors slowing the development ofthe Treasury bill market, given the benchmarkrole that German securities play in severalother segments of the euro yield curve. Thisalso helps to explain why non-residents tendto stay out of the euro Treasury bills market.

Given the lower issuance of Treasury bills,institutional investors18 tended to investmore heavily in CP and bank CDs. In addition,in a context of decreasing interest rates,institutional investors sought additionalreturns by shifting to longer-term instrumentswith higher yields.

As regards the rise in the supply of privatepaper, a tentative explanation can be found inthe rebound in economic activity in the euroarea, as reflected in a recovery in investmentexpenditure. In addition to the traditionalfunding patterns prevailing among Europeancorporations, i.e. the issuance of long-termpaper and recourse to bank loans, the financialcontext created by the single currency fosteredan increased resort to the issuance of CP. In a

context of increased merger and acquisitionoperations, CP issuance may have been boostedfurther, since such operations were, to someextent, also financed by resorting to the issuanceof short-term securities. Furthermore, theattractiveness of the euro market as a wholeand its future prospects encouraged some majornon-resident issuers to enter it and to establishregular issuing activity. Finally, it should be notedthat these developments have taken place inthe context of a structural movement towardssecuritisation and an increased preference forcollateralised lending.

It is important to note that, throughout theeuro area, the supply of bank CDs and CP isnot standardised, as issues are often tailoredto meet the specific needs of domesticinvestors (e.g. as in the case of bills with aspecific variable rate). In some countries itis mostly banks which buy CP. As aconsequence, CP issuance is part of thebusiness relationship between a corporationand its bank. Therefore, funding is still globallyintermediated by banks. The very shortmaturity of most banks’ CDs and CP isanother consequence of this situation: forthe investment of temporary liquiditysurpluses, CDs and CP appear to be analternative to bank deposits.

18 In France the share of CD subscriptions at the beginning of1999 was as follows: 30% were subscribed by banks, 30% bycorporates, 20% by UCITS (“undertakings for collectiveinvestment in transferable securities”) and 15% by insurancecompanies. As regards commercial paper subscriptions, thedistribution was as follows: 70% by banks, 15% by UCITS and10% by corporates.

CP27%

in 1998

CDs39%

Treasury bills34%

CP27%

in 1999

CDs47%

Treasury bills26%


In Belgium, France, Ireland and Spain19 therewere significant increases in bank CD issuanceafter the introduction of the euro. Changesin the fiscal treatment (as in the case ofSpain)20 or in legal regulation (as in the caseof France)21 have made this kind of papermore attractive to investors.

While the data available on non-residentparticipation in the primary market are onlypartial, they show that developments in thisregard varied greatly among euro areacountries. In Ireland the issuance of bank CDsby non-residents in the first half of 1999 wasaround 98% of the total, which is explainedby the fact that the two largest issuers arelarge international banks. In Italy non-residentpurchases in the primary market for ItalianTreasury bills (BOTs) increased from€4.1 billion at the end of 1997 to€27.3 billion at the end of 1998. In Finland,while in 1998 Treasury bills were sold mainlyto domestic investors, the situation wasreversed in 1999 as most paper was placedwith non-residents. Although there are nofigures available for Germany, there isregularly a strong non-resident demand forGerman “Bubills”.

A comparison of the two periods underreview showed no relevant changes asregards the usual issuing maturities for short-term securities. The most common maturitiesare three, six and 12 months.22 For Treasurybills, the 18-month maturity was also used.

Even before the start of Stage Three, short-term securities were issued almost exclusivelyin book-entry form. The issuance of physicalpaper is confined to some paper issued inFinland (CP and municipal debt paper). Duringthe first few months of 1999 this trend wasenhanced by the fact that, following theintroduction of the single currency, onlysecurities transferable in book-entry formbecame eligible as collateral for theEurosystem’s monetary policy operations.The registration of short-term assetsnormally occurs at securities depositories,both domestic and international. In mostcountries there are at least two central

securities depositories for clearing thedifferent types of securities. The large numberof accounts to be maintained with differentdepositories tends to discourage non-residents from participating in some of theless liquid markets (see Section III).

1.3.2 Amounts outstanding

As a consequence of the issuing activitydescribed above, the total amountoutstanding of Treasury bills decreasedsubstantially (by 17% between the end of 1998and the end of 1999) and stood at EUR 254billion at the end of 1999.23 The share ofthese instruments decreased to around 44%of the whole market for short-termsecurities, from 55% in the second half of1998 (see Chart 8). Such a decline was morethan offset by the increase in the amountoutstanding of euro-denominated CDs, CPand other securities issued by private sectoreuro area residents. The amount outstandingof CDs and other short-term paper issuedby financial institutions grew by 51%, whilethat of securities issued by non-financialcorporations (mainly CP) grew by 43%. Still,at the end of 1999 Treasury bills remainedthe most important single segment of theeuro area short-term securities market.

According to data for the first half of 1999,almost half (44%) of the amount outstandingconsisted of securities issued in Italy. Frenchand Spanish securities together representedapproximately 32% of the total amountoutstanding, and Belgian securities another12%. Comparatively small amounts of

19 In Spain bank CDs are referred to as “bank bills”.20 In Spain there is a favourable fiscal treatment for assets of this

kind issued after 1 January 1999.21 In France a change in the regulation took effect at the beginning

of 1999. This new legal framework allowed banks to issuevariable CDs directly, and reduced the minimum maturity ofCDs and commercial paper from ten days to one day. Manycredit institutions (around one-third) and a few companies resortto this new possibility: by mid-1999 issues of less than ten daysrepresented about 30% of the total amount of CD issues, butonly 1.5% of the outstanding amount.

22 Shorter maturities are also usual, notably in France (seefootnote 15).

23 By comparison, the total amount outstanding of US Treasurybills reached €649 billion.


Chart 9Outstanding amounts of euro-denominated short-term securities by issuer sector(EUR billions)

Note: Values refer to euro-denominated securities other than shares issued by euro area residents.

Treasury bills were outstanding in the othereuro area countries. A reduction in theamount outstanding was recorded in the firsthalf of 1999 in most countries (especially inSpain and Portugal), whereas an increase wasexperienced in four countries: Austria,Belgium, Finland and the Netherlands.

Overall, the figures show an increase in theamount outstanding of private paper by 41.5%in 1999 (see Chart 9). Paper issued by non-financial corporations (mainly CP) grew by43.2% (from €46.5 billion to €66.6 billion),while paper issued by Monetary FinancialInstitutions (MFIs, mainly CDs) grew by 51.2%(from €164.9 billion to €248.5 billion).

Available data for individual countries mustbe interpreted with particular caution, giventhe lack of figures in some countries and thefact that, in some others, only estimates areavailable. At the end of the first half of 1999,

the greatest amount of bank CDs and CPwas concentrated in France (53%), whereboth categories of assets recorded a largeincrease. Spain and the Netherlands recordeda substantial increase in the amountsoutstanding of bank CDs, as did Finland forCP. Nevertheless, these amounts appear tobe small, particularly when compared withUS markets: in the first half of 1999, theamount outstanding of bank CDs for thewhole of the euro area reached €226 billion,compared with €977 billion for US CDs,whereas CP outstanding stood at €86 billion,compared with €249 billion for the US market.

1.3.3 Secondary markets

The behaviour of investors with regard toshort-term paper tends to restrain theliquidity of the secondary market. In manycountries (notably France and Spain) the

Dec. Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.

350

300

250

200

150

100

50

0

350

300

250

200

150

100

50

0

central government non-financial corporations Monetary Financial Institutions

1998 1999


major investors in short-term paper areinvestment funds (especially money marketfunds in France24 ), which usually tend to keepmost of the paper in their portfolios and arebarely active in the secondary market.

A comparison of secondary market data forthe first half of 1999 and the second half of1998 (see Tables 3 to 5)25 shows that thetotal turnover for Treasury bills declined byaround 5%. Moreover, activity was unevenlydistributed among countries and wasconcentrated mainly in France and Belgium(where it increased by 23%). In most othercountries turnover declined. By contrast, theturnover of CP increased sharply in the sameperiod (by 128% as a whole), mainly inBelgium. The total turnover of bank CDsdeclined (by 8%). However, this figure issomewhat misleading owing to the fact thatthe availability of data regarding turnover inCDs is rather poor. A significant fall inFinland’s turnover was the cause of theoverall decrease (see Table 4), while theturnover in the rest of the countries forwhich data are available (Belgium, Spain and

France) showed significant increases. Inrelative terms, although Treasury billscontinued to be the most traded instrument,the share of trading in CP increased to 14%,from 6% in the second half of 1999 (seeChart 10).

The structural features of the primary marketfor bank CDs described above explain theweakness of the secondary market and theslow integration of the various markets.Overall, turnover was moderate, owing tothe limited supply and the fragmented demandfrom investors, which is very much focusedon the peculiarities of the different securities.Some dualism seems to exist between theretail and wholesale markets. Major investorsin CDs are not active in the secondarymarket, as structured bank CD issuance(e.g. of those CDs linked to a specific index)is not aimed at market trading, but rather at

Table 3Activity in the primary and secondary markets for Treasury bills(EUR billions)

24 The importance of money market funds in France is linked tothe prohibition of the payment of interest on current accounts.

25 Annex 2 provides details on the coverage and methodology ofthe ESCB surveys on which Tables 3, 4 and 5 draw. Luxembourgis not included in Table 3 because the Treasury did not issueshort-term paper in 1998 and 1999.

Source: ESCB market surveys.1) On 13 April 1999 the Bank of England took over from HM Treasury as the issuer of euro bills with maturity dates from October

1999. The issuance of Bank of England euro bills exactly offsets the reduction in HM Treasury euro bill issuance.

Outstanding Gross new issuances Total turnover(data at the end of the period) (during the period) (during the period)

2nd half 1st half % of 2nd half 1st half % of 2nd half 1st half % ofof 1998 of 1999 variation of 1998 of 1999 variation of 1998 of 1999 variation

BE 36.7 38.3 4.3 53.0 42.3 -20.3 126.3 154.9 22.6

DE 10.2 9.9 -3.3 10.2 9.9 -3.3 n.a. n.a. n.a.

ES 59.8 51.3 -14.2 27.0 20.3 -24.9 19.2 16.1 -16.4

FR 47.2 46.1 -2.2 72.3 52.3 -27.6 299.9 266.1 -11.3

IE 1.5 1.4 -6.1 4.9 5.5 12.9 0.1 0.1 10.0

IT 137.8 135.0 -2.0 104.7 106.0 1.2 27.2 22.0 -19.1

NL 6.8 11.0 61.4 19.5 34.0 74.3 n.a. n.a. n.a.

AT 4.9 5.8 17.4 0.0 1.9 100.0 n.a. n.a. n.a.

PT 1.9 0.6 -71.3 1.0 0.2 -82.6 0 0.05 2400.0

FI 2.6 3.2 24.2 2.8 2.8 -1.9 12.4 6.3 -49.2

SE 0.0 0.3 100 0.0 0.3 100 n.a. n.a. n.a.

UK 1) 3.5 3.5 0 6.0 6.0 0 6.8 3.4 -49.9

Total 312.9 306.1 -2.2 301.5 281.2 -6.7 492.0 468.9 -4.7


Table 4Activity in the primary and secondary markets for bank certificates of deposit 1)

(EUR billions)

Table 5Activity in the primary and secondary markets for commercial paper 1)

(EUR billions)

accommodating the needs of specificinvestors. Finally, the short average maturityof the CDs structurally reduces tradingopportunities in the secondary market.

CP issues are largely bought by banks in orderto finance corporations. Weak activity on thesecondary market can therefore be largelyexplained by the above-mentioned links

Source: ESCB market surveys.1) See footnote 25.2) Italian CDs are not traded.3) These figures exclude available data from Sweden and Germany respectively in order to obtain representative percentages.


2nd half 1st half % of 2nd half 1st half % of 2nd half 1st half % ofof 1998 of 1999 variation of 1998 of 1999 variation of 1998 of 1999 variation

BE 2.8 3.8 32.7 9.3 15.1 62.4 9.9 15.2 52.3

DE 7.3 4.3 -40.5 36.4 n.a. n.a. n.a. n.a. n.a.

ES 0.3 2.1 539.2 0.5 7.2 1,430.1 0.7 2.5 234.9

FR 96.8 116.5 20.4 329.0 490.7 49.1 11.7 24.6 109.6

IE 2.5 3.4 34.8 1.3 5.1 292.6 n.a. n.a. n.a.

IT 38.1 32.0 -16.0 n.a. n.a. n.a. 0 2) 0.0 0.0

LU 15.9 16.5 3.6 n.a. n.a. n.a. n.a. n.a. n.a.

NL 2.8 9.2 234.9 n.a. n.a. n.a. n.a. n.a. n.a.

FI 18.2 13.6 -25.2 n.a. n.a. n.a. 76.7 48.5 -36.7

SE n.a. 2.4 n.a. n.a. n.a. n.a. n.a. n.a. n.a.

UK 3.7 9.0 143.2 n.a. n.a. n.a. n.a. n.a. n.a.

Total 188.5 210.5 3) 11.7 340.13) 518.1 52.3 99.1 90.7 -8.5

Source: ESCB market surveys.1) See footnote 25.2) These figures exclude available data from Sweden and Finland respectively in order to obtain representative percentages.


2nd half 1st half %of 2nd half 1st half %of 2nd half 1st half % ofof 1998 of 1999 variation of 1998 of 1999 variation of 1998 of 1999 variation

BE 7.1 8.3 16.4 22.7 28.7 26.4 23.5 65.5 178.8

DE 10.6 11.0 3.6 37.8 36.7 -3 n.a. n.a. n.a.

ES 2.7 3.6 33.5 2.8 3.1 10.3 3.7 4.0 7.1

FR 37.0 47.5 28.6 138.0 191.8 39.0 18.2 28.9 58.9

IE 3.2 5.0 56.0 19.1 7.7 -59.8 n.a. n.a. n.a.

NL 0.7 0.6 -14.7 n.a. n.a. n.a. n.a. n.a. n.a.

PT 2.2 2.9 30.0 6.8 7.1 4.0 3.0 5.0 66.6

FI 1.6 3.0 81.9 15.6 17.3 11.1 n.a. 5.2 n.a.

SE n.a. 0.1 n.a. n.a. n.a. n.a. n.a. n.a. n.a.

UK 1.2 3.9 229.0 n.a. n.a. n.a. n.a. n.a. n.a.

Total 66.2 85.7 2) 29.3 242.8 292.3 20.4 48.4 103.6 2) 113.6


between corporations and banks (seeSection I.3.2). This pattern could be definedas pseudo-disintermediation, in the sense thatneither is it traditional bank lending activitynor does it fit within the usual patterns ofsecurities issuance, in which banks normallyplay a less important role.

Furthermore, owing to the low turnoverprevailing, the pricing of bank CDs and CP iscomplicated, as securities are often notquoted daily. The absence of regular priceshinders the valuation of portfolios, which, inturn, discourages investors (particularlyforeign investors) and reduces liquidity.

The share of non-resident investors differswidely among countries. In Portugal and Spainoutstanding securities (Treasury bills and bankCDs) are held mainly, if not exclusively, byresidents. In Italy the share of Treasury bills(BOTs) held by non-residents was around32%. In that country the opportunity to have“remote access” to the screen-based MTSsecondary market has been exploited since1998 by non-resident market participants,which increased their share from 0.4% in thesecond half of 1998 to 12% in the first half of1999. In the Netherlands the share of non-residents in the secondary market wasestimated at around 20%.

Chart 10Shares of total turnover of short-term securities


second half of 1998

CDs15%

CP8%

Treasury bills77%

first half of 1999

CDs14%

Treasury bills71%

CP15%

Few changes were observed in tradingsystems during the period under review.Although an interest in replacing brokers ordecentralised intermediation with electronicsystems was emerging, the development ofsuch systems was still at an early stage, partlyowing to the limited trading in these assets,which tend to be held until maturity.Brokerage activity continued to be presentand significant in countries such as Finland,France and Spain.

1.3.4 Microstructure of the marketand liquidity

In the markets for Treasury bills, the firstfew months of Stage Three saw the startof a process of investment diversificationconducted by banks and, to a lesser extent,by fund managers, aimed at benefiting fromthe rate discrepancies prevailing in the variousnational markets. As in the process describedabove, regarding banks’ activities in thesecured and unsecured interbank markets,major banks undertook the internalreorganisation of their trading activities withthe aim of trading both short and long-termdebt on a pan-European basis. In addition, inmost cases major banks are primary dealersin countries where such a system exists, toenable them to participate in short-termTreasury bill auctions. For instance, someforeign institutions started to bid in Treasury


bill auctions in Italy, trying to exploit thehigher yields of Italian Treasury bills.26 While,in the case of bonds, market arbitrage activityis widely developed (see Section I.2), in thesecondary markets for Treasury bills suchactivity is hindered by reduced liquidity anddepth.

Market liquidity was poor globally, and bid-offer spreads were wide, even in countrieswith a relatively high turnover.27 This situationwas partly linked to the relative scarcity ofsupply resulting from the decreased issuanceof government paper. Additionally, the lackof liquidity was also due to the fact thatTreasuries’ supply was fragmented, and alarge number of issues were non-fungible(i.e. issues, the features of which do not allowthem to be treated homogeneously from alegal and technical point of view). Forinstance, in Italy, the largest market forTreasury bills within the euro area, at thebeginning of July 1999 there were 21 differentlines of BOTs (discount bills) outstanding,9 lines at a maturity of up to one year for CTZ(zero coupon securities), and 9 lines with amaturity of less than one year for CCT(medium-term notes with annual interest). InFrance there were 23 lines of BTF (discountbills). By comparison, only 32 different linesexisted in the US market for Treasury bills.

Despite the substantial increase in issuanceactivity and in the amounts outstanding ofshort-term CP and banks’ CDs, in almost allcountries market depth in these sectorsremained considerably lower than that ofTreasury bills. This was partly a result of thestill very limited rating activity in relation tocorporate entities in the euro area, inparticular in comparison with other capitalmarkets (notably the United States). Anincrease in the availability of ratings will helpthe financial soundness of such instrumentsto be assessed and should therefore boostinstitutional investors’ interest in these typesof assets.

With regard to the evolution of the spreadsbetween Treasury bills and AA-rated CP sincethe start of Stage Three, different trends were

26 For a maturity of one year, Italian Treasury bills were issuedaround 10 basis points above French and around 5 basis pointsabove Spanish Treasury bills. With regard to the three-monthmaturity, the prevailing yield differential between French andItalian issues reached around 30 basis points at a certain pointin time, the Italian paper bearing the highest yield within theeuro area.

27 In France, for instance, bid-offer spreads were wider than in1998 owing to their relative scarcity, as was illustrated by theincreasing spreads between Treasury bills and swaps (e.g. thethree-month spread between BTF and a swap at a maturity ofthree months was above 30 basis points).

observed throughout the euro area. In Franceand Germany a widening of the spreads(i.e. an increase in the positive differentialbetween the return on private paper and thaton Treasury bills) was observed between1998 and 1999. In Belgium the spread, whichwas initially negative, was reversed. In someother countries spreads tended to narrow. InFinland the spread between Treasury bills andCP oscillated between 0 and 20 basis pointsand decreased slightly in the 12 months underreview. In Ireland the spread betweenTreasury bills and AA-rated CP narrowed byaround 10 basis points for a maturity of onemonth and by 40 to 50 basis points for amaturity of one year. In Spain spreads decreasedby 10 basis points for a maturity of six months.In Austria the spreads remained stable.

1.3.5 Changes in the use of short-termpaper as collateral in monetarypolicy operations

The proportion of short-term paper,especially Treasury bills, put forward ascollateral for monetary policy operationsdiffered widely among countries in the firsthalf of 1999 compared with the second halfof 1998. In Belgium, Ireland and theNetherlands the proportion remained stable,while in most other countries it increased. InItaly the share of BOTs used as collateral inreverse transactions with the Banca d’Italiarose from around 15% in the second half of1998 to around 30% at the start of StageThree (first half of 1999). In some othercountries, such as Portugal and Finland, theuse of short-term securities decreased.In Portugal the use of Treasury bills


for collateralisation in monetary policyoperations declined from 3% to negligibleamounts. In Finland the use of bank CDsdecreased from a maximum of 30% of totalcollateral in Stage Two to around 20% inStage Three.

It is interesting to note that, in the UnitedKingdom, government short-term paper, aswell as other government securities issuedwithin the euro area and denominated ineuro, became eligible for sterling open marketoperations of the Bank of England as from31 August 1999.


When discussing the impact of theintroduction of the euro on the Europeancapital markets in general and, in particular,on the bond market, a first caveat to bear inmind stems from the difficulties involved indisentangling the effects of the introductionof the euro from those of other structuralfactors for structural change currentlyaffecting the financial markets, such asdemographic, technological and regulatorydevelopments. In addition, in theEuropean context the effects of the gradualimplementation of the Single Market forfinancial services are an important factor inexplaining ongoing changes. In many respects,the Single Market-related changes interactwith the introduction of the euro in amutually reinforcing process.28 A secondcaveat stems from the fact that the timeelapsed since the start of Stage Three of EMUis too short for any observation of structuralchange to be done properly, in particularon account of the difficulties involved indistinguishing short-lived factors affectingmarket developments and one-off effectsof the introduction of the euro from thestructural changes which can be expected toremain as a consequence of the new contextbrought about by the creation of the singlecurrency. While the latter caveat also holdstrue for the money market developmentsdiscussed above, the relatively smallerproximity of the bond market to theimmediate impact of the single monetarypolicy implies that changes in the bond marketcan be expected to be somewhat slower thanthose in the money market, and also thatmore caution is warranted when linking themto the introduction of the euro.

A description of the main effects that theintroduction of the euro might have beenexpected to have a priori in the bond marketcan be used as a tentative benchmark againstwhich the developments observed since theintroduction of the euro can be appraised.

A first grouping of the effects which mighthave been expected would include two mainconcepts: first, the appearance of economiesof scale stemming from the disappearance of

II The euro bond market

currency and other related barriers; thisshould be reflected, in particular, in anincreased investor base and an increaseduniverse of potential issuers and, second, anincreased homogenisation of practices bothon the supply side (in the form of innovativecompetition with regard to issuing techniquesand some aspects of secondary marketorganisation) and on the demand side(affecting the degree of diversification withinthe euro area). Some more specific effectslinked, to a varying extent, to the twoeffects broadly described above include agreatly increased diversification of investors’portfolios within the euro area, an increasein the number of market participants (issuers)and in the average size of individual issues,increased relative incentives for the issuanceof bonds (in fact, of securities in general)compared with bank borrowing, which shouldlead to a process of securitisation, enhancedopportunities for access to the capitalmarkets by new sectors of the economyformerly absent from it (in particular smalland medium-sized enterprises and high-growth corporations), improved secondarymarket liquidity and more efficient priceformation. Virtuous interaction amongmany of the above-mentioned factors couldultimately be expected to bring about areduction in the costs of financing, althoughno attempt is made here to analyse such adevelopment.

Bearing in mind the caveats mentioned aboveand also the scope of the issues addressed inthis Paper, the evidence reflected in this sectionprovides indications that, only a year after theintroduction of the euro, there were a numberof signs of major changes in the European bondmarket.29 In such a short period the European

28 Some reviews of the implications of EMU for capital marketsare Dermine and Hillion (1999), Gros and Lanoo (2000), Bishop(1999), Danthine, Giavazzi and von Thadden (2000), Gros(1998), McCauley and White (1997), Mayer (1999) and Pratiand Schinasi (1997). Recent, general discussions on financialsystems can be found in Allen and Gale (2000), Demirguc-Kuntand Levine (1999) and Levine (2000). This broader issue is notaddressed in this Paper. ECB (2000a) contains a review ofdevelopments during the first year of EMU.

29 In this context references to the European bond market must beunderstood as references to the euro-denominated bond market,even if some of the issues discussed may also have affectedother European bond markets.


bond market became significantly larger andmore integrated; in particular, the sovereignsegment of the market became morehomogeneous and signs of increased integrationwere perceived in other segments; privateissuers’ activity overtook that of sovereignissuers, which had traditionally dominated thebond market, and signs of innovativecompetition were observed with regard toissuing techniques. Likewise, in a context ofincreased competition among issuers, substantialefforts were made to try to improve liquidityconditions and, thereby, the attractiveness ofindividual issues for a much broader investorbase. As a result of such developments, signs ofimproved liquidity were also perceived. Withregard to international bond issuance, during itsfirst year of existence the euro slightly overtookthe US dollar as the denomination currency.30

Overall, the euro area bond market is startingto become an important source of financefor the private sector and, in particular,for corporations, thus complementing theincreasing role of the short-term securitiesmarket in this same respect. A larger numberof firms have access to the market owing tothe increased willingness of investors to buy

paper with lower ratings, while innovationsin issuing and trading are improving liquidity.

As regards the technical aspects of thetransition to EMU, such as the re-denomination and re-conventioning of bondsdenominated in the euro legacy currenciesinto euro-denominated bonds, it workedsmoothly and was hardly seen as an issue bymarket participants.31

This section analyses the major changes whichoccurred in the euro bond markets in 1999. Itis based on the analysis of several data sources,as well as on an ESCB market survey, whichwas mainly of a qualitative nature, on thechanges brought about by the introduction ofthe euro.32 While it is difficult to make adistinction between those changes which weremainly demand-driven and those which wereprimarily supply-driven, for methodologicalreasons the description provided below startswith a discussion of developments affectinginvestors’ demand and follows with adiscussion from a supply-side perspective.Thereafter developments in secondary markets,in derivatives markets and those affecting marketparticipants are briefly addressed.

30 See Detcken and Hartmann (2000) for a discussion on theinternational role of the euro and, in particular, its role as thedenominator of securities.

31 The only exception to such rule are the few remaining issuesdenominated in euro legacy currencies, for which liquidity decreased.

32 See Annex 2 for more details.33 See French and Poterba (1991) and Tesar and Werner (1992);

for a discussion of the effects of EMU on portfolio management,see Brookes (1999).

34 The source on which the discussion is based here is the qualitativeinformation obtained through the ESCB market survey describedin Annex 2. The coverage of the survey was broad enough toensure that the answers did indeed reflect the bulk of ongoingdevelopments. While not precise in quantitative terms (in somecases some estimates were provided by institutional investors),the survey clearly indicated that the diversifcation processprompted by the introduction of the euro was very significant.

II.I The demand side: developments in investment behaviour

Traditionally, fixed income Europeaninvestors have shown a strong home bias,i.e. a tendency to keep internationaldiversification below optimal levels, a patternalso found at a more general, global level.Such behaviour constitutes the so-calledhome-bias puzzle and has never beenexplained, from a theoretical point of view,in a fully satisfactory way, in the sense thatthe magnitude of such a bias seems to reflecta departure from economic rationality on thepart of investors.33 The discussion herefocuses on the European experience sincethe start of EMU with regard to bothgeographical diversification and diversificationinto new financial instruments, which is alsopartly related to EMU. The lack of data onportfolio diversification, however, does notallow any quantitative estimate to be provided

on the degree of diversification reached sofar. Yet, with the caveats derived fromthe lack of quantitative information,34 theevidence reflected in this chapter could beinterpreted as an indication of the relevanceof the existing barriers (including exchange


rate risk and others) to diversification: theremoval of the exchange rate risk within theeuro area together with other associatedinstitutional changes were reflected in anintensive diversification process during thefirst year of EMU.35 The “frictional costs”and information imperfections are at the coreof the explanations traditionally invoked forthe investors’ home bias. More specifically,relevant factors might include the existenceof legal and institutional impediments tointernational diversification, such as currencymatching rules (i.e. rules limiting thecurrency risk exposure incurred by investors),familiarity with the domestic market, a heavyreliance on domestic counterparties andinsufficient expertise for large-scale, cross-border investments, or existing accountingconventions (see Section II.1.1.5).

Since the mid-1990s a tendency to diversifyand internationalise has been observed amongEuropean institutional investors. To someextent such a tendency was also observed innon-European countries, in the wake ofgeneralised financial liberalisation since the1980s. Prior to Stage Three of EMU fixedincome funds’ managers tried to exploitintra-European interest rate differentials andexchange rate fluctuations.36 However, theportfolio diversification resulting from EMU-related flows was still limited and was largelyconfined to government bonds.

It was only after the final decision on theadoption of the single currency, in mid-1998,that intra-European currency risk ceasedto affect transactions among currenciesprospectively merging into the euro. Fromthat moment, a clear trend towards thegeographical diversification of institutionalportfolios into assets issued in prospectiveeuro area countries was observed. As aconsequence, yields experienced a quickand substantial convergence. While thediversification process under way in theeuro area is primarily geographical, it is alsoaffecting the distribution of investment amongthe various asset classes. A clear shift fromgovernment bonds into all sorts of “credits”(i.e. securities other than government bonds,

such as corporate bonds), asset-backedand mortgage-backed securities such asPfandbriefe (i.e. German mortgage bonds),structured products and even “junk” (high-yield) bonds is being observed.

The ongoing portfolio diversification in theeuro area is discussed in this section,focusing on the geographical diversificationof government bond portfolios, the shiftinto new asset classes and the change inbenchmark indices. Remaining impedimentsto diversification are also briefly described.

II.1.1 Investment diversification

II.1.1.1 Geographical diversification within theeuro area

Following the removal of the exchange ratebarrier within the euro area, in the course of1999 the strategic focus of investorsshifted and this brought about a substantialreallocation of portfolios. However, theimpression was that the diversificationprocess prompted by the introduction of theeuro was far from complete after the firstyear of Monetary Union. With regard to thediversification of investment in governmentbonds, a factor which may have slowed theprocess somewhat is the limited incentive fordiversification implied by the reduction inthe spreads among the various euro areagovernment bonds. As a consequence,and considering transaction costs, someinvestors seem to have followed a pattern of“passive diversification”, confining it to thereinvestment of coupons, redemptions andnew cash flows.

35 The adequacy of the term “diversification” in this context couldbe challenged on the grounds that the exchange rate risk facedby euro area investors has ceased to exist for euro-denominatedfinancial transactions, and cross-border investment should justbe referred to as such. However, the usual terminology ispreferred here since “diversification” may refer to factors otherthan the currency denomination.

36 In particular, the “convergence plays” among EU countries’government bonds, i.e. market transactions induced byexpectations related to the prospects for accession of individualEU countries to EMU, became common in the years prior toEMU.


As a rule, institutional investors in smallercountries diversified more quickly than didinvestors in larger countries, mainlybecause the incentives for diversification arepotentially bigger for investors with arelatively reduced choice of domestic assets.On the other hand, the fact that, since thestart of EMU, liquidity has become the maindifferentiating feature among governmentbonds, together with credit risk, has putlarger countries in a privileged position asrecipients of investment reallocated in the

wake of EMU (see Box 1). In some cases, thelimited liquidity prevailing in the smallergovernment debt markets was not offset bythe yield differentials. As a consequence,many investors tended to concentrate theirholdings in larger and more liquid euro areagovernment bond markets.37

Box 1Liquidity premia and specialness of government bonds

When looking at the European government bond market, spread variations along the yield curves can be

explained by one major factor besides the difference in creditworthiness: liquidity. The most common

definition of “liquidity” refers to the extent to which market participants are able to conduct sufficiently large

transactions without producing major price movements, and tends to be reflected in tight bid-offer spreads and

the absence of price gapping. In the bond market, the liquidity of issues depends on matters such as issue size,

age (recent issues tend to be more actively traded) and secondary market making commitments. In any case,

liquidity is to a large extent a “self-fulfilling process”. This is because certain bonds are liquid as a result of the

market expectation of their being liquid, which attracts buyers and sellers, minimises transaction costs and

generates high turnover.

Liquidity enables traders and investors to manage portfolios actively or to hedge positions at the lowest

possible cost. The market preference for liquidity can be priced and translates into a liquidity premium for

liquid bonds, i.e. investors accept a lower yield when investing in a liquid instrument. Volatility and market

expectations tend to drive liquidity preferences.

Another factor that can cause bonds to be expensive is their deliverability into futures contracts. CTDs

(cheapest to deliver in a futures contract) in particular can have significantly lower yields in relation to the

yield curve. Normally, this tends to be reflected in the repo market: market participants are willing to lend

money at lower than money market rates if they receive the CTD bond as collateral. In this case the bond is

said to be “special in repo”. Repo specialness is not necessarily confined to CTDs. Other bonds that trade at a

premium, such as non-CTD deliverables and recent liquid bonds which traders can sell short in order to hedge

positions, can be special in repo. The repo market, therefore, can be seen as a link between liquid and less

liquid bonds.

The importance of liquidity as a driver of yield differentials in government bond markets is partly the

consequence of the integration of these markets, but more temporary factors, such as the 1998 liquidity crisis

and Year 2000 considerations, can also occasionally play a role. Furthermore, as investors diversify into other

(usually less liquid) credit classes, while overall wanting to maintain a reasonably liquid portfolio, the

liquidity preference translates disproportionately into the government bond markets.

Looking forward, it is expected that liquidity will gain greater importance as the main driver of yield

differentials in the euro area. Indeed, it is thought that the euro area bond market will increasingly resemble

the US Treasury market, with a clear difference between on-the-run and off-the-run bonds. In explaining yield

differences on the euro area yield curve, liquidity, benchmark and CTD premia are already more important

than credit risk.

37 From the technical standpoint, i.e. that of the benchmarkindices used by portfolio managers, such an approach isfacilitated given the degree of freedom around the benchmarks(measured in terms of tracking error) and the high correlationsbetween euro area government bonds (see Section II.1.1.5 andBox 2).


As regards diversification into corporatebonds, this seemed to be somewhat slowedby the costs associated with credit riskanalysis and by the need on the part ofinvestors to reconsider their strategies. Inparticular, the size of small and medium-sizedinvestors’ portfolios may not be sufficientto compensate for the costs of internalcredit risk management (i.e. hiring andtraining credit specialists and implementingtechnology). As a consequence, many havechosen to participate in institutional creditfunds (often offered by the larger investors).

The persistence of liquidity and creditdifferences among sovereign bonds in theeuro area results in a non-unique governmentbond yield curve. In this respect, theEuropean bond market still differs from fullyintegrated markets. German and Frenchbonds are broadly seen by market participantsas the main components of the yield curvefor euro-denominated bonds. German bondsare seen as the benchmark for the two-yearand ten-year sectors of the curve, whileFrench bonds are considered to be thebenchmark for the intermediate sector andfor maturities of over ten years.38

II.1.1.2 Diversification into other asset classes

While the introduction of the eurobroadened the concept of “domestic” marketfaced by individual euro area investors, italso forced portfolio managers to changetheir asset allocation strategies. In order tooutperform their benchmarks, for investmentwithin the euro area, portfolio managers mustnow essentially focus on the management ofcredit risk and yield curve risk (i.e. the risklinked to the positioning through thevarious segments of the yield curve). Suchdevelopments, together with the low interestrates and the tight spreads for triple A andagency bonds (i.e. bonds issued bypublic institutions other than centralgovernment) prevailing at the start of EMU,prompted investors to diversify into a widerrange of corporate bonds, encompassingrelatively low-rated bonds. While the demandfor AA and A-rated bonds grew substantiallyin 1999 (reflected in issuance growth ofaround 100% compared with 1998), the

Chart 11Increase in euro area issuance: breakdown by issuer rating(percentage increase in issuance in 1999 compared with the 1996-98 average)

Source: Capital Data Bondware, 2000. Includes all international and domestic issues, apart from auctioned domestic governmentdebt.Note: Data up to 1998 refer to euro legacy currencies and ECU-denominated issues; in 1999, euro-denominated issues. All issueamounts are provided in USD millions in order to give consistent comparisons.

38 The heterogeneous fiscal treatment of the various bonds alsocreates difficulties. Some price distortions are reported as beingrelated to large (tax-induced) domestic holdings of the bondsinvolved.

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Chart 12EMU-11 bond issuance 1996-99 in euro, by rating(USD millions)

Source: Capital Data Bondware, 2000.Note: Data up to 1998 refer to euro legacy currencies and ECU-denominated issues; in 1999, euro-denominated issues. All issueamounts are provided in USD millions in order to give consistent comparisons.

issuance of Baa-rated bonds grew by muchmore (around 500% during the year, seeCharts 11 and 12 and the next section onissuing activity), albeit from very low levels.Decisions to resort to diversification alongthe maturity spectrum were also observed.

The development of new investmentstrategies along the lines described abovealso had consequences for the internalorganisation of investors. Many of them havereinforced, or have initiated, credit research.Some of them have decided to outsource themanagement of credit risk, confining theirin-house operations to interest rate riskmanagement.

II.1.1.3 Changes in the use of indices

The process of strategic repositioning ofinvestment portfolios in the wake of theintroduction of the euro has clearly beenreflected in the change in the indices thatinvestors use as a benchmark (see Box 2). Bythe beginning of 1999 most investors in theeuro area had replaced the widely usednational bond market indices with Europeanindices. However, both the speed ofimplementation of the new benchmarks and

the way in which they were constructed differgreatly.

The concept of a “euro benchmark” is usuallyunderstood by investors in a broad sense. Insuch a context, “Europe” is often not seen asbeing a synonym for the euro area, andwider definitions including EU non-euro areacountries (Greece, Denmark, Sweden andthe United Kingdom) and sometimes othercountries (i.e. EU accession countries) arecommon. Moreover, not all investorsfollow the standard indices; most of themadjust the indices to accommodateindividual preferences. Some investors feeluncomfortable with indices which are toowide, as they prove to be difficult to replicateand track. In such cases the benchmarks canhave a strong home bias or be based on thenational indices of the larger EU countries.

II.1.1.4 Remaining impediments to diversificationand integration

Despite the substantial progress observedduring the first year of EMU, the integrationof the European capital markets is far fromcomplete. While the integration process andthe increased diversification trend are, in any

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Box 2Index use

In order to assess returns on investments, investors, portfolio managers and risk managers must take into

account the risks incurred. For a bond market investment, such risks include interest rate risk, credit risk,

liquidity risk and – for an international portfolio – currency risk. Both investment decisions and performance

evaluations are usually seen in the light of the risk taken on. Therefore, some neutral yardstick, or benchmark,

able to reflect strategic investment decisions is required. This is the role of indices.

An index is a hypothetical portfolio of securities that closely matches the risks an investor accepts or is willing

to take. The degree of freedom for the actual management of the portfolio is usually defined in terms of

“tracking error” (a measure of the maximum allowed deviation of the value of the portfolio) vis-à-vis the

benchmark portfolio. To be useful as a benchmark, an index must be well diversified over all the relevant risk

factors. Moreover, the index should consist of sufficiently liquid bonds in order to enable a performance

evaluation frequently marked-to-market (i.e. adjusted to market prices).

Traditionally, the American investment banks have dominated the production of bond indices. Since the start

of EMU, constructing a good index for a European bond portfolio including “credits” has been a major

challenge given the temporary gap existing between an increased demand for diversification and a still limited

supply of corporate bonds. The completeness of the index (i.e. the width of its coverage of various asset

classes) has to be balanced against its liquidity (which, given the still limited development of the euro area

secondary bond markets, can be very limited in some asset classes, thus causing the index to be less useful as a

pricing reference if these are included).

event, structural processes which are likelyto take time, the existence of institutional orlegal barriers to them within the euro area isalso a factor behind its relative slowness. Inthis regard, the following factors are the mostrelevant:

• With regard to the legal impediments, thelack of clarity and uniformity in bankruptcylaws is often mentioned, which, inparticular, might hinder diversification intothe high-yield bond market.

• Certain tax regulations have to be takeninto account in considering furtherinternationalisation. Withholding tax ismentioned most frequently in this respect.

• Accounting conventions: integration can beslowed down by the accounting treatmentof institutional investors’ profits; in a low-yield environment diversification wouldrequire investors to sell above par bonds,thereby boosting accounting profits forsome insurance companies (and bringing

taxes forward). While the incidenceof such a factor depends on marketcircumstances, it is seen as an additionalreason for investors to take a gradualapproach towards investment in foreignbonds.

• Fragmentation of European settlementsystems is seen as a factor limitingintegration and portfolio diversification,even though it affects trading more thaninstitutional investment (see Section III).

Overall, the trend of increasedinternationalisation and diversification ofportfolios in the euro area is expected tocontinue. First, it is likely that remainingimpediments will gradually be overcome.Second, in the current low-yield environmentand in the absence of exchange rate risk withinthe euro area, investors are willing to invest ininstruments with a higher risk and return andthis greater demand should increasingly be metby the corporate sector in the coming years,also on account of the expected decrease in


government debt issuance (see Section II.2).Finally, the need for European savers to preparefor their increasing future pension needs willalso contribute to boosting securities demand

Chart 13Bond issuance in 1996-99 in euro and euro legacy currencies(USD billions)

Source: Capital Data Bondware, 1999. It includes all international and domestic issues apart from auctioned domestic governmentdebt.Note: Data up to 1998 refer to euro legacy currencies and ECU-denominated issues; in 1999, euro-denominated issues. All issueamounts are provided in USD millions in order to give consistent comparisons with previous years.

39 Data in charts 13, 16 and 17 are taken from Capital DataBondware, and when analysing them it should be kept in mindthat they do not include the bulk of government bonds, whichform the major part of the euro area bond market (around60%). The rate of issuance growth in 1998 was bigger than thatin 1999, as reflected in Chart 13. However, the major increasetook place in 1999 as regards corporate issuance (269% growthcompared with 30% in 1998).

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in the euro area. Nevertheless, even taking allthese factors into account, it might take yearsfor the corporate capital market in Europe tobe comparable with its US equivalent.

II.2 The supply side: developments affecting issuer behaviour

The integration of national capital marketshas significantly increased the competitionamong issuers. Owing to the shift, asillustrated above, in investors’ focus fromtheir respective national bond markets to awider range of bonds, both sovereign andprivate issuers – in particular smaller ones –have to focus on a broader investor basewhen defining their strategies. At the sametime, they are increasingly competing withone another. While in some respects theforces for change and increased competitionare common to both the government and thecorporate bond segments, their starting-pointwas rather different: whereas the nationalgovernment bond markets were alreadyrather developed prior to EMU, Europeancorporate bond markets were largelyunderdeveloped. The main trends observedin the structure of supply in the euro areabond markets are described below.

All in all, the impact of EMU on the euro areabond market on both the demand side (asdiscussed above) and the supply side (as discussedbelow) was reflected in a substantial increase inthe total issuance of euro-denominated bonds,which grew by 38%, and in particular of corporatebonds (see Charts 13 and 16).39

II.2.1 Government bonds

In general, sovereign bond issuers in theeuro area have benefited from the ongoingintegration of national capital markets.


Following the introduction of the euro,currency-related risk premia have vanishedand, as a result, funding costs have beenreduced, albeit to a varying extent, for thevarious euro area sovereign issuers. Yielddifferentials among the euro area governmentbonds have converged markedly since theMay 1998 pre-announcement of theirrevocable fixing of the parities of theprospective euro area currencies. Since then,they have usually remained below 30 basispoints, whereas in the past spreads in excessof 100 basis points had been common.Furthermore, the prospect of a relativescarcity of government bonds – as a result ofthe Stability and Growth Pact and the relateddecrease in overall supply and the likelyincrease in corporate issuance – contributedto driving government bond yields down inrelation to other asset classes, thereby furtherreducing funding costs for governments.

The fact that, since the start of MonetaryUnion, the various euro area nationalTreasuries have to a large extent beencompeting to access a common investor basehas been reflected in the introduction of anumber of changes in their issuing frameworks,in order for them to be able to cope with thenew situation and, ultimately, attract funds inthe best possible conditions. As mentioned inthe previous section, investors increasinglyfocus on liquidity, and competition for thebenchmark status has become increasinglyimportant. This context has mostly benefitedthe larger sovereign issuers. As a consequence,the pressure for increased competitivenesshas increased for smaller issuers. In thiscontext of increased competition, a significantharmonisation of issuing practices hasemerged, leading to convergence in thedirection of best practices. The main changesobserved in sovereign issuing practices sincethe start of Monetary Union can be summarisedas follows:40

• Issue sizes have become bigger. A nominalamount of €5 billion per issue seems tobe a minimum and benchmark issues tendto be tapped until their total issue size isaround €20 billion.

• Sovereign issuers focus increasinglyon a policy aimed at creating discretebenchmark issues, especially in cases wherethe total amount of government debt istoo small to ensure sufficient liquiditythrough the whole yield curve. The focusis usually on specific market segments,i.e. a pre-commitment to issue only largeliquid issues at, for example, three,ten and 30-year maturities. The mostprominent example of a benchmark policywithin the euro area is Ireland, which hastotally restructured its outstanding debtinto a few liquid benchmark issues.Other countries, such as Spain andthe Netherlands, have also introducedprogrammes to exchange old illiquid bondsfor new benchmark bonds.

• Generally, sovereign issuers have improvedmarket transparency. Efforts in this areainclude a trend towards the introductionof pre-announced auction calendars with avarying degree of detail and commitment.

• A number of governments have alsochanged their issuance procedures in orderto attract more investors. There is a cleartrend towards an increased use of primarydealers (see Box 3), although some of thesmaller issuers have also resorted tosyndication procedures in order to reacha larger set of investors.

• Governments are also trying to to findways in which to enhance the secondarymarket liquidity of their bonds otherthan through primary dealerships. Mostimportant in this respect is the promotionof new liquidity-enhancing technology.Some governments have been very keento see the establishment of trading systemssuch as EuroMTS (see Section III) andthe introduction of their bonds in thesesystems. While such initiatives can beexpected to increase liquidity, available

40 For a discussion of the effects of EMU on sovereign issuers seeFavero, Missale and Piga (2000). Bishop (1999-2000) providesa complete discussion of bond market developments in the euroarea, including both government and corporate bonds.


indicators of secondary market activity inthe first half of 1999 do not generally showa significant change compared with thesecond half of 1998; in some countriesturnover increased slightly, while in othersit seems to have diminished somewhat; noclear modifications seem to be in placeregarding bid-ask spreads. The standarddeal size seems, however, to have grownin a number of cases.

• Finally, governments can try to focus onparticular investor needs in order to carveout a market niche by concentratingon innovation. The French and SpanishTreasuries seem to have been those

initially most active in this field, byproviding the market with constantmaturity and inflation protectedalternatives in addition to their ordinarybonds.41

The amount outstanding of government bondsincreased slightly in the course of 1999, in spiteof decreasing gross issuance during the year.The decreased issuance in 1999 (see Chart 14)was the result of a number of factors, notably,on the one hand, the reduced borrowing needscaused by the globally improved fiscal situation

41 Constant maturity bonds have a coupon that is periodically resetto the prevailing ten-year bond yield, for example.

Box 3Primary dealership

Primary dealership systems for government bonds currently exist, in several varieties, in all the euro area

countries, with the exception of Luxembourg. In most of these countries primary dealers have been in place

for many years, their creation usually being associated with the modernisation of the local financial market

structures and debt issuance procedures. Only in the Netherlands was a system of primary dealers introduced

in order to address specifically the changes triggered by the euro.

The reason for establishing a primary dealership system or for updating an existing one can be twofold.

Sovereign governments want to secure a smooth and diversified placement of their debt. As a consequence,

special emphasis has been placed on the internationalisation of this placement. This movement has taken two

different forms: on the one hand, some issuers have opened their primary dealership system to non-resident

intermediaries, putting them on an equal footing with domestic participants. On the other hand, countries such

as France and Belgium have created, in addition to the status of primary dealer, a specific group of market

participants devoted to promoting the sale of public debt on foreign markets.

Primary dealerships usually entail market-making commitments for banks in the group. Sovereign issuers

make use of these provisions to enhance secondary market liquidity.

Even if they are based on a similar philosophy, the various primary dealership schemes appear to be quite

different in their practicalities. For instance, in Germany the commitments of the members of the “Bund Issues

Auction Group”, which replaced the former Federal Bond Consortium at the beginning of 1998, refer only to

an adequate participation in the auction, while in most other countries this commitment is complemented by

some benefits (a monopoly on stripping activity, for instance, in France, the Netherlands, Belgium and Spain)

and requirements on the secondary market (quotations for clients, and market-making for other intermediaries

in France, Belgium, the Netherlands, Spain, Portugal, Finland, Italy and Ireland).

The extent to which a primary dealership system contributes to bond market integration depends largely on the

composition of the group of dealers. In this respect, the trend is towards wider international representation.

Too much emphasis on domestic houses might be perceived by the market as being a protectionist measure

rather than with an attempt to reach a wider investor base.


Chart 14Government bonds in the euro area: gross issuance in 1999(EUR billions)

Source: ECB.

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and, on the other, an increased preference forlonger maturities, in a context of low long-terminterest rates, which was also reflected in thereduced issuance of Treasury bills, as discussedabove. In addition, some concentration ofissuance in the first few months of the year(“frontloading”) was observed, which can beexplained by the competition between sovereignissuers for benchmark status during the firstfew months of Monetary Union. All in all, thesize of the euro area government bond marketincreased slightly in the course of 1999 (seeChart 15).

Issuance by non-euro area sovereign issuersin the euro bond market was limited in1999, as swapping the proceeds into domesticcurrency was not attractive at the prevailingswap levels.

II.2.2 Supranational and governmentagency issues

Supranational issuers had traditionallyenjoyed a privileged position in Europe priorto EMU owing to the combination of their

size and their high rating, which allowed themto offer a constant (i.e. equal credit quality)benchmark across different currency bondmarkets. The improvements in the situationfaced by other highly rated euro area issuers(sovereign or corporate ones), as broughtabout by the changes in investor behaviourdescribed above, have been reflected in aworsening, in relative terms, of the situationfaced by supranational issuers, which nowface increased competition. Like sovereignborrowers, since the start of EMUsupranational issuers have therefore beentrying to make their bonds more attractiveby increasing the issue sizes, providingbenchmarks and enhancing secondary marketliquidity. Despite such efforts, supranationalissuers seem to have lost some ground in theEuropean bond markets during the first yearof Monetary Union. Issuance targets wereincreasingly hard to meet at the termssupranationals had been accustomed to andtheir bonds tended to trade at higher yieldsin the secondary markets. As a consequence,total euro-denominated issuance during theyear stood 35% lower than the average ofthe previous three years (see Chart 16).


The impact of the introduction of the euroon securities issuers such as governmentagencies and local governments during thefirst year was not unambiguous. On the onehand, like other euro area issuers, suchinstitutions enjoyed a wider investor base;on the other, they faced increasedcompetition between one another and withsovereign issuers. Such competition may notbe easy for such institutions in terms of thesize of issues. However, they also tried toimprove liquidity conditions by means oflarger issues. All in all, global issuance duringthe year was similar to that in the previousthree years (see Chart 16).

II.2.3 Corporate bonds

Although the amount outstanding of privatelyissued bonds in the euro area is still relativelymodest compared with that in the UnitedStates, the issuance of corporate bondsincreased markedly in 1999 (see Chart 16). Anumber of mutually reinforcing factors, both

demand and supply-driven, were behind thisdevelopment. The former have already beendiscussed above; on the supply side thefollowing could be mentioned:

• As a consequence of the furtherdevelopment of European capital markets,corporations – those with a good creditrating, in particular – have increasinglybeen exploring the opportunities for directfinancing, looking for better fundingconditions. This was facilitated, in somecases, by the fact that the credit ratings ofa number of corporate issuers are betterthan those of their banks.

• Increased financing needs also seem tohave been a factor in the growth ofcorporate issuance. To a large extent, in1999 these were related to an intensiveprocess of consolidation under way in theEuropean corporate sector, partly as aconsequence of EMU. Increased mergerand acquisition activity usually coincideswith increased financing needs.

Chart 15Outstanding amount of government bonds in the euro area(EUR billions)

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• The context of EMU-related increasedcompetition in the European businesssector seems to have prompted corporatemanagers to focus more on theirfinancial structure and optimal financialleverage, which might have reinforced thedisintermediation trend highlighted above.

• Corporate issuance tends to be facilitatedby banks. The increased focus onshareholder value by corporate managers,new BIS regulations on bank capital, andstronger competition in the Europeanfinancial sector prompted banks to usetheir balance sheets more efficiently, inorder to increase their return onequity. As a consequence, banks areincreasingly facilitating direct access bycorporations to the capital markets(i.e. by lead-managing bond issues). Thisdisintermediation trend was also reflectedin the substantially increased issuanceprogrammes of financial institutions (seeChart 16).42

• The new dimension of the market was alsoreflected in the fact that the average size

Chart 16Euro-denominated issuance by issuers other than central governments in euro andeuro legacy currencies; global, domestic or foreign markets; volume of gross issuance(USD billions)

of corporate issues approximately doubledin the euro area in 1999 compared withthe previous three years (see Chart 17).

During 1999 the amount outstanding of euro-denominated bonds issued by non-euro arearesidents grew by 39%, while that issued byeuro area residents grew by 8% according toECB data.43

Despite the significant growth observed inthe euro area bond market during 1999, itshould be noted that some market segmentsremain underdeveloped, particularly thosefor lower credit rated and unrated debt.Relatively few euro area corporations have acredit rating, and this is a factor currentlyrestricting their access to the bond market.Market participants foresee that corporates

42 An in-depth analysis of such a trend, however, which is notintended here, should compare these developments with trendsin bank lending activity, which also showed rapid growth in 1999and early 2000.

43 See Molinas and Woodworth (2000) for a discussion of this andother developments in the euro bond market.

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Source: Capital Data Bondware, 1999. Includes all international and domestic issues apart from auctioned domestic governmentdebt.Note: Data up to 1998 refer to euro legacy currencies and ECU-denominated issues; in 1999, euro-denominated issues. All issueamounts are provided in USD millions in order to give consistent comparisons with previous years .


Chart 17Average size of corporate bond issues denominated in euro and euro legacycurrencies

Source: Capital Data Bondware, 1999. Includes all international and domest ic issues apart from auctioned bonds.Note: Data up to 1998 refer to euro legacy currencies and ECU-denominated issues; in 1999, euro-denominated issues. All issueamounts are provided in USD millions in order to give consistent comparisons with previous years.

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will increasingly be inclined to applyfor ratings. Another sign of the limiteddevelopment of the European credit marketis the fact that price information is still poor.Trading is thought to be hampered by opaqueprices in some markets and institutionalinvestors sometimes have difficulty infinding reliable prices for marked-to-marketvaluations of their credit portfolios.

Notwithstanding the substantial progressalready achieved in the first year of EMU, bycomparison with the US corporate bondmarket that of the euro area is still behindregarding liquidity and market completeness.The size of the European corporate bondmarket, as measured by the market value ofoutstanding issues, is also small in comparisonthe US market (an estimated €700 billionin Europe compared with €3,500 billionin the United States). This being said, thevolume of new corporate issuance in the euroarea in 1999 brought it closer to its UScounterpart. A comparison relating tointernational corporate bonds (i.e. excludingdomestic bonds for which issuance statisticsare difficult to compare on a consistent basis)shows that euro-denominated issuance in

1999 was approximately 28% higher thanUS dollar denominated issuance.

II.2.4 Asset-backed and structuredproducts

The increased focus of banks on their balancesheet use and on the achievement of a highreturn on equity not only gave rise toincreased corporate bond issuance, but alsogave a major impetus to the asset-backedmarkets in the euro area. Such a form ofsecuritisation was fostered by an increasedappetite for new products among investorslooking for higher returns.

Mortgage portfolios are the main category ofbank assets demanded by investors. Thedegree of market development for such assetswidely varies among euro area countries.The most developed market is theGerman “Pfandbriefe” market. In particular,acceptance of the highly liquid Jumbo-Pfandbriefe market is well established amonginvestors. Since the start of EMU, total Jumboissuance has roughly doubled; a substantialshare of the amount outstanding was held


outside Germany. This success can beattributed to the combination of large issuesizes and an efficient system of marketmaking. Following the German example, othercountries (i.e. France and Spain) set up similarmortgage-backed markets. Nevertheless, the

44 This situation was starting to change, however, at the beginningof 2000, as turnover in the MATIF ten-year “Notionnel” contractgrew substantially; the often argued technical superiority of thatcontract might be the explanation.

asset pools backing mortgage portfolios arenot homogeneous, owing to differences inthe legal frameworks governing the variousnational mortgage and housing markets. Fora pan-European market to develop, these legalobstacles should be overcome.

II.3 Developments in secondary markets

While liquidity is usually a key factor in thefunctioning of all markets, it is more visible for theeuro area bond markets, given the disappearance,or significant reduction, of other sources ofdifferentiation among highly rated euro areasecurities from an investor perspective (see alsoBox 1). Liquidity tends to be increasinglyconcentrated in benchmark issues, resulting inhigher spreads between on-the-run and off-the-run issues. In some market segments, especiallycredits and the off-the-run small-sized bonds ofsome countries, liquidity diminished comparedwith Stage Two of EMU. All in all, the euro bondmarket has a long way to go before its secondarymarket activity will be comparable with thatprevailing in the United States. Factors explainingthis situation are similar to those referred toabove with regard to primary market activity,such as the non-homogeneity of sovereignissuance in Europe (no single issuance calendar;differing procedures) or the fact that the marketsfor less creditworthy non-government bonds arerelatively underdeveloped.

While the information sources availableregarding activity in the secondary markets for

bonds are rather limited, available indicatorssuggest that the secondary market forgovernment securities generally functionedsmoothly during 1999, and experienced anincrease in the nominal size of orders. Mostmarket participants suggest that formerlystandard DEM 20 million to DEM 50 milliondeals were replaced with EUR 20 million toEUR 50 million standard deals. Bid-ask spreadswere usually seen as little changed comparedwith those prevailing prior to EMU. However,those prevailing for benchmark issues (owing totheir cheapest-to-deliver status or their listingon EuroMTS) seem to have narrowed markedly.

In the corporate market, the size of issueshas clearly increased (by two to three times),which, together with a generally broaderinvestor base for the securities, hascontributed to bringing increased liquidity tothe secondary market. The average size ofcustomer transactions has also nearly doubled,while bid-ask spreads have narrowed, thanks tothe presence of more market-makers. However,overall secondary market activity has remaineduneven and limited.

II.4 Bond-related derivatives markets

II.4.1 Futures

The trading volumes of euro-denominated bondfutures have increased dramatically since thebeginning of 1999, indicating a high level ofturnover in euro-denominated bond markets.While short-term interest rate futures weredominated by contracts on LIFFE, in the courseof 1999 liquidity for bond futures was almostexclusively centred on the German Bundcontracts of the German/Swiss derivatives

exchange, Eurex. The Bund future is widely usedas a hedging vehicle for all euro-denominatedissuance owing to the liquidity it offers to investorsand intermediaries, as a consequence of whichBund futures are often the cheapest availablemeans of hedging.44 The basis risk entailed in thistype of hedge was well accepted by investors.


It is interesting to note that, compared withthe joint volumes traded on the US ten-yearand the long bond contracts (i.e. the relevantcomparison for the US futures market) theturnover in the Bund contract was biggerthroughout 1999: the trading volume of theBund contract was steadily above the sum ofthe two US contracts (see Chart 18).

As regards other new euro exchange-tradedinstruments, such as multi-issuer contracts,new lower notional coupon LIFFE contracts,or swap-based futures, these did not succeed,in the course of 1999, in generating a “criticalmass” able to attract investors and tradersand generate substantial liquidity. There maybe different reasons for the lack of liquidity.Some financial intermediaries hold theview that multi-issuer contracts, which werelaunched by competing exchanges, will notwork. The cheapest-to-deliver bond of sucha contract is likely to be either the leastliquid or the worst rated bond includedin the basket, which would make it lessattractive than the Bund future contract.While a reduction in the notional couponaimed at updating its level is in principle seenas an appropriate step, it will not improvethe attractiveness of a future unless the

Chart 18Ratio between volumes (expressed in euro) of ten-year Bund futures and US ten-yearlong bond contracts (one-month moving average)

Source: Bloomberg.

Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.

3.0

2.0

1.0

0.0

3.0

2.0

1.0

0.0

1999Jan.2000

contract is liquid enough. LIFFE did changethe notional coupon of its Bund future tomarket levels. However, it did not seem tomodify the relative share of activity withrespect to Eurex, which maintained itsnotional coupon at 6%. The success of otherefforts by LIFFE to launch a swap-basedcontract seemed to be limited by the factthat the swap community showed littleinterest in providing liquidity in the future atthe expense of giving up the lucrativebid-offer margins. In any case, a kind of“vicious circle” is always at stake when itcomes to market liquidity: market participantsare reluctant to participate in a marketbecause of the absence of liquidity, and thisin turn exacerbates the illiquidity, while theopposite happens as soon as one or otherfactor turns the vicious circle into a virtuouscircle.

II.4.2 Swaps

The introduction of the euro led to anexpansion in the importance of swap marketsfor euro area fixed income asset managementand hedging activities. A major factor in thisrespect was the increase in corporate bond


issuance. The hedging of this increasedcorporate issuance through the swap marketand increased swap market liquidity. Thetrend towards hedging corporate bondpositions with swaps, rather than adoptingshort positions in government paper orfutures, went further in 1999 following the1998 liquidity crisis, during which governmentbond futures proved to provide poor hedgingqualities for corporate bonds.

Furthermore, since the introduction of theeuro interest rate swaps have increasinglybeen used as a valuation benchmark. Thehomogeneity and liquidity provided byinterest rate swaps explain the observedtrend of their increasing use as a commondenominator for a comparison of relativeasset values between issues of different euroarea government bonds, as well as thoseissued by supranational institutions and bygovernment agencies. The use of the swapcurve as a relative value tool is currentlycommonplace with LIBOR-based institutionsand might gain importance in the absence ofa homogenous euro area benchmark curve.

II.4.3 Bond repos

As liquidity becomes an increasinglyimportant factor in the pricing of government

bonds within the euro area and, as a result,benchmark premia increase, repo markets,as a powerful liquidity-enhancing tool, arebecoming more and more important forthe development of bond markets. Marketparticipants are, therefore, increasingly inclinedto conduct repo transactions and foresee aconsiderable growth of the repo market foreuro area sovereign issues. However, it mighttake some time before a European repo marketcomes close to the US market in terms of sizeor liquidity. More importantly, the currentfragmentation of clearing and settlementsystems is considered a major impediment tofurther development of the European repomarket (see Section III).

II.4.4 Credit derivatives

The appetite for credit risk amonginvestors increased markedly in 1999. As aconsequence, for certain credit classes therelevant corporate bonds were either tooilliquid to satisfy investor demand or evennon-existent. As a consequence, investordemand for credit derivatives, notably defaultswaps,45 developed as a means of taking oncredit risk. In the short term, the lack ofhomogeneous documentation may be animpediment to a rapid growth in creditderivatives.46

45 A default swap is a derivative instrument whereby the underlyingissuer’s credit risk is transferred by the holder of the security to athird party who is willing to bear it in return for a higher yield.The initial holder’s benefit stems from its risk upgrading.

46 The legal background applicable in the event of a major defaultmay also raise problems. For example, the 1998 debtmoratorium in Russia highlighted differences in default definitionsin the various credit derivative instruments.

II.5 Market participants

As in the case of money market activities,since the start of Monetary Union mostfinancial intermediaries have restructuredtheir bond trading desks. In general, a switchfrom a specialisation pattern focused oncountries towards a maturity-bucket orcredit-based specialisation (i.e. government,agency, credit) has been implemented. Anumber of banks have also been centralisingtheir trading activities in a single centre (insome cases, this may be conditional upon theneed to have a physical presence to performprimary dealer functions). At the same time thenumber of sales teams has increased in orderto provide a global service to customers

through a decentralised structure, since alocal presence across the euro area is seen,in some cases, as being useful for distributionpurposes.

The major players in the euro area bondmarkets are a small group of Europeanuniversal banks and a handful of American


investment houses. In general, financialintermediaries foresee increased competitionand consolidation as a consequence of therestructuring of the banking industry. It isthought that within a few years 10-15 keyplayers will dominate the euro area bondmarkets. Banks with a sufficient size (in termsof placing power, balance sheet, primarydealerships and distribution network) areexpected to occupy the most prominent

places. Other small and medium-sized playersare expected to focus on customer needs orspecific market niches. An example is thePfandbriefe market, where German bankshave a head start over their competitors. Asa consequence, German banks are frequentlyamong the most active bond market players,even though they are not as active in othersegments of the market.


The aim of this chapter is to identify andanalyse the main infrastructural barriers tothe integration of the euro interbank repoand debt instrument markets and to proposesome actions in order to enhance theintegration of the existing infrastructure,thereby increasing the integration of euromoney and financial markets.

It is broken down into two sections.Section III.1 describes the differentcomponents of the financial infrastructure of

III Infrastructure of the market

the money and bond markets. Section III.2tries to pinpoint the areas in which particularbarriers to integration exist, to describe whythey are problematical and what initiativeshave been or may be taken primarily by themarkets to reduce these barriers. Thedescription and analysis provided in thischapter take into account discussions heldwith a representative group of users of thefinancial infrastructure described.

III.1 General framework

This section describes the infrastructureof the money and bond markets. Theinfrastructure of these markets can be dividedinto three groups of components: tradingplatforms, clearing houses and settlement(and payment) systems. The infrastructureshould be seen in the context of thesurrounding legal environment – including thefiscal and accounting treatment of operations.The components and their interaction areillustrated in Chart 19 and described below.

A trade in the bond market or in thesecured money market may originate froman organised trading platform or may takeplace over the counter (OTC). It may gothrough a clearing house or go directly tosettlement, and it needs settlement for boththe securities and the cash leg, preferably insystems closely linked to one another.

From the point of view of settlement, thecase of the unsecured money market differsfrom both the secured money marketand the bond market. As no collateralis exchanged for the cash loan, anuncollateralised loan only needs a paymentsystem for cash settlement. The settlementof payments in euro mainly occurs viaTARGET (the Trans-European AutomatedReal-time Gross settlement Express Transfersystem). TARGET offers the possibility oftransferring central bank money on a cross-border basis as smoothly as domestically.TARGET can be used for all transfers in euro

between EU countries. It processes bothinterbank and customer payments and thereis no upper or lower limit to the amounts ofthe payments which can be processed.TARGET is a decentralised system in whichcredit institutions keep their settlementaccounts with their home central bank.Therefore, local payments continue to beprocessed in the national RTGS systems.Cross-border payments are processedthrough the national RTGS systems andare exchanged on a bilateral basis directlybetween national central banks. Since its launchin January 1999, the volume of cross-borderpayments processed via TARGET has increasedto a level of close to 40,000 transactionsper day – representing a total daily value ofmore than €400 billion. The number ofpayments processed in TARGET as a whole,i.e. cross-border and domestic payments takentogether, amounts to a daily average of morethan 187,000 (of which 147,000 are domestic),representing a total daily value of more than€1,000 billion (€605 billion).47

The fact that the unsecured money marketcan rely on TARGET, while both the repoand the bond markets also depend on thesecurities settlement infrastructure, is the

47 See also “TARGET and payments in euro”, ECB, ECB MonthlyBulletin, November 1999, pp. 41-52, and “The TARGET system”,ECB, ECB Monthly Bulletin, March 2000, pp. 63*-64*, as wellas the ECB’s website (www.ecb.int) for the latest statisticsavailable on the use of TARGET and other euro paymentsystems.


Chart 19Infrastructure of the money and bondmarkets

OTC

legalenvironment

trading platform

clearinghouse

SSS and payment systems

main reason why the unsecured moneymarket seems to be the most integratedmarket in the euro area. Therefore, the restof this chapter will focus on the securitiesside as – from an infrastructural point ofview – this is the main feature differentiatingthe secured from the unsecured moneymarket.

For the settlement of securities, no highlyefficient, fully integrated system comparableto TARGET exists, which covers the domesticlevel as well as the cross-border level. Untilthe start of Stage Three of EMU, the moneyand bond markets were predominantlynational. There were a few internationalmarkets based on the international centralsecurities depositories (ICSDs). Thesegmentation of the national markets ranalong different fault lines, most of whichcoincided with the national borders: currency,standard contracts, tax and accountingregimes, the structure of portfolios mainlybased on national assets, trading platforms,market practices, central bank practices, andclearing and settlement facilities for cash andsecurities.

With the introduction of the single currency,only three of the above-mentioned barriersreally changed – those relating to currency, thesettlement of cash and central bank practices.First, the currency is now the same throughoutthe euro area. Second, TARGET has been builtand is facilitating the efficient cross-border

settlement of cash. Finally, central bank practiceshave become somewhat more similar, althoughdifferences persist.

The other barriers have not really changed,and although Monetary Union certainly setsthe stage for integration, further initiativeswill have to be taken – mainly, but notexclusively, by the private sector – beforefurther integration of the market is achieved.

III.1.1 Trading in the euro securitiesmarket

Trading in the euro money and bond marketshas historically taken place OTC. Lately,some initiatives to create structured tradingplatforms for these markets have emerged inthe euro area. Some of these are mentionedbelow.

A common trading platform has been createdfor the government bonds of seven major euroarea issuers (Belgium, Germany, Spain, France,Italy, the Netherlands and Austria). The systemis called Euro-MTS. It is based on the originalItalian system MTS-PCT and is a screen-basedelectronic system. It has recently introducedfeatures for trading repos directly, enabling itsparticipants to trade special and generalcollateral repos at different maturity ranges.

The International Securities Market Association(ISMA) has created a trading system calledCOREDEAL for spot transactions and repooperations on debt instruments.

The most recent announcements have beenthe merger of the stock exchanges of Paris,Brussels and Amsterdam into a singleentity called EURONEXT (for the tradingof equities, bonds and derivatives) and themore equities-oriented merger of the Londonand Frankfurt stock exchanges to form iX.Moreover, talks are underway between theiX partners, NASDAQ and the Madrid andMilan exchanges. Finally, the EURONEXTpartners have announced a plan to create a24-hour global equity market in co-operationwith the stock exchanges of Tokyo, New


York (NYSE), Australia, Hong Kong, Toronto,Mexico and São Paulo.

Other market initiatives exist, such as thedevelopment of a trading platform for reposby Reuters and of an electronic platform bysome brokers.

The Eurosystem is observing the developmentof trading structures with great interest.However, only to a very limited extent doesit use trading platforms for its own purposes.Therefore, the Eurosystem has not taken anyinitiatives such as the issuance of standardsfor trading platforms. To the extent that afew trading systems emerge with a ratherlarge market share, this can enhanceintegration in two ways. First, it will implythat the traders have a common place tolook for counterparts to their trades. This initself is likely to accelerate market integration,compared with the inherent inertia in anOTC environment where there is a greattendency to continue to trade with the samecounterparts. Second, the integration oftrading, the first step of the infrastructure,may act as a driving force for integrationfurther down the infrastructure chain, i.e. forclearing and settlement.

III.1.2 Matching, netting and clearinghouses in the euro securitiesmarket

Matching covers the activities related tocollecting the trade, matching it, confirming itand transmitting it for settlement. Thesefunctions could also be carried out by atrading system, but if the market ispredominantly OTC, it may be particularlyuseful to have another institution performingthis function.

Netting refers to the reduction in the amountof processing or of the level of exposure byoffsetting a counterparty’s debit and creditpositions, leaving smaller obligations. Nettingconcerns obligations both for cash and forassets. Netting can be both bilateral and

multilateral. In the case of bilateral netting,the result is to leave each pair of participantswith the smallest possible obligation towardsone another. In the case of multilateralnetting, netting is the setting-off of mutualobligations leaving just a single obligation toor from the counterparty for each nettedasset and for cash. The effect of all nettingmethods is to reduce the need for liquidityand assets to a minimum. In a world inwhich there is increasing pressure for efficientmanagement of liquidity and assets, it isbeneficial to introduce netting into theprocess as early as possible.

If all trades were made on the sameunderlying assets, then the advantages ofnetting would be the same for assets as forcash. However, the traded assets aretypically heterogeneous and, therefore, thegain achieved by netting is smaller for assetsthan for cash. To increase the netting gain onthe assets side, the range of traded productsthat can be netted is extended, therebyperforming so-called cross-product netting.The idea of cross-product netting is to allownetting between, for example, a repo and adirect trade on the same underlying asset.

Until now, matching has frequently beenperformed by the trading platforms, whereasclearing has often been linked to thesettlement systems. With the emergence ofindependent clearing houses in the euro area,these functions may be taken over by suchinstitutions.

Clearing houses may also act as a centralcounterparty, when they replace the originalcounterparties in a trade and become thesingle counterpart for all participants, therebyassuming their counterparty risk. To managethe risks taken over from the participants,the central counterparty relies on initialmargins and margin calls, and, to coverextreme situations, other measures, such asown funds, dedicated members’ funds,insurances and loss-sharing schemes. Thetechniques used for margining are a keyaspect of the safety of such institutions. If


global cross-margining is used – balancing apotential gain in one part of the participant’sportfolio of outstanding trades with a loss inanother part – the collateral needed tomanage the risk can be reduced. Inan environment with a radically increasednumber of potential counterparts, thereduction of risks related to trading with lesswell-known entities is helpful for theintegration of the market.

In the domestic securities infrastructure, theestablishment of clearing houses has not beena general feature. At the euro area level,however, independent clearing houses seemto be a growing trend.

Given that independent clearing houses actingas central counterparties did not exist inmost countries prior to EMU, this currentlyrepresents the segment of the infrastructurewhere there has been the greatest integrationso far. The two leading market initiatives, thenetting facilities of the London ClearingHouse and Clearnet (France) have recentlycome to an agreement to set up a commonclearing house with a central counterparty.The Belgian and Dutch clearing houses couldalso be associated with this project in linewith the EURONEXT project. Another majormarket initiative is Eurex, the Swiss/Germanclearing house. Eurex has so far clearedonly derivatives, but it may develop andinclude other products. Other initiativeshave been taken domestically in somecountries. The success and impact of all theseinstitutions at the euro area level remain tobe seen.

III.1.3 Settlement in the eurosecurities market

The settlement of securities refers tothe final discharge of the obligation ofcounterparties on the one hand to deliverfinancial instruments and on the other to payfor them. Settlement normally occurs throughsecurities settlement systems (SSSs) on the basisof delivery versus payment (DVP) procedures.DVP is the principle of delivering the cash and

the securities simultaneously to the settlementso that principal risk is entirely eliminated. 48

Before the beginning of Monetary Union, thesettlement structures were clearly dividedinto national central securities depositories(CSDs) and the two international centralsecurities depositories (ICSDs). Thedistinction between these two types ofdepositories is increasingly blurred and thecurrent situation is one of transition. Thereseem to be two main models vying for thefuture of European settlement. The maindifference is the degree of centralisation.

First, the European Central SecuritiesDepositories Association (ECSDA) has, interalia, defined a model for links49 between SSSsaimed at maintaining full functionality at thedecentralised level. Since then, national CSDshave been establishing new links or upgradingthe existing ones. Given that links used to beone of the hallmarks of the ICSDs, the spreadof links to the CSDs has contributed to areduction in the distinction between thepractices of CSDs and ICSDs. The biggestadvantage of the links is that they can beused to move securities irrespective of theiruse, be it for central bank collateral orwhatever commercial purpose. However, agreat deal of work still needs to be carriedout before decentralised integration throughlinks is achieved. First, some SSSs remainvirtually unlinked and, second, those linksestablished so far are almost exclusivelyfree-of-payment links and only some are fullyautomated. They are thus not the real-timeDVP links required for fully decentralisedintegration. These obstacles have given riseto a change of strategy involving the creationof a “super-highway”, where a few large SSSs

48 For definitions of DVP see BIS, (1992). DVP can take place on areal-time basis, i.e. each trade is settled as it enters the system,or on a batch basis, where all trades entered into the systemduring a certain period of time are settled in one batch, at theend of which the net transfers of cash and securities take place.Another way of settling securities transactions is free of payment,where only the securities transfer takes place in the SSS (eitherthere is no cash to be transferred or the cash is transferredseparately through a different system or procedure).

49 For the latest version of the report, see ECSDA, June 2000,“ECSDA cross-border settlement”.


are connected to one another via efficientDVP links. Each of these “hubs” is thenconnected to a number of “satellites” or“spokes”, i.e. the smaller SSSs. For this modelto be successful, it must be possible to movea security efficiently from one satellite toanother through the hub or the super-highway of hubs.

Second, two initiatives promoting a morecentralised integration of the settlementinfrastructure are under way. In May 1999Cedelbank, the ICSD situated in Luxembourgand DBC, the German CSD, announced theirmerger, which became effective on 1 January2000, creating Clearstream. The aim is tointegrate the systems fully within three years.In December 1999 Euroclear, the Belgium-based ISCD, and Sicovam, the French CSD,announced their alliance. In March 2000 itwas confirmed that the intention was tomerge the two into Euroclear. Since then, ithas been announced that the Central Bankof Ireland Securities Settlement Office,which settles Irish government debt, will endits operations and the activities willbe transferred to Euroclear. Both theClearstream and the Euroclear initiativesrepresent a tendency towards thecentralisation of settlement and will havea major impact on the integration ofthe markets, compared with the currentdecentralised infrastructure.

III.1.4 Legal environment

The legal environment actually goes beyondwhat is the “pure” legislative framework ofthe markets and encompasses issues such asfiscal, accounting and contractual regimes. Asthese have predominantly been domesticallydetermined, large differences persist eventhough Directives issued by the EuropeanCommission have gone a long way towardsironing out some of the most cumbersomedifferences.

In particular, the Investment ServicesDirective, the Capital Adequacy Directive andthe Settlement Finality Directive deal withissues of relevance for the financial markets.Unfortunately, it seems that some importantdetails have yet to be implemented in a fullyharmonised way. For example, some EUcountries impose capital requirements forthe temporary transfer of ownership such asrepos, while others do not. Furthermore,some key areas such as tax and, to someextent, accounting are not covered by theDirectives.

The European Commission, the mostimportant driving force in this area, hasrecently received assistance from theEurosystem on the legal acts of relevance forthe integration of the euro financial markets.

III.2 Barriers to integration

The barriers to integration in the area oftrading and, to a certain extent, of clearingmostly relate to the multiple, heterogeneoussystems. However, the multiplicity andheterogeneity of structures has a differentimpact on the trading and clearing sides. Iftwo counterparts want to trade a giveninstrument with each other, having more thanone system with which to do so is not reallya problem. If the systems are too expensive,too slow or suffer from some other problem,there is always the possibility of trading OTC.

It therefore seems that the barriers tointegration are mainly to be found in theareas of settlement, the legal environmentand, less critically, the clearing area. Thefollowing particular problems have beenidentified and will be discussed in more detail:

1) the lack of availability of cross-bordersettlement on a DVP basis;

2) the lack of standardised legaldocumentation for repos;


3) the lack of common practices concerningsettlement procedures;

4) the lack of harmonisation ofcollateralisation processes betweencentral banks and interbank operations;

5) the heterogeneity in fiscal and accountingprocedures; and

6) the need for a clearing house.

III.2.1 Availability of cross-bordersettlement on a DVP basis

An important issue for counterparties in themoney and bond markets concerns the lackof procedures for the simultaneous cross-border settlement of cash and securities,i.e. the lack of cross-border securitiessettlement on a DVP basis. At the domesticlevel, DVP in central bank money has forsome time been the standard for thesettlement of securities transactions in theinterbank market. At the cross-border levelsuch a service is not yet provided. Until thetechnical platforms of the merged entities(Euroclear and Clearstream) become one,links between SSSs will remain the only wayin which to settle an interbank transactionon a cross-border basis. At present, linksare predominantly free of payment. To theextent that they offer DVP settlement, theyonly do so in private bank money. Thisreduces risk but does not eliminate it,because the risks on the settlement bankremain. This may be one important reasonwhy the use of links – although growing –remains limited compared with domesticsettlement and even with the cross-bordercollateralisation taking place through thecorrespondent central banking model(CCBM50 ) (see Section III.2.4).

DVP can operate both on a batch basis andon a real-time basis. The trend in the EUsettlement industry is clearly towards real-time DVP settlement. This development haspartially been driven by one of the standardsof the ECB for the use of SSSs in central

bank credit operations, demanding real-timesettlement procedures for Eurosystem creditoperations.51 However, such procedures arenot yet available in most countries, not leastbecause investments in such systems requiresignificant lead times and technical andfinancial resources. The bulk of DVPsettlement at the domestic level thuscontinues to take place on a batch basis. Fordeveloping real-time DVP links, SSSs mustfirst of all be able to offer real-time servicesdomestically. Furthermore, even if SSSsare able to provide real-time settlementfor domestic transactions, this does notautomatically ensure the implementation ofreal-time DVP links. Communication betweentwo real-time DVP systems may requireadditional technical procedures.

For cross-border DVP facilities to beimplemented, the cross-border transfer ofsecurities – through the link – and the relatedcross-border transfer of cash – throughTARGET – must be connected. If the DVPfacility needs to be in real-time, both of theSSSs involved would also need to offer real-time services.

The impact of the lack of real-time DVPsettlement differs between the various markets.

In the case of a simple purchase of a security(settled, as a rule, on a T+3 basis52 ), the lackof intraday DVP settlement is not particularlyproblematical. There is time for the seller tomove the security through the link to an

50 The correspondent central banking model is an interimmodel established by the ESCB to allow equal access for allcounterparties to all eligible collateral. It is a mechanism wherebycentral banks act as custodians for one another to allowcounterparts to forward collateral on a cross-border basis. Forfurther details see ECB (1999a).

51 Standard 7 of ECB, 1998, “Standards for the use of EU SSSs inESCB credit operations” states that “SSSs must provide facilitiesto settle certain ESCB operations (those involving intraday andovernight credit) with intraday finality (i.e. settlement cannot bereversed or unwound). SSSs must not expose NCBs to othersources of settlement risk when they are settling operations withcounterparties in an SSS and/or via linked arrangements. SSSsused for settlement of central bank transactions should havefacilities in place by 2002 to allow the option of intraday DVPsettlement in central bank money. This may take the form ofreal-time gross settlement, or a series of batch processes withintraday finality.”

52 Settlement takes place three days after the trade is made.


account in the SSS of the buyer and then tosettle the trade through a domestic DVPprocess. By contrast, in the case of anintraday repo, where money and cash areexchanged several times in one day, aprocedure unable to settle with finality on anintraday basis is not very useful. This couldexplain why the euro area market for bondssomehow seems to be more integrated thanthe secured money market. It makes littlesense to make a cross-border deal in thesecured money market, if the flows of cashand securities are not linked. If the exchangeof cash is not tied directly to the exchangeof collateral, one ends up with thecharacteristics of an unsecured money marketdeal. This is supported by the fact that theshare of the secured money market comparedwith the unsecured is significantly lower in thecase of cross-border transactions comparedwith the domestic market (see Table 1).

In sum, the current cross-border settlementinfrastructure may cater for some of theneeds of the bond market, whereas thesecured money market – particularly at theshort end, e.g. intraday repos – seems not tobe well served.

III.2.2 Lack of a uniform legalframework

A problem for the development of a euromoney and bond market stems from thedifferences between the various national legalframeworks. The single currency area doesnot coincide with a single jurisdiction.Investigating these differences, understandingwhich are important, finding ways in whichto operate cross-border in spite of themand keeping track of changes is costly andcumbersome.

The various Directives of the EuropeanCommission concerning the development of theSingle Market for financial services laid thefoundations for legal integration. The Directiveof the European Parliament and of the Councilof 19 May 1998 on settlement finality in paymentand securities settlement systems has been

particularly helpful. An important furtherinitiative is the forthcoming Directive oncollateral, included in the recently adoptedframework for action on financial services.Other initiatives have been driven mainly bymarket participants trying to define uniform legaldocumentation. The exercise is difficult owingto the remaining differences in the legal systemsof the member countries.

A particular problem seems to exist for repos.When the single monetary policy was beingprepared, an attempt was made to harmonisethe repo agreements between national centralbanks (NCBs) and their counterparts; thisresulted in a non-binding template masteragreement. However, the existing divergencebetween the national jurisdictions did not allowfor the implementation of a single masteragreement, and thus it was only implementedby some NCBs and then only after nationalmodifications.

For the time being, one possible standardcontract is the initiative of ISMA – the GlobalMaster Repo Agreement (GMRA) basedexclusively on English law or US New Yorklaw. This agreement was initially used only ininternational repo contracts, but as thesegrow in importance and some domesticmarkets seem to be increasingly willing touse the GMRA, it may become the de factostandard, even though, for all countriesother than the United Kingdom, this willthen happen under a foreign (i.e. English)jurisdiction. Various European federationsof banks agreed on a European MasterAgreement for repos (EMA) with theintention of having the EMA replace the“domestic” European standard agreementsincluding, in time, the GMRA.

Uniform legal documentation will certainlyhelp in the development of the euro repomarket. Further legal initiatives may also benecessary, in particular through the currentdraft of a European Directive on the cross-border use of collateral, which aims ateliminating all legal uncertainties surroundingthe establishment, enforcement andrealisation of cross-border collateral.


III.2.3 Lack of common practicesconcerning settlementprocedures

Now, as before the start of Monetary Union,the repo market (or, more generally, themarket for collateralised operations) isoperating in accordance with the rules andpractices of each trading place.

In accordance with local practices, repos canbe either general or specific. Specificcollateral repos require that the securities tobe delivered be clearly identified at the timeof entering into the repo. By contrast, generalcollateral repos can be based on any of anumber of assets. To be eligible, the assetsmust meet certain quality requirements,e.g. the rating of the issuer, liquidity, the sizeof the issue and the time to maturity, but theasset is not identified before actual deliverytakes place. To achieve continued flexibilityafter delivery, the collateral should also besubstitutable throughout the duration of therepo. Having full flexibility with regard to theunderlying assets before and after settlementassures maximum integration and liquidity ofthe market.

Before the introduction of the euro, thevarious domestic “general repos” werebased on domestic collateral only. With theintroduction of the euro, the integrationof financial markets should lead marketparticipants increasingly to use euro areacollateral irrespective of the country of issue.As a consequence, a general repo could bebased on any collateral meeting the standardquality requirements (e.g. all tier one assets).This “Europeanisation” of general reposseems to be taking place slowly. The bulk ofrefinancing activity remains at the nationallevel and is based on domestic securities. Inaddition to the legal obstacles mentioned inSection II.2.2, a number of other factorsexplain this. One is simple inertia, includingthe slow internationalisation of the portfoliosof market participants. Another is the factthat the settlement of non-domesticsecurities is difficult and costly. Domesticsettlement systems still mainly provide

settlement facilities related to domesticassets. Market participants would needmembership of several systems – directly orthrough agents – in order to have accessto area-wide settlement. Even so, settlementis complicated by the fact that procedures,communication standards, services, operatingtimes, etc. differ between the individualsystems. This means that multiplemembership is costly, both in terms ofindirect costs of developing and maintainingthe necessary know-how, and in terms ofdirect costs such as multiple membership feesand a multi-system back office. Links andmergers are slowly changing this, but there isa long way to go before market participantshave easy and equal access to all eligiblecollateral.

The effect of the lack of harmonisation ofprocedures between SSSs, in particular withregard to the settlement of repo and debtinstrument transactions, should be furtherdocumented and analysed in order to identifythe most serious obstacles to area-wide equalaccess to collateral.

III.2.4 Lack of harmonisation in thecollateralisation processbetween central bank andinterbank operations

The central bank and interbank markets forcollateralised lending serve similar, but notidentical functions. They also rely on the samecollateral and the same SSS infrastructure. Itseems reasonable to assume that the betterintegrated they are, the more efficient therefinancing activity of the banking system as awhole will be.

Moreover, irrespective of their market share,central bank refinancing operations usuallyhave a large normative impact on the market.First, central bank refinancing operations aremandatory for any market player wishing tobe independent from competitors forcentral bank money. Second, as central bankstraditionally focus on safety, security andequal treatment, their practices and standards


easily form an agreeable benchmark for theentire market. This may also be the case forthe technical procedures, the legal frameworkand other aspects of market practices. Inaddition, it is important to note that, althoughit need not necessarily be so, the interbankmarket for collateralised lending almostexclusively uses repos in their various forms,whereas the current use of pledges is moreor less restricted to central banks.

Central bank refinancing operations inthe euro area are based on a decentralisedinfrastructure, using different legal instruments,techniques and systems and with a cross-borderdimension based on the specific correspondentcentral banking model (CCBM) procedure andon eligible links between SSSs. At the start ofthe EMU, this lack of harmonisation was notconsidered to be a problem for theimplementation of the single monetary policy,as no economic difference was seen betweenthe arrangements used by central banks. Hencea single monetary policy could be implementedthrough not completely harmonised systems andprocedures. Nevertheless, even if there was noeconomic difference between the variousprocedures, the practical consequence is abarrier to the further integration of the market.These barriers manifest themselves in twoparticular areas: (1) legal and technicaldifferences, and (2) settlement procedures forthe cross-border use of collateral.

Prior to the introduction of the euro,completely homogeneous legal frameworks,techniques and systems with regard to theacceptance of collateral did not necessarilyexist within individual countries. Thecollateralisation techniques of the centralbank may have differed to a greater or lesserextent from the technique(s) used in thatparticular domestic market. However, withthe introduction of the euro, there is now amultitude of legal frameworks, techniques andsystems both on the central bank side and onthe interbank side in the “domestic” euromarket. That is clearly a barrier to the fullintegration of this market. In this respect,reducing the number of arrangements –ideally ultimately to only one type of

arrangement for all central bank operations –would also help the integration of theinterbank euro repo market.

In addition, the need for collateral isincreasing, as is the need for intradaysettlement. A growing number of operationsare collateralised and RTGS procedures forsecurities and payments are spreading.

All barriers to the efficient management ofcollateral should therefore be considered,with a view to improving the currentsituation. A fully compatible and morestandardised legal framework, documentationand set-up for the interbank and central bankrepo markets would help to resolve most ofthese problems. Therefore, the effect of thelack of harmonisation between central bankprocedures for collateralisation should befurther documented and analysed andinitiatives to harmonise practices should betaken with a view to advancing the integrationof the euro repo market.

At present, the cross-border use of collateralis settled via the correspondent centralbanking model (CCBM) and, more recently(as from July 1999), also by using some linksbetween SSSs. The CCBM has been crucial increating a common market for central bankcollateral. However, when considering therepo market as a whole, there are somebarriers inherent in the CCBM.

First, the CCBM can be used only for centralbank credit and not for interbank repos ordebt instrument operations.

Second, in the CCBM normally only thecentral bank in the country of issue acts asa correspondent for the lending or homecentral bank. This creates a need for“repatriation” of those assets which are notkept in their country of issue, but which havebeen moved to another SSS. These assets canbe used via the CCBM only after having been“repatriated” to the country of issue. This isslowing down the cross-border use ofcollateral and therefore has a negativeimpact on the liquidity and availability of


the securities, effectively leading to asegmentation of the markets.

This problem can be reduced in some cases.For instance, the development of eligiblelinks will limit the problem of the repatriationof collateral. The merger of SSSs willalso eliminate the problem of repatriationbetween the two merged SSSs.

A further problem with the CCBM is itsrelative slowness and limited operating times.As an interim solution, it is based more orless on manual processing. Furthermore, itnecessitates the involvement of additionalentities such as custodians and “foreign” SSSs,and it therefore takes time to mobilise orreturn collateral through the model. Thismay be considered as problematical,especially if repatriation is necessary.

III.2.5 Heterogeneity in fiscal regimesand regulation

Market participants have reported thatheterogeneity in fiscal regimes and regulation,for the treatment of debt instrumentoperations and repos, is hindering the smoothdevelopment of a euro market. The mainreasons are the differences in treatmentdepending on the legal jurisdiction in whichcounterparties are located.

On the tax-related aspects, the fundamentalproblem concerns the differences in thetaxation of investment income from variousinstruments, which has given rise to cross-border distortion and entire markets beingmoved into or out of particular countries.Furthermore, for repos, the tax treatment isnot harmonised yet and this is hindering fullintegration or is pushing for the delocalisationof these activities, which are penalised in oneparticular country. This can limit thepossibility of moving securities from onecountry to another and creates difficultiesand complexities for the treatment ofcorporate events, and the payment of intereston debt instruments.

Concerning the regulatory aspects, theproblem is the transposition of the CapitalAdequacy Directive (CAD) for repos, whichis not uniform among Member States. Forinstance, some local authorities considerthat repos conducted with an appropriaterisk management procedure with haircuts anda daily margining process, such as tripartiterepos, do not need any capital requirement,although some other authorities would applya capital requirement in accordance with thequality of the issuer of the securities used ascollateral.

III.2.6 Need for a clearing house

Although the presence or absence of aclearing house cannot be considered as anactual barrier to the integration of the marketinfrastructure, the development of suchservices in the market could help integration.Indeed, the benefits of the activities of theclearing house, in particular for netting, aredependent on volume, and so it is likely thatthere will be a race to become the clearerfor the euro securities markets. Theemergence of a single clearer will also benefitthe integration of the market. Even if manytrading platforms remain unconnected to oneanother and no dominant one emerges, thesedisparate systems may all connect to oneclearing system which, in turn, would connectto several settlement systems. A largeindependent clearer would therefore go along way towards the integration of themarket.

The clearing system could also be part of oneSSS and serve it exclusively. However, limitingsettlement activities to a single SSS (in amarket with several SSSs) would limit thepotential volumes to be offset. Moreover,whereas trading and settlement institutionsdo not incur or manage any risk, clearingwith a central counterparty does involve risks.Mixing a risk management business with tradeand settlement functions that are theoreticallyrisk-free may not be the best arrangement.


As a result, the business case for clearinghouses lies in the fact that they enableparticipants to save liquidity and, in the caseof central counterparties, to take overcertain risks from market participants. Lessimportantly, and to the extent that settlementvolumes are significantly reduced throughnetting, part of the operational risk shiftsfrom the SSSs to the clearers. In anycase, the potential volumes that a dominantclearing house covering the whole of the euroarea would attract would mean that quite asignificant risk would be concentrated in,and therefore have to be managed by, thatinstitution. Mismanagement of such businesscould have a large negative impact on themarket: first, as a result of its systemicimplications and, second, on account of thefact that it would set back the process ofcentralisation. The Eurosystem is interestedin the increased efficiency offered by theseinstitutions, but given the potential systemicrisk inherent in their business, may considerthe possibility of setting standards andestablishing a co-operative framework for anoversight regime which would take intoaccount the pan-European nature of theactivities of such institutions.

In addition, it should be mentioned that thebenefit from an individual trade going througha clearing house depends on the time tosettlement of the trade in question. Anintraday repo, where cash and securities areto be exchanged twice a day to obtain animmediate liquidity effect, and where marketrisk is limited because of the short time tosettlement, will benefit less from a clearinghouse than other products with a longersettlement lag.

The recent agreement between Clearnet andthe netting services of the London ClearingHouse to create a single clearing housewith an area-wide dimension is a positivestep towards integrating the market.

In conclusion, the emergence of a moreefficient clearing function in the euro areashould take place in line with the followingprinciples: 1) not limiting such an entity toonly one SSS; 2) avoiding a multiplicity ofclearing houses, which would reduce theefficiency of such a system in the marketinfrastructure; 3) focusing their activity onthe clearing of operations other than intradayoperations; and 4) developing cross-productnetting or global clearing in order to increasethe effect of netting.


Glossary

Annex 1

Arbitrage: profiting from differences in price when the same security, currency or commodityis traded in two or more markets.

Bank certificates of deposit (CDs): short-term securities issued by banks.

Bid-ask spread: differential prevailing in the market between the bid price and the offeredprice.

Bons à Taux Fixe (BTF): French Treasury bill.

Bubill: German Treasury bill.

Buoni Ordinari del Tesoro (BOT): Italian Treasury bill.

Central counterparty: an intermediary which takes over the obligation of either side inrespect of a trade. After clearing with a central counterparty, the two trading parties nolonger have an obligation towards each other, but rather towards the central counterparty,which thereby assumes any replacement cost risk resulting from market moves between thetime of trade and the time of settlement.

Certificati del Tesoro zero cupon (CTZ): Italian government debt instrument issued atdiscount with a maturity of up to two years.

Certificati di Credito del Tesoro (CCT): Italian government bond with a maturity ofseven years.

Clearing: the process of transmitting, reconciling and, in some cases, confirming the paymentorder and the securities transfer prior to settlement. In the context of repos, this can havethree separate aspects: confirmation/matching, netting and clearing with the centralcounterparty.

Commercial paper (CP): short-term securities issued by corporations.

Confirmation/matching: the process of ensuring that the two counterparties agree withregard to the terms of the repo – price, asset(s), value dates, settlement data, includingrelevant account numbers – before the payment and transfer orders are sent for settlement.

Depo/repo spread: differential prevailing in the market between the interest rate ofunsecured and secured transactions.

Deposit facility: a standing facility of the Eurosystem which counterparties may use to makeovernight deposits at the central bank which are remunerated at a pre-specified interest rate.

Eurex: German futures and options exchange market.

EURIBOR: the euro area interbank offered rate for the euro, sponsored by the EuropeanBanking Federation (EBF) and the Association Cambiste Internationale (ACI). It is an index pricesource covering dealings from 57 prime banks.


Euro overnight index average (EONIA): the overnight rate computed as the euro areainterbank offered overnight rate for the euro. It is computed as a weighted average of allovernight unsecured lending transactions in the interbank market, initiated within the euroarea by the contributing panel of 57 prime banks.

EURODEM: interbank offered rate for the Deutsche Mark, negotiated outside Germany.

EUROLIRA: interbank offered rate for the Italian lira, negotiated outside Italy.

European Master Agreement: legal contract sponsored by the European BankingFederation and the European Savings Banks Association, which aims to consolidate into asingle set of harmonised documents various master agreements used within the euro area andcertain neighbouring countries, particularly for repurchase transactions and securities lending.

European System of Central Banks (ESCB): the European Central Bank and the nationalcentral banks of the EU Member States.

Eurosystem: the European Central Bank and the national central banks of the EU MemberStates which have adopted the euro.

Foreign currency swap: an agreement between two parties to exchange future payments inone currency for payment in another currency. These agreements are used to transform thecurrency denomination of assets or liabilities.

Forward rate agreement (FRA): cash-settled forward contract on a Eurodollar deposit.

General collateral: collateral which, owing to its homogeneous features, is broadly accepted.

Interest rate swap (IRS): exchange between two parties of a fixed interest rate instrumentfor a floating interest rate instrument.

Junk bond: high-yield bond with a credit rating of BB or lower.

LIFFE: London futures and options exchange market.

Main refinancing operation (MRO): regular lending operation against underlying assetsexecuted on the initiative of the central bank in the financial markets.

Marginal lending facility: standing facility of the Eurosystem which counterparties may useto receive overnight credit against a pre-specified interest rate.

Matif: French futures and options exchange market.

Mercato Interbancario di Depositi (MID): Italian screen-based market for interbankdeposits.

MIBOR: interbank offered rate in Madrid for unsecured transactions.

Monetary Financial Institutions (MFIs): financial institutions which form the money-issuing sector of the euro area. It includes the Eurosystem, resident credit institutions asdefined in Community law and all other resident financial institutions whose business is to


receive deposits and/or close substitutes for deposits from entities other than MFIs and, fortheir own account (at least in economic terms), to grant credit and/or invest in securities. Thelatter group consists predominantly of money market funds. At the end of 1999, there were9,443 MFIs in the euro area (12 central banks, 7,906 credit institutions, 1,517 money marketfunds and 8 other financial institutions).

Money market fund (MMF): fund that invests in short-term securities.

Mortgage bond: bond issue secured by a mortgage on the issuer’s property, the lien onwhich is conveyed to the bondholders by a deed of trust.

Netting: the process of offsetting cash or securities positions. Through netting, the grosspositions are reduced. This is particularly true for the cash side, as all cash is fungible,whereas all assets are not.

OTC (over-the-counter): OTC is a bilateral way of trading, where the buyer and sellercontact each other directly, e.g. by telephone, without going through an organised exchange.

Pfandbriefe: German mortgage bonds.

PIBOR: interbank offered rate in Paris for unsecured transactions.

Pledge: legal arrangement by means of which the borrower pledges some assets to thelender in order to collateralise a credit. By contrast with a repo, a pledge can only be used togenerate cash credit.

Primary dealer: selected credit institution authorised to buy and sell original issuance ofgovernment securities in direct dealing with the Treasury.

Real-time gross settlement (RTGS) system: a settlement system in which processingand settlement take place on an order-by-order basis (without netting) in real time(continuously).

Repo: financial instrument which serves to exchange cash temporarily for securities for apredetermined period. Various legal arrangements exist to perform this basic economicfunction (repurchase agreements, reverse repurchase agreements, sell/buybacks and securitieslending). All forms of repos entail a change in ownership.

Reserve maintenance period: period over which compliance with reserve requirements iscalculated. For the ESCB this would be one month, starting on the 24th calendar day of eachmonth and ending on the 23rd calendar day of the following month.

Reserve requirement: requirement for institutions to hold minimum reserves with thecentral bank.

Special collateral: collateral other than general collateral.

TARGET (Trans-European Automated Real-time Gross settlement ExpressTransfer system): TARGET is the RTGS payment system for the euro. It consists of15 national RTGS systems and the ECB payment mechanism, which are interlinked so as toprovide a uniform platform for the processing of cross-border payments.


Tier one assets: marketable assets fulfilling certain uniform euro area-wide eligibility criteriaspecified by the ECB. Among these criteria are the requirements that they must bedenominated in euro, be issued (or guaranteed) by entities located in EEA countries, and belocated in a national central bank or SSS of the euro area.

Tier two assets: marketable or non-marketable assets for which specific eligibility criteriaare estabilised by the national central banks, subject to ECB approval.

Treasury bill: short-term government debt instrument issued at discount with a maturity ofone year or less.

Treaty: the Treaty establishing the European Community. It comprises the original EECTreaty (Treaty of Rome) as amended by the Treaty on European Union (signed in Maastrichton 7 February 1992).

UCITS: undertakings for collective investment in transferable securities.

Zero coupon bond: security issued at discount or a security which delivers a single couponat maturity.


The ESCB market surveys

Annex 2

The ESCB market surveys referred to in thisPaper were conducted in the context of thestudies on the money market and on thebond market mentioned in the Foreword.

As regards the money market study, twodifferent surveys were conducted, onefocusing on the unsecured, the repo and theforeign currency swap markets, and one onthe market for Treasury bills and other short-term paper.

The survey on the unsecured, the repo and theforeign currency swap markets was mainlyquantitative, although some qualitative questionswere included with the help of the NCBs toimprove the understanding of the data obtained.The result of the quantitative survey is

summarised in Table 1 of this Annex. It coveredtwo periods chosen to identify, to the extentpossible, the effects of the introduction of theeuro on the relevant segments of the market,namely the fourth quarter of 1998 and thesecond quarter of 1999 (the latter was preferredto the first quarter of 1999 in order to avoiddistortions related to the very first period afterthe introduction of the euro). The data reflectresponses from 75 banks located in 7 euro areacountries, with the following geographicaldistribution: 14 in Germany; 7 in Finland; 16 inFrance; 10 in Ireland; 11 in Italy; 10 in Portugaland 7 in Spain.

Other relevant details on the coverage onthe unsecured, the repo and the foreigncurrency swap markets are as follows:

1) Reflects data from responses to ESCB market survey by seven euro area countries (Germany, Spain, France, Ireland, Italy,Portugal and Finland). Some discrepancies appear between the upper and lower parts of the table owing to errors in reporteddata by counterparts.

2) Transactions effective on the day after the contract (t + 1), maturing one day later (t + 2).3) The breakdown only contains figures over three months.

Table 1Euro money market turnover 1)

(daily transactions average in EUR millions)

Unsecured Repo Swap againsttransactions transactions foreign currencies

1999 1998 Variation 1999 1998 Variation 1999 1998 VariationQ2 Q4 as a % Q2 Q4 as a % Q2 Q4 as a %

Breakdown of lendingtransactions by maturity

Overnight 61,197 42,927 42.6 10,727 8,123 32.1 9,718 9,654 0.7Tom next 2) 9,062 8,794 3.0 11,916 9,289 28.3 15,383 18,944 -18.81 week 11,118 14,561 -23.6 8,983 7,378 21.7 2,689 3,486 -22.92 weeks 1,883 1,826 3.1 2,665 3,045 -12.5 2,316 2,301 0.71 month 1,986 2,408 -17.5 2,773 2,248 23.3 3,800 7,651 -50.33 months 1,984 3,197 -37.9 1,776 1,244 42.8 3,010 5,079 -40.76 months 704 1,553 -54.7 333 433 -23.2 1,160 2,156 -46.29 months 189 552 -65.8 109 148 -26.4 568 1,350 -58.01 year 403 450 -10.6 344 136 153.3 490 606 -19.1> 1 year 79 32 145.6 20 5 303.0 185 243 -23.9

Total 88,605 76,302 16.1 39,646 32,049 23.7 39,318 51,471 -23.6

Breakdown of transactionsby type of counterparty 3)

Domestic counterparties– borrowing 25,988 32,487 -20.0 16,257 13,220 23.0 2,894 1,985 45.8– lending 39,534 43,900 -9.9 14,917 11,759 26.9 5,574 10,926 -49.0

Euro area– borrowing 11,312 7,391 53.1 6,470 3,715 74.2 2,856 1,995 43.1– lending 30,753 13,167 133.6 11,394 9,209 23.7 17,871 18,387 -2.8

Others– borrowing 4,835 4,430 9.1 7,078 2,891 144.8 2,420 5,280 -54.2– lending 11,668 7,094 64.5 8,414 7,012 20.0 12,709 17,921 -29.1


All data (for the unsecured deposit market,repo market and foreign currency swapmarket) include only transactions betweencredit institutions. In particular, repo marketdata do not include transactions with centralbanks.

Repo transactions include all collateral(general and special) and also sell/buybacktransactions and securities lending againstcash.

The survey on the market for Treasury billsand other short-term paper was also mainlyquantitative, but nonetheless had a qualitativecomponent. Its main findings are shown inTables 3, 4 and 5 of this Paper, together withsome details on the coverage (see the notesto the tables). It covered the second half of1998 and the first half of 1999. The datawere provided by the relevant NCBs andreflect a variety of sources including NCBdata and other official statistics, whereavailable (mainly regarding Treasury billsdata), and estimates based on ad hoc marketsurveys conducted by the NCBs. They include

euro-denominated instruments. Turnoverfigures refer to total and outright transactionsconducted in the period (i.e. no dailyaverages).

The survey on the bond market was of aqualitative nature. The reason for this wasthat, on the one hand, data availability forbond markets is relatively good compared,for instance, with that for the money market.Relatively exhaustive interviews were heldwith credit institutions (14 as a whole) andvarious categories of final investors (14 as awhole, including insurance and reinsurancecompanies and pension funds) located in 4countries, namely France (3 credit institutionsand 4 institutional investors); Germany (5credit institutions and 4 institutionalinvestors); the Netherlands (3 creditinstitutions and 4 institutional investors; andthe United Kingdom (3 credit institutions and3 institutional investors). The choice of thebanks and investors to be interviewed wasmade with a view to ensuring that the resultswould be representative and fully reliable.


Evolution of the bid-ask spreads in the Italian MID (“MercatoInterbancario di Depositi”) since the introduction of the euro

Annex 3

On the grounds of the fairly high degree ofintegration shown by different domesticmarkets – at least at the shortest maturities –looking at the evolution of bid-ask spreadson the MID may throw some light on theoverall EU interbank market. For thispurpose, differences between hourly averagesof bid-ask rates – taken as a proxy for actualbid-ask spreads – have been related to dailycoefficients of variation of interest rates andto a dummy variable for the last day ofthe reserve maintenance period, on theassumption that bid-ask spreads are likely towiden as uncertainty on interest rates (caughtby daily coefficients of variation) increasesand on the last day of the reserve

maintenance periods.1 Both the assumptionsseem to be confirmed, but in 1999 spreadswere slightly narrower (on average from1.5 basis points to around 3 basis points). Thischange may be explained mainly in terms ofimproved competition – also in the domesticsegment of the interbank market – which theenlargement of the market has brought about(in Stage Three the intercept is about 1 basispoint lower) and, to a lesser extent, in termsof the lower volatility of interest rates. Nosignificant change seemed to have occurredin the sensitivity of spreads with regard tointerest rate variability and to the last day ofthe reserve maintenance period (whichremained steady at some 5 basis points).

1 In order to check for some Stage Three effects on spreads and on their sensitivity to interest rate variability and days at the end ofa reserve maintenance period, the following functions have been estimated (data refer to overnight interest rates on the MID inthe period between 1 January 1998 and 13 September 1999):

SPR = 0.0186 – 0.0091* STAGE3 + 0.0045*CV + 0.0538*RES + 0.0004*CVXSTG3-0.0182*RESXSTG3(t=7.36) (t=-2.29) (t=13.39) (t=4.79) (t=0.26) (t=-0.85)(p>|t|=0.0001) (p>|t|=0.0225) (p>|t|=0.0001) (p>|t|=0.0001) (p>|t|=0.7958) (p>|t|=0.3951)R2 = 0.37F = 50.83D.W. d = 1.92

SPR = 0.0189 – 0.0095* STAGE3 + 0.0045*CV + 0.0482*RES(t=7.59) (t=-2.56) (t=13.81) (t=5.38)(p>|t|=0.0001) (p>|t|=0.0108) (p>|t|=0.0001) (p>|t|=0.0001)R2 = 0.37F = 84.71D.W. d = 1.90

where:SPR = ON interest rate bid-ask spreadSTAGE3 I = 0 in 1998 I = 1 in 1999CV = daily coefficient of variation of ON

interestRES I = 1 on the last days of reserve

maintenance periods I = 0 on the other days

CVXSTG3 = STAGE3*CVRESXSTG3 = STAGE3*RES


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European Central Bank OccasionalPaper Series

1 “The impact of the euro on money and bond markets” by J. Santillán, M. Bayle andC. Thygesen, July 2000.


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occasional paper series no. 1 · july 2000 · ecb occasional paper series no. 1 • july 2000 5...

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