Christian Noyer: The development of financial markets in the euro area
Speech delivered by Mr Christian Noyer, Vice-President of the European Central Bank, at the Royal
Institute of International Affairs, London, on 26 June 2000.
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Ladies and gentlemen,
I am very pleased to be here at Chatham House today to address such a distinguished audience.
Over recent years, the economic and financial structure of the euro area has undergone sweeping
changes. Overall, these changes have led to the rapid development of financial markets in the euro
area. This trend seems to have been reinforced since the introduction of the euro on 1 January 1999.
Over a period of a few years, financial markets in the euro area have grown in size and have come to
play a more important role in the economy.
The development of financial markets in the euro area is shaped by a set of broad economic trends, all
of which are conducive to the development of deeper, more liquid and more efficient financial
markets.
One of these broad trends is the programme of Economic and Monetary Union, which has contributed
to further economic integration and convergence of the economies of the European Union over most of
the past decade. As the processes of economic activity became more intertwined in the European
Union, this naturally led to the development of more cross-border financial interconnections. In the
countries which adopted the euro, the evidence available so far suggests that the single currency
facilitated this process. The euro acted as a catalyst for the development of area-wide financial
markets, although this process is still far from complete.
Another trend is the solid establishment of price stability in the euro area. This followed the
considerable progress made in the run-up to EMU. During the second half of the 1990s, the rate of
increase in consumer prices at the level of the euro area declined steadily to reach values in line with
price stability. Even more importantly, during this period the citizens, firms and other organisations of
the euro area progressively came to consider it credible that price stability would henceforth continue
to be firmly maintained. This confidence on the part of the public is of the utmost importance for the
continued success of the monetary policy of the Eurosystem. As we all know, price stability is
beneficial in numerous ways, not only in creating a climate for higher economic activity over the
medium term, but also in reducing the economic and social inequalities caused by the asymmetric
distribution of the costs of inflation on the various economic agents. In addition, when inflation is low
and expected to remain low and subject to limited variations over the medium term, the prices of
financial assets incorporate lower inflation risk premia, by contrast with a situation of high or
uncertain inflation. As the inflation risk premium becomes relatively less important as a determinant
of financial prices, other factors such as credit risk can take on a larger role in the price formation
mechanism. Ultimately, this results in a more efficient allocation of financial resources.
In the run-up to Stage Three of EMU, the governments of the European Union also, where necessary,
made efforts to reduce their deficits and their debt so as to bring them into line with the requirements
specified by the Maastricht Treaty. As was intended by the drafters of the Treaty, this development
contributed to achieving sounder fiscal policies, which would be more conducive to economic growth
over the medium term and which would make it possible for automatic fiscal stabilisers to work more
effectively when needed. A further effect of the reduction in public deficits and debt, all other things
being equal, is the freeing of financial resources for use by the private sector. This reduces hindrances
to the development of financial markets for private borrowers such as the corporate bond market.
A final item in this short list of the broad economic trends shaping the future of financial markets in
the euro area is the phenomenon of population ageing. Taken together with the liberalisation of
financial markets, over the coming years population ageing will lead to further demand for long-term
investment instruments on the part of rapidly developing pension funds, along the lines, for instance,
of what we are already beginning to see in the United Kingdom. As borrowers strive to meet the
increased demand for investment instruments, this is likely to provide a further impetus to the
development of a wide range of suited financial instruments available to pension funds, and more
generally to savers at the end of the intermediation chain.
Having identified broad economic trends, which all seem to point in the direction of a wider role for
financial markets in the euro area over the coming years, I should like today to discuss what has
actually happened so far and consider what challenges lie ahead. I shall first consider the degree of
development of the various segments of financial markets in the euro area, so as to assess whether and,
if so, why some segments are less developed than others, at area-wide level. I will then move on to
consider, more generally, the progress made in the efficiency of the functioning of the financial
markets of the euro area.
Are certain segments of euro area financial markets less developed than others and, if so, why?
The discussion of this issue should be precursored with the observation that, in the euro area, financial
markets rely more on bank credit than in the United States or the United Kingdom. By contrast, debt
securities and shares represent a considerably smaller proportion of GDP in the euro area than they do
in the United States or the United Kingdom. Hence, and notwithstanding the processes of
disintermediation and securitisation currently under way, the financial structure of the euro area can be
characterised as being more bank-oriented than security or market-oriented. Starting from this
situation, many commentators have correctly observed that the euro area is currently engaged in a
process of structural change towards more market-based finance. As Alan Greenspan put it, recent
"changes appear to be moving continental Europe's financial system closer to the structure evident in
Great Britain and the United States".
With regard to debt securities, outstanding amounts in euro-denominated instruments increased in all
issuing sectors in 1999. However, the increase was more pronounced in the private than in the public
sector. At end-1999, with a share of 52% the public sector still accounted for a considerable proportion
of total debt securities denominated in euro, but this had declined compared with the 55% witnessed at
end-1998. At the same time, the share of the financial sector had increased from 38% to 40% and the
share of the non-financial private sector had increased from 5% to 6%. Obviously, significant changes
in the relative share of the various sectors occur only gradually over time. However, the developments
seen in 1999 received a large amount of attention on the part of market commentators, for several
reasons.
First, there was a considerable increase in private issuance in the euro area between 1998 and 1999.
This continued broadly unabated at the beginning of 2000. It should be recognised that temporary or
exceptional factors may have played a role in 1999. For example, some borrowers may have
frontloaded issuance activity in 1999, so as to benefit from a possible enhanced attractiveness of new
issues in the aftermath of the introduction of the euro. In addition, issuers may have wished to avoid
placing new issues around the century date change for fear of possible liquidity problems, which
eventually did not occur. However, these explanations are not sufficient to account in full for the
increase in private issuance activity seen in 1999, all the more so since the trend has continued at the
beginning of 2000.
Second, the available data showed not only an increase in private issuance, but also a series of changes
in the various characteristics of the newly issued debt securities. For example, the average size of new
bond issues increased considerably in 1999, as the number of very large issues, of EUR 1 billion or
more, increased significantly. It should be recognised that this development partly reflected the
increased preference of investors for deep and liquid instruments following the episode of financial
turmoil in the autumn of 1998. However, another reason for this change, which was particularly
notable in the euro area, was the fact that borrowers were able to take advantage of the newly created
euro-denominated bond market. By virtue of its size and high degree of openness, the
euro-denominated bond market is more able to absorb very large issues than the individual bond
markets of the predecessor currencies of the euro.
Looking in more detail at the components of the increase in private euro-denominated bond issuance,
it is noteworthy that issuance by non-residents, although small relative to the total, increased
particularly rapidly in 1999. Standing at around EUR 630 billion at the end of 1999, the outstanding
amount of euro-denominated debt securities issued by non-residents represented slightly less than
one-tenth of the total outstanding amount of euro-denominated debt securities. However, this
constituted an increase of more than 40% compared with end-1998. In 1999, the amount of new issues
of euro-denominated debt securities by non-residents came very close to that of new
dollar-denominated issues by non-residents. Hence, in the course of 1999 the euro-denominated
component of international bond markets played a far larger role than the predecessor currencies of the
euro had hitherto. This development was in line with the predictions made by some commentators
before the introduction of the euro. However, the speed of the increase in euro-denominated
international bond issuance during 1999 was remarkable.
In 1999 the main investors active in the euro-denominated segment of the international bond market
were, as in previous years, investors located in the euro area. Hence, as shown in a recent ECB
working paper, although the euro became an important placement currency for international bonds
virtually from the beginning, the use of the euro as an international investment currency is likely to
develop more gradually over time. From the point of view of monetary policy, let me recall that the
internationalisation of the euro is not a policy objective as such and that, therefore, it will be neither
fostered nor hindered by the Eurosystem.
Turning to securities in the form of shares, close to 900 companies were newly listed on stock
exchanges in the euro area in the course of 1999. This represented an increase of some 40% compared
with 1998. In the United States, there were close to 800 new stock listings in 1999, a slight decline
compared with 1998, and in the United Kingdom new stock listings also declined from 1998 to 1999.
These changes may obviously have reflected circumstantial factors, such as differing positions in the
business cycle, for example. These circumstantial factors notwithstanding, the increase in new listings
also seems to have reflected the enhanced attractiveness of stock market listing in the euro area.
Following the introduction of the euro, a number of firms found it more attractive to issue stocks in the
euro area, as these stocks could be marketed to a wider array of investors than had been possible in the
stock markets of the predecessor currencies of the euro.
Furthermore, in 1999 and in the first half of 2000, there was an exceptional array of initiatives taken
by stock exchanges with a view to forming alliances or merging activities, both within the euro area
and beyond, involving exchanges located in the United Kingdom and the United States. These
initiatives clearly reflected not only factors specific to the euro area, but also other factors, such as the
impact of new information and telecommunications technology. These new technologies seem to have
led to a marked increase in the economies of scope and scale that can be achieved by stock exchanges
through alliances or mergers. At the level of the euro area, the process of consolidation of stock
exchanges is taking place in the context of the integration of stock markets at area-wide level.
In summary, both corporate bond markets and equity markets in the euro area, while remaining
somewhat less developed than their US counterparts, developed rapidly in 1999. This development
seems, in particular, to have brought benefits to the less well-rated borrowers, as the amount of bonds
issued by this category of borrowers increased most rapidly in 1999.
It cannot be denied that the process of Economic and Monetary Union has contributed positively to
this development.
With the introduction of the euro, financial prices are no longer affected by intra-area foreign
exchange risk premia. Furthermore, as I mentioned earlier, financial prices generally incorporate much
lower inflation risk premia. As a result of lower foreign exchange and inflation risk premia, credit risk
has gained more importance, in relative terms, in the pricing of financial instruments. In order to deal
with this evolution, financial market participants active in the euro area have stepped up their
assessment of the credit quality of the security issuers. This development may be described as the
development of a "credit risk culture". In the course of 1999, the development of a "credit risk culture"
amongst investors active in the euro area led borrowers to seek more ratings for their securities. This
explains why the number of new ratings provided by ratings agencies to borrowers located in the euro
area increased very substantially in the course of 1999, also for borrowers with ratings somewhat
below the best levels.
Second, with the creation of the euro, investors and borrowers active in the financial markets of the
euro area have de facto been granted access to the euro-denominated market. This market, even if it is
not yet fully integrated at the area-wide level, is larger and more open than any of the markets
denominated in the predecessor currencies of the euro. As the remaining barriers to the efficient
functioning of financial markets at the area-wide level are progressively removed, borrowers will have
easier access to financial resources and investors will enjoy more varied opportunities for investment.
Obviously, this development will not necessarily provide benefits only for large borrowers and large
investors. For example, as large borrowers are able to obtain more funds directly from the financial
markets, some bank resources will be freed and thus become available for smaller borrowers
particularly suited to the kind of credit monitoring relationship that can be established with a bank. In
addition, smaller investors will clearly be able to reap the full benefits of the establishment of large
financial markets in the euro area, either through the use of retail brokerage services or, more often,
through the purchase of mutual fund shares. In this respect, it is also noteworthy that the amounts
invested in mutual funds located in the euro area continued to increase, by 6% in 1999, following a
considerable increase of 34% in 1998.
Although considerable progress has been made so far, there appear nonetheless to be some areas in
euro area financial markets which are lagging behind in terms of development. Let us take, for
example, the case of the repo market. The unsecured money market became fully integrated at the
level of the euro area soon after the introduction of the euro. However, it is striking that, although
some progress has also been made in the secured money market, the repo market has not yet become
integrated to anything like the same extent as its unsecured counterpart. In particular, turnover in
cross-border repo transactions, although it increased, did not do so very considerably. Furthermore,
market liquidity, as measured, for example, by bid-ask spreads on repo transactions, still varies
significantly across countries. Several technical factors seem to have prevented the full development
of an area-wide repo market so far. First, the market infrastructure currently available for repo
transactions is not conducive to cross-border trades. Trading and clearing platforms are not sufficiently
integrated. In addition, securities settlement systems do not always make it possible to transfer
efficiently the ownership of securities on a short-term basis, as is needed in repo transactions. A
second set of factors hindering the development of the repo market at the area-wide level seems to be
related to country differences in the tax regimes applicable to repo transactions. Furthermore, there are
also legal differences across countries, in particular relating to the possibility of netting financial
obligations. These problems have been posing considerable challenges to the preparation of the
contractual documentation underlying repo transactions.
With regard to market infrastructure, the Eurosystem believes that it is up to market participants to
deal with the problems and find the best market-oriented solutions. In its own repo operations, in order
to ensure a level playing-field, the Eurosystem has put in place a system whereby its counterparties
can use any eligible asset, irrespective of its location, as collateral against credit received from the
Eurosystem. At the risk of treading on rather technical ground, let me recall that this system consists
of two parts. First, the national central banks act as correspondent banks for one another, and take
eligible assets in custody for one another's account. Second, when there are links between the
securities settlement systems, assets may be transferred using such links, provided that the links have
been reviewed by the European System of Central Banks (ESCB) and judged to comply with ESCB
standards. In fact, thanks to these facilities, the counterparties of the Eurosystem make extensive use
of collateral on a cross-border basis.
Are the financial markets of the euro area becoming more efficient?
I should now like to reflect upon the question of the efficiency of financial markets in the euro area. I
will first briefly touch upon retail financial markets. I shall then address wholesale financial markets in
greater detail.
One particular development can illustrate the progress recently made in retail banking markets. In the
euro area the dispersion of interest rates on loans for house purchase declined noticeably in the course
of 1999, continuing a trend which had been apparent since 1996. Between 1996 and 1998, the
convergence of interest rates on loans for house purchase had been in parallel with the convergence of
market interest rates across those countries which would later form the euro area. By 1999 differentials
between market interest rates had reached stable levels across the euro area. However, cross-country
differentials between interest rates on loans for house purchase continued to narrow sizeably. More
specifically, in countries where they used to be particularly high, interest rates on loans for house
purchase came closer to the euro area average in 1999. Hence, despite the fact that banks do not yet, in
many cases, directly compete with each other on a cross-border basis in the granting of loans for house
purchase, customers have already been able to benefit from more competitive loan prices. This
development was particularly interesting as interest rates rose during 1999 from the exceptionally low
levels recorded at the beginning of that year.
Although considerable progress has already been made, there clearly remain obstacles to the
development of more competitive markets for banking products and services at the level of the euro
area. For example, there is a need to improve cross-border retail payment services in the euro area. In
order to encourage the development of cross-border payment systems enabling the public to benefit
more fully from the single currency, the Eurosystem has drawn up a list of desirable objectives for
cross-border retail payments in the euro area. It stands ready to play a coordinating and supportive
role. In particular, the Eurosystem considers it highly desirable that the prices and settlement lags of
cross-border transfers be similar to those of national transfers, whenever the applicable standards and
procedures permit.
Turning to the wholesale financial markets, progress has clearly been more rapid than for retail
financial markets. Already in the run-up to the introduction of the euro, but especially since 1 January
1999, there has been a large decline in transaction costs in many areas. In foreign exchange, interest
rate and equity markets, bid-ask spreads often declined in 1999 compared with 1998, sometimes very
significantly. Furthermore, trading activity expanded, particularly in some segments such as the
private bond markets. As a result of the increase in trading activity, market participants were able to
carry out large transactions within a short period of time more easily and with lower costs. Hence, in
1999 not only bid-ask spreads but also other indicators pointed towards an increase in the depth and
liquidity of financial markets in the euro area.
The changes in transaction costs are particularly notable on the unsecured money market. In the
context of the conduct of monetary policy, the creation of an area-wide operational framework for the
refinancing operations of the Eurosystem has modified the micro-structure of the money market
considerably. Despite the continued use of different trading systems, the money market of the euro has
gained a clear cross-border orientation, largely thanks to the establishment of TARGET. Very soon
after the introduction of the euro, typical bid-ask spreads quoted on the unsecured money market of
the euro became as narrow as in the most liquid money markets at the global level. Furthermore,
swaps indexed on the overnight reference rate, as measured by the EONIA, which have become a very
widely used instrument, also offer particularly small bid-ask spreads. It is therefore clear that the
unsecured money market of the euro has become fully integrated and is functioning well. However, as
already mentioned, there is still some scope for further development in the repo market.
In other segments of the euro-denominated interest rate markets and in the equity market, the range of
financial instruments available to market participants expanded markedly in 1999. For example, the
most widely traded short-term interest rate futures denominated in euro are contracts indexed on the
three-month EURIBOR. For these instruments, the range of available delivery dates currently goes up
to five years. This is less than the ten years available for three-month Libor futures traded for the
United States. However, this is wider than the range of maturities which used to be available in the
predecessor currencies of the euro. From the point of view of monetary policy, the market prices of
such products provide information of interest about market expectations.
The development of the mortgage bond market constitutes another example. In several countries of the
euro area, legal texts were recently enacted which permitted the development of a market for mortgage
bonds similar to the German Pfandbriefe. New issues of non-German Pfandbriefe have been very
successful, as there was a strong demand on the part of investors for this type of instrument.
In 1999 a number of financial market institutions created a wide array of stock price indices and bond
indices covering the euro area as a whole. This development has contributed to extending the range of
trading and position-taking opportunities available for investors.
Stock price indices are available mainly in two forms: broad and narrow. Broad indices provide a
precise measure of stock price developments in the euro area stock market. The narrower indices,
which by nature cannot be considered representative for the euro area as a whole, are useful because
they are easier for investors to track through the purchase and sale of a limited number of stocks. For
this reason, narrow indices have been instrumental in the development of equity derivatives contracts.
Overall, turnover on area-wide stock index derivatives has grown steadily over the past 18 months,
increasingly taking up a larger share of total turnover on stock index derivatives in the euro area. With
the progress of economic integration in the context of Economic and Monetary Union, over recent
years stock market investors have increased the share of their stock portfolios which is managed with
reference to area-wide risk factors. This process accelerated in 1999, as the introduction of the euro
seemed to act as a catalyst for the creation of area-wide stock price indices.
In the course of this process, investors have also taken advantage of sectoral stock price indices. In
particular, it is interesting to observe that exchanges have created futures and options contracts
indexed on certain sectoral stock price indices, such as the technology sector, the telecommunications
sector or the bank sector, to take a few examples. Not only does the introduction of such financial
products respond to the demand of investors, but it also makes it possible to process more information
and circulate it across the market through the price formation mechanism. This information on
area-wide sectoral developments is clearly beneficial for investors managing large area-wide
portfolios. It is also useful for smaller investors, whom it can help to form judgements about the taking
of positions in certain specific stocks. At the global level, it is noteworthy that, at the beginning of
2000, the various financial market institutions publishing sectoral stock price indices took steps
towards a better harmonisation of sector classifications. These changes, which can be expected to
bring benefits to the users of such data, were obviously also applied to the stock price indices available
for the euro area.
For bond indices, much the same observations can be made as for stock price indices. The available
bond price indices include area-wide indices which are split according to the various maturity buckets
along the yield curve and further broken down according to whether the issuers are governments or
from the private sector. In turn, private sector indices are often available in sectoral breakdowns, for
example financial sector versus non-financial sector, and in credit ratings breakdowns, for example
triple A versus double A versus single A and so forth going further down the credit curve. It cannot be
denied that such benchmark indices for bonds can play a useful role in the course of the development
of bond markets in the euro area.
In sum, wholesale financial markets of the euro area are currently benefiting strongly from the
continued reduction in transaction costs, the development and spreading of new financial products
such as Pfandbriefe, and the introduction of a wide set of area-wide and sectoral indices for stock
prices and bonds.
Looking forward, there are a number of challenges to be met. In this regard, without aiming at being
exhaustive, I should like to address three topics: the question of benchmarking in euro area bond
markets; the challenges posed by the electronification of trading systems; and the need to take into
account the risk of extreme events when modernising market infrastructure in the euro area.
Over recent weeks, there have been episodes when, in those countries, such as the United States and
the United Kingdom, where the process of reducing public debt is more advanced, government bond
yields have been subject to very strong and unexpected downward pressures. Some of the downward
pressures on yields reflected sudden increases in liquidity premia. Investors seemed to be concerned
that the future pace of reduction of government debt would become so high as to create an imbalance
between high demand and low supply of government bonds. On the heels of these developments, the
question of benchmarking instruments in bond markets was naturally considered to be quite acute.
Prior to the introduction of the euro, in euro area countries with a non-negligible private bond market,
government bonds were generally used as a benchmark for the pricing of corporate bonds.
Furthermore, government bonds were also generally used as conduits for position-taking and hedging
on interest rate markets. In this respect, futures and options contracts using the national government
bonds as underlying references were widely used, in conjunction with position-taking on both
government and private bond markets. Since the introduction of the euro, a certain limited number of
government bonds have played the role of benchmarks at the level of the euro area as a whole. This
mainly includes German government bonds and, at the shorter end of the maturity spectrum, French
government bonds. Furthermore, total turnover on government bond futures and options has become
very concentrated on the contracts indexed on German government bonds, although there has been
renewed competition from other contracts over recent months. The risks associated with having an
open position on a single contract which is larger than the underlying bonds available for delivery may
have played a role.
In this context, the question has arisen of whether the amount outstanding of benchmark government
bonds will remain sufficient to cover benchmarking needs, particularly as public deficits and debts
should be reduced further in the euro area. Already quite some time ago, some commentators had put
forward the idea that the interest rate swap market, which, by international standards, is very well
developed in the euro area, could at least partly play the role of benchmark. In fact, it is clear that the
swap curve constitutes a widely used reference for the pricing of private sector debt instruments as
well as the measurement of market risk on these instruments. With regard to derivatives instruments, I
am confident that financial market institutions will come up with solutions to any possible shortage of
the underlying government bonds. This development, in itself, would be welcome, as it would reflect a
decline in government deficits and debt to levels in line with the Stability and Growth Pact. For
example, other instruments or pools of instruments may be used to provide the underlying price
references for exchange-traded derivatives instruments. All in all, there are two main conditions to be
fulfilled by instruments to serve as a reference in interest rate derivatives contracts. First, reference
instruments should be traded in a market which is sufficiently deep and liquid to constitute a reliable
and efficient price source. Second, the requisite legal and institutional conditions should be in place to
ensure that positions on derivatives may easily be either reversed prior to expiry, rolled over at the
time of expiry or settled at the time of expiry by way of a cash payment.
Moving on to the second item in my short list of issues, let me now consider the challenges posed by
the electronification of trading systems. This development has been most remarkable in the foreign
exchange markets. Automatic trading systems have very rapidly, over the course of the past three
years, become the most widely used way of matching buy and sell orders. In the course of this
development, a large part of the voice-based trading process has disappeared. In this context, certain
observers regarded it as symptomatic of possible problems that, on particular days in 1998 and 1999,
foreign exchange rates fluctuated by unusually large amounts within very short periods of time. These
observers argued that the changing role of market makers in the price formation mechanism, as a result
of market electronification, was the cause underlying some of the unusual gapping behaviour seen in
foreign exchange rates on these particular days. If this hypothesis proves correct, then it is likely that
any gapping phenomenon would disappear once the transition to the new framework is complete and
the new market infrastructure has become well established.
Meanwhile, the electronification of markets has also made progress in interest rate and equity markets.
Over recent months, certain institutions have made available, particularly on the internet, relatively
cheap automatised trading systems. T