Benoît Coeuré: Government bond markets in a changing environment
Keynote address by Mr Benoît Coeuré, Member of the Executive Board of the European
Central Bank, at the Government Borrowers Forum, Paris, 3 May 2016.
* * *
Summary:
In a keynote address at the Government Borrowers Forum, in Paris, ECB Board member
Benoît Coeuré analyses the impact of recent policy interventions on market functioning. His
remarks focus on unconventional monetary policy measures, regulatory developments and
private-public partnership in financial market reforms. «Policy interventions are having an
impact on market functioning today» he says, but in the case of the ECB's monetary policy,
«ongoing monitoring so far does not suggest impairments to the price discovery process» and
«our monetary policy has not suppressed market discipline». The new market environment is
more constrained, but also more resilient. «At the same time, more safety is not a substitute
but a complement to well capitalised banks and sound public finances» he concludes.
***
Let me begin by saying thank you to the World Bank and the Agence France Trésor for inviting
me to speak today.
The speed of change during the financial crisis, and of the regulatory responses to it, has
particular resonance for borrowers who think in long time scales, such as governments. Six
years have now passed since the famous Pittsburgh G20 communiqué, where many initiatives
for the ongoing regulatory agenda to prevent similar crisis in the future were launched. Some
of those initiatives have already had a profound impact on global interest rate markets, such
as those related to derivatives clearing and market transparency. Yet six years is also
significantly shorter than the average new issuance maturity for the government borrower
members present here today. This implies that many bonds issued in 2010 will be rolled over
in very different markets - from level, structural and regulatory perspective - from those that
we knew at the time. And that is not to mention the ultra-long bonds recently issued by several
governments, including France's latest 50 year issuance.
In some cases, for instance for trade reporting and transparency, the crisis simply provided the
necessary catalyst for overdue improvements in market practices. In others, related for
instance to risk-taking by banks or the rigging of benchmark rates, the bad practices of the
past had to be curbed by regulatory fiat. A third group of changes, such as the rise of electronic
trading, were happening already before the crisis. While it is straightforward to see the
steadystate benefits of all these developments, the potential side effects and transition problems are
more difficult to assess. As a result, a holistic assessment of their impacts on systemic stability
and economic efficiency is needed. But that is beyond the scope of my remarks today.
What I would like to focus on is one issue in particular, namely the impact of recent policy
interventions on market functioning. Specifically, I would like to discuss three areas: the impact
of unconventional monetary policy measures; the impact of regulatory developments; and the
role of private-public partnerships in financial market reform.
1. The impact of unconventional monetary policies
Starting with monetary policy, the key issue is as follows. Efficient price formation requires
that large transactions can be rapidly executed at low cost with limited price impact - i.e. that
markets are liquid. But are unconventional measures, such as negative interest rates and asset
purchases, positively or negatively affecting market liquidity conditions and thereby that price
formation mechanism? It is of course difficult to disentangle the individual effects of each of
the policy measures we have taken in the recent years, as they have all been introduced as
part of wider policy packages. Still, there are some points that can be made about the tools in
isolation.
First, negative interest rates on our deposit facility. Beyond some initial hesitation, the transition
to negative rates has happened smoothly in both capital and money markets. The technical
challenges related to the implementation of negative rates, notably in terms of market
infrastructures, have been well anticipated and addressed by market participants, and we now
have proof that market functioning below zero does not imply different logics and mechanisms.
Or as I said elsewhere, there is life below zero.1 In particular, possible adverse effects of
negative rates on general trading activities seem to have been limited. While volumes in the
euro money markets have been declining,2 they have been also impacted by the significant
increase in excess liquidity as well as regulatory developments.
A case in point is the volumes traded in the Eonia market, which did fall substantially after the
deposit facility rate was cut below zero in 2014, but are up 60% since the beginning of this
year. In addition, negative rates have been accompanied by receding fragmentation in the
unsecured overnight money market, at least for the higher-rated counterparties. For example,
the spread between rates paid by banks with an investment grade credit rating in formerly
stressed and non-stressed jurisdictions is close to its pre-Lehman level and significantly
improved since mid-2012. The secured money market and security lending market have also
been fairly resilient, and repo markets in formerly stressed jurisdictions have seen noticeable
increases in trading activity, thanks to an overall improving environment. These developments
are all the more important for us at the ECB since we take great care to ensure that our
exceptional policy measures do not have an irreversible impact on market structures.
More generally, we have not yet seen negative rates have a major impact on market makers
themselves - in particular via the topical channel of banks and their profitability. I can only
repeat here what the ECB has already said on several occasions, namely that banks'
profitability has actually improved when you look at the overall impact of our monetary policy,
thanks to a combination of lower funding costs, increased lending volumes and lower loan-loss
provisions, which dominates by far the direct cost of negative rates. To be sure, this would not
necessarily remain true if the deposit facility rate were to be set at significantly lower levels.
But this is why I have said elsewhere that we would not take it to absurdly low levels.3 If
anything, the smooth changeover to negative rates has only underlined the adaptability of
market participants to this new environment, especially the money market funds industry.
Turning to the longer end of the yield curve, can the same upbeat assessment by made about
our asset purchase programme? As of 2 May, the ECB had purchased EUR 733 billion of
securities under its Public Sector Purchase Programme (PSPP). Theoretically, such
largescale asset purchases by the central bank could have either a positive or a negative effect on
market liquidity. On the one hand, the willingness of the central bank to purchase assets
reduces market risk for potential buyers - that is, the risk that they are unable to sell the assets
later on when needed to obtain liquidity. Such investors might therefore be ready to buy those
assets at a somewhat higher price, which compresses the standard measure of market
liquidity, the bid-ask spread. This situation is more likely in cases where investors fear that
markets might become disrupted and demand dries up.
On the other hand, with central bank purchases the risk that potential sellers might be unable
to sell at a later point in time is also reduced. Those investors may therefore be ready to sell
now only at a somewhat higher price, which makes the bid-ask spread wider. Moreover, if the
central bank holdings of a particular security are sizeable relative to the total amount issued,
that security becomes scarcer. This can translate into longer inventory holding problems and
higher trading costs and this case investors will be more reluctant to hold those securities.
In other words, the impact of the PSPP on market liquidity remains an empirical question. And
looking at the available data, we do not see evidence of significant disruptions in market
functioning.
First, price discovery appears to be smooth and issuers are able to place new securities to the
market in large volumes. Trading volumes have not fallen systematically as a result of PSPP.
Based on TradeWeb data, trading volumes in core markets such as Germany are roughly 5%
lower than two years ago. However, trading volumes in Italian, Spanish and Portuguese bonds
on that platform are around 20% higher. That said one should not draw hasty conclusions from
what remains a fragile set of indicators. Too little is known of the liquidity offered by dealers to
end-investors. And therefore, the ECB will monitor market liquidity carefully as our asset
purchase programme is further rolled out.
Second, it is important to learn from Arthur Conan Doyle and note 'the dogs that didn't bark'.
We have witnessed several shocks since we began our purchase programme that, in other
conditions, might have led to substantial market volatility. For example, the major realignments
of global FX reserve portfolios in the summer of last year passed without a significant increase
in euro area yields or yield volatility. In this sense, the presence of PSPP has aided market
functioning by providing a constant source of demand in the market and by flexibly directing
this demand towards particularly oversold securities. At the same time, the spike in sovereign
yields in Portugal earlier this year shows that our monetary policy has not suppressed market
discipline.
Finally, as general remark, one should always keep in mind that our combined measures are
designed to prevent growth and inflation from being too low for too long. If we allowed such a
situation to materialise, the impact on banks and investors would be much more severe than
the impact our measures are said to have.
2. The impact of regulation
Alongside monetary policy, the new regulatory environment is a second key policy parameter
affecting market functioning. The most prominent regulations cited by dealers as having had
an impact on market liquidity are the leverage ratio, the liquidity coverage ratio (LCR), the net
stable funding ratio (NSFR), as well as structural bank reforms (e.g. the Volcker rule). While it
is difficult to definitively identify a causal link - some observers note that banks and dealers
are in the process of re-allocating business between risk-weighted asset and leverage ratio
constrained lines of business - there are some reasons to suggest that market behaviour is
consistent with the dealer behaviour mainly being constrained by the leverage ratio.
The implied reduction of balance sheet available to trading desks, however, does not have a
straightforward effect on liquidity. Instead of a general widening of bid-offer spreads, which
would be consistent with a general drop of liquidity, the reduction of available balance sheet
has had two salient features in recent years. First, liquidity has been rationed to a larger degree
in the sense that dealers have had to deploy their balance sheet selectively towards the most
profitable businesses. Second, liquidity itself has become more volatile and unevenly
distributed across market segments, leading to greater market segmentation.
In particular, it is now more difficult for dealers to use cross-market positions to bridge liquidity
across the sub-segments of the euro area bond market, because it is more expensive to carry
spread positions. Volumes in the bond futures market provide a good example. Before the
crisis, only three German government bond contracts on Eurex were reasonably liquid and the
bellwether 10 year Bund contract saw trading of around one million contracts a day. Today,
daily trading volumes in that contract have fallen to around 600,000, while around 100,000 10
year BTP contracts and 80,000 10 year OAT contracts trade every day. Neither of these
contracts even existed before the crisis. Bearing in mind that the locus of trading has shifted
from cash bonds towards futures, these volume developments show that trading activity has
decreased overall at the same time as it has splintered across markets.
To give another example of this trend, we can recently observe that it has become more
expensive to borrow certain securities, such as those issued by the German government, over
the quarterly balance sheet closing dates.4 Other securities borrowing markets, however, show
the more established behaviour of cheapening around the same period. This divergence may
be being caused by increased focus on sufficient high-quality collateral holdings (linked to the
LCR) on part of some banks rather than the usual focus on cash funding. The concurrent
tightening of bank leverage rules may also have restricted the ability of banks to engage in
collateral transformation, further exacerbating temporary collateral demand and supply
imbalances in specific cases. Importantly, the Eurosystem is helping to alleviate these
collateral shortages by making all securities purchased under the PSPP available for securities
lending, both by national central banks and by the ECB.5
But what is the longer term solution to the side-effects of regulation? In the policy discussion,
the focus is now turning from designing the next piece of regulation to assessing the
compounded impact of what has been done and implemented so far. In my view there is scope
to fine-tune and streamline the regulatory landscape to iron out some of these unintended
consequences. But even if costs are identified, that would not justify rolling back the core tenets
of what has been achieved. I can only agree with New York Fed President Bill Dudley that
"even if higher capital and new liquidity requirements were found to result in greater transaction
costs, these costs would need to be assessed against the benefits of having a more robust
and resilient financial system and a reduced risk of financial crises in the future."6
Remember that in the run up to the financial crisis, there was an illusion that liquidity could be
provided for free to issuers and investors. Such liquidity was a mirage7 created by distorted
risk assessments and hidden cross-subsidisation across capital market activities. So even if
we now legislate to prevent the risks we know, we will not abolish the risks we don't know. On
the contrary, the more we eliminate the obvious risks, the higher the conditional probability of
experiencing a crisis stemming from a non-obvious source. That is why upholding legislation
to make the financial sector more resilient - in particular stronger bank capital - is such an
important complement to stronger market regulation. Better regulated markets may mean that
banks bear less risk, but it does not mean they should not be strongly capitalised.
3. The role of private-public partnership in financial market reform
The new market environment, however, is not only being shaped by official regulation, but also
by quasi self-regulation - that is reform initiatives adopted by market participants, with the
public sector giving it the initial impetus and a strong steer. This brings me to the third
part of my remarks. While such changes are by definition less spectacular, what could appear
as "soft developments'" can sometimes lead to considerable improvements in terms of market
safety and reliability. Take the example of the reference rates, notably in interest rate or FX
industry. Over the last years, a number of scandals have illustrated that relying purely on
market practices in order to calculate benchmarks was not necessarily optimal, and in some
specific cases, detrimental to financial stability.
In reaction, the private sector has been active in improving the benchmark-setting process.
Codes of conduct have been developed by the benchmark administrators to better control the
rate-setting process and clarify the responsibilities of contributors. The governance of the
benchmark administrator itself was also clarified so as to avoid interest conflicts. For some
benchmarks, audits are regularly performed to verify the reliability of the contributions to a
benchmark. Additionally, private initiatives to rethink market needs and identify alternative
benchmarks are taking place.
But the public sector has not been absent in the genesis of these market changes: since 2013
the FSB and the International Organisation of Securities Commissions (IOSCO) have worked
on a reform process of benchmarks,8 accompanying and steering the efforts of private market
participants to define more robust and reliable benchmarks and related "best practices". In
addition, in the European Union the public sector has supported the process with legal texts.
Indeed, the final draft of an EU Regulation on financial benchmarks was voted by the European
Parliament on 28 April.9 A wide range of benchmarks will now be covered by the new
regulation, improving the reliability of the benchmarks, complementing and supporting the "soft
law" of market practices.
On these topics, the ECB has been strongly committed to the improvement of the relevant
benchmarks for the euro.10 While the ECB was always of the opinion that financial benchmarks
should be private initiatives to best suit private needs, we have also helped the private sector
in some of the benchmark reforms given the tremendous consequences of certain benchmarks
for proper market functioning.
In particular, we are closely accompanying the transition of the Euribor from a quote-based to
a transaction-based index. We have been involved in the discussions for some time as,
together with the Euribor administrator, we launched data collections in 2012 and 2013 to
analyse the feasibility of a transaction-based reference rate. Now the transition to the
transaction-based methodology, with a pre-live phase starting this summer, is foreseen by the
Euribor administrator for early 2017. The small size of the panel of contributors, however,
remains a risk for the continuity of this reference rate. For that reason, the ECB expects banks
as active users of Euribor to take responsibility for the benchmark and to stand behind its
production as contributors with the launch of the new calculation methodology. If the private
sector fails to assume responsibility for the benchmark, given the major consequences at
stake, the ECB would support the possibility of mandating the banks judged as relevant to
contribute to the benchmark under the newly voted EU Regulation.11
8
See IOSCO, "Principles for financial benchmarks: Final report", FR07/13, July 2013, and "Review of the
Implementation of IOSCO's Principles for Financial Benchmarks", OR02/2015, February 2015. The 19 IOSCO
Principles are a set of recommended practices that should be implemented by Benchmark Administrators and
Submitters. They are covering four areas (governance, quality of the benchmark, methodology, accountability).
While not superseding existing laws, IOSCO members were encouraged to support the implementation of the
Principles including through regulatory action where appropriate. IOSCO regularly reviewed which the Principles
have been implemented by obtaining the input of Stakeholders, Market Authorities and, as appropriate,
Benchmark Administrators.
9
See European Parliament News, Interest rates: final vote to ensure robust and transparent benchmark setting.
10
See European Central Bank, "European Commission's public consultation on the regulation of indices:
Eurosystem's response", November 2012, and "Reference interest rates: Role, challenges and outlook",
Monthly Bulletin, October 2013.
11
While the competence to make Euribor contributions mandatory lies with other EU and national institutions (NB:
the Belgian supervisory authority and other supervisors forming a college of supervisors following an act of the
European Commission to establish a list of critical benchmarks), the ECB is willing to provide all necessary
Regarding FX benchmarks, the ECB has also been active in the recommendations of the
Foreign Exchange Benchmark Group of the FSB, along with other central banks and
regulators. In particular, the ECB took the lead by reforming its own FX reference rates
framework so as to discourage market participants' trading activity related to it. Given that ECB
reference rates are provided as a public good for individual citizens and institutions, it is
essential to safeguard a high level of integrity.
4. Concluding remarks
Let me conclude.
Policy interventions are undoubtedly having an impact on market functioning today. The key
question, however, is what is the sign and magnitude of those impacts, and whether the
tradeoffs they present are worth it.
In the case of the ECB's monetary policy, our ongoing monitoring so far does not suggest
impairments to the price discovery process. But even more importantly, our measures are
essential to restore a more robust economic environment where inflation is in line with our
mandate. That environment is the most important variable for dealers and investors and
therefore for market functioning.
What is more, it is important to remember that not only policy interventions affect market
liquidity. For example, high frequency electronic trading has been blamed for various rapid
market moves and charges have been brought against some uses of such technology.12
Though innocuous in certain situations, such technology can also raise barriers to some
investors' access to liquidity, which would narrow the range of trading interests and could
exacerbate volatility spikes when no market participant is there to "catch a falling knife".
So to return to my initial question of how changes in market structure will affect the funding
strategies of long-term borrowers, the best answer I can provide is that the interests of
regulators, issuers and investors are aligned. All want markets to be able to absorb debt
without large dislocations and price formation to be orderly and transparent. This requires that
we continue the direction set in Pittsburgh in 2010.
From regulatory developments to best practices, market structures are progressively changing,
evolving to a new market environment that is more constrained but also more resilient. At the
same time, more safety is not a substitute but a complement to well-capitalised banks and
sound public finances.
Thank you very much for your attention.