Benoît Coeuré: Ensuring the smooth functioning of money markets
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the 17th Global Securities Financing Summit, Luxembourg, 16 January 2013.
* * *
Ladies and Gentlemen,1
It is a pleasure to speak to you today at this annual Global Securities Financing Summit
organised by Clearstream / Deutsche Börse Group.
In my remarks today, I will talk about the smooth functioning of money markets and the role
of market infrastructures in this respect.
The speech is composed of two parts. I will start with some comments on developments in
the euro area (interbank) money markets. As you are well aware, the financial crisis and the
subsequent sovereign debt crisis have led to a gradual shift from the unsecured to the
secured segment of the money markets. Moreover, the crises have exposed the weaknesses
of certain financial institutions, causing the European interbank money market to fragment.
Fragmentation has occurred between cash-rich and cash-strapped banks and also between
different jurisdictions, leading to a "renationalisation" of money markets. Since money
markets can be a source and a propagation channel of financial instability, it is important to
ensure their proper functioning and mitigate the potential risks they pose.
In the second part of my speech I will consider the role of market infrastructures in ensuring
well-functioning money markets. For this part, I will refer back to work conducted by the
Basel Committee on Payment and Settlement Systems (CPSS) in 2010 when it examined
the extent to which the market infrastructure for repos added to the uncertainty or instability
evident in some repo markets. I will take up two issues identified in the related report
published by the CPSS2 and which can be considered relevant for the smooth functioning of
euro money markets, i.e. the role of market infrastructures in providing adequate protection
against counterparty risk as well as the efficient use of collateral. In so doing, I will also
discuss some tensions which have emerged recently relating to a particular development at
market infrastructure level, where it is important to quickly address the underlying issues in
order to move forward.
1. Secured and unsecured money markets: developments in the euro area
Well-functioning money markets are an essential component of the financial system. When
money markets do not function, financial stability and the transmission of monetary policy are
at risk, with potentially severe adverse consequences for the real economy. Deep and liquid
money markets insure banks against liquidity risk, a risk that arises naturally in banking,
where maturity mismatch is the nature of the business. Unsecured money markets exert a
useful disciplinary effect on banks. Money markets also are the starting point for the
redistribution of the liquidity provided by central banks and hence the starting point for the
transmission of monetary policy. For example, the EONIA rate - the rate of unsecured
overnight lending between some of the largest euro area banks - is an important first link in
the chain of monetary policy transmission.
Ever since the financial turmoil started in August 2007 - more than five years ago - and then
became a severe crisis with the bankruptcy of Lehman Brothers one year later in
September 2008, money markets have not been operating smoothly. The outbreak of the
financial crisis has been well documented, but it is worthwhile recalling the extent of the
shocks, which are still being felt today.3 Within a few days after the demise of Lehman
Brothers on 15 September 2008, the EURIBOR-OIS spread, which had been zero a little
over 12 months before, rose to a staggering 186 basis points (in the United States the
spread rose to 365 basis points).
In addition, cash-rich banks were apparently no longer lending to cash-poor banks. The flow
of liquidity in the financial system came to a sudden stop. Prior to the bankruptcy of Lehman
Brothers, banks hardly ever deposited funds at the ECB (where they earn the deposit facility
rate, which at the time was 1% less than the policy rate). After the Lehman bankruptcy,
banks suddenly deposited an aggregate amount of around €200 billion. Deposits increased
since the ECB responded to the tensions in the market by accommodating the increase in
banks' demand for liquidity.4 The extent of banks' use of the ECB's deposit facility is a useful
indicator of the impairment of the flow of liquidity throughout the banking system, especially
when the group of depositing banks is different from the group of borrowing banks.5
A further troubling indication of the malfunctioning of money markets right after the Lehman
bankruptcy came from cross-border transactions. Before the bankruptcy, cross-border
transactions accounted for 60% of all unsecured overnight interbank lending. Right after the
bankruptcy, this proportion dropped to 50%. A fall in the cross-border flow of liquidity
indicates a fragmentation of the euro area money market along national borders and
threatens the implementation of a common monetary policy throughout the euro area.
The ECB reacted and succeeded in calming markets, including money markets, first by
conducting two monetary policy operations with a three-year maturity, and then, most
recently, by committing to remove redenomination risk in countries having signed to an
ESM assistance programme (the so-called Outright Monetary Transactions, OMTs for short).
For example, the share of the cross-border overnight transactions increased gradually from
30% to 50% following the OMT announcement.
The rise and fall of the EURIBOR-OIS spread, of the use of the ECB's deposit facility and the
proportion of cross-border transactions all indicate that banks are more risk-averse than they
were before the financial crisis. Money markets, especially unsecured ones, suffer from
counterparty risk, that is, the fear of not being repaid.
Accordingly, driven by the desire to protect and ensure repayment, transactions in money
markets have become both more short-term and secured. There is no official data on the
overall size of the repo market in the euro area, although surveys are regularly conducted by
ICMA and the ECB. According to the latest ICMA survey, the total value of repo contracts
outstanding on the books of the 62 participating institutions was €5.6 trillion in June 2012,
down from €6.2 trillion in December 2011.6 The ECB's Money Market Study of
3
See, for example, F. Heider, M. Hoerova and C. Holthausen, "Liquidity hoarding and interbank market
spreads: The role of counterparty risk", ECB Working Paper No 1126, 2009. See also B. Coeuré, "The
importance of money markets", speech delivered at the Morgan Stanley 16th Annual Global Investment
seminar, Tourrettes, Provence, 16 June 2012.
4
Injecting liquidity in the financial system increases the assets of the Eurosystem, which leads to an equivalent
increase in liabilities, in this case in the form of more deposits from banks.
5
A similar cessation of interbank lending after the Lehman bankruptcy has been documented in the United
States. See G. Afonso, A. Kovner, and A. Schoar, "Stressed, Not Frozen: The Federal Funds Market in the
Financial Crisis", Journal of Finance, Vol. 66, No 4, 2011.
6
See International Capital Market Association, "European Repo Market Survey", No 23, June 2012, available at
http://www.icmagroup.org/assets/documents/Market-Info/Repo-Market-Surveys/ICMA-ERC-European-RepoSurvey-June-2012.pdf.
December 2012 with 172 banks participating shows a similar development.7 The Money
Market Study also compares the development of the secured with the unsecured market.
And indeed, while the unsecured money market has steadily contracted since 2007, the
secured money market has held its ground over the same period.
Another, more recent and troubling development in the functioning of the money markets is
the on-going investigations into manipulations of key money market reference rates. The
ECB is closely following this development and is supporting the attempts to reform reference
rates, given the role they play in the transmission of monetary policy. In our response to the
European Commission's public consultation, while stressing that reference rates should
remain private market initiatives, we have called for short-term governance reforms to restore
and uphold the credibility of these reference rates, associated with longer-term measures
involving changes in the calculation methodology. In the short term, governance reforms and
increased supervisory and regulatory scrutiny can help to restore the market's confidence in
the integrity of the benchmarks and to ensure their continuous viability. An appropriate
balance must be found between a sound production process with adequate controls and
safeguards on the one hand, and cost-efficiency for contributing banks on the other hand.
Also it is important that regulation is uniformly applied and enforced within the EU to avoid
risks of further fragmentation in the money markets, and that international coordination is
sought. In the longer term, a broader overhaul can be conceived, involving changes in the
calculation methodology and possibly other changes to reflect the structural changes that
have taken place in terms of the functioning of the money market since the onset of the
crisis, such as the shift towards secured transactions. However, this process should be
primarily driven by the market, based on the needs of end-users, while being supported by
the public sector.
In light of the fundamental importance of money market reference rates, we are closely
following the developments taking place as regards the shrinking number of panel members
for establishing EURIBOR and EONIA rates. Given the authorities' commitment to
addressing the shortcomings revealed in the rate-setting process, it is in the interest of
markets that banks remain in the panel while the regulatory framework is being amended
and behave as responsible market participants, thus preventing potential disruption in the
functioning of an important financial market segment.
Related to the shift of money market transactions to the secured segment is the use of
central counterparties (CCPs).8 In 2012, CCP repo transactions accounted for 55% of all
repo transactions (up from 50% in 2010). In addition to the use of CCPs, triparty repo9 has
become more important. Triparty repo accounted for 11% of all repo transactions in 2012 (up
from 9% in 2010).
I will come back to CCPs and triparty repo later on, but would first like to say some words on
collateral and haircuts.
Collateral of course is intended to hedge default risk, while haircuts are usually seen as
being intended to hedge the risk on that collateral. In times of market stress however, large
and sudden margin increases can create self-reinforcing, pro-cyclical spirals of increasing
weakness, exacerbate market swings and oblige market dealers to provide collateral to
support secured transactions just when it is most costly to do so. Two examples come to
mind.
First, when the sovereign debt crisis intensified, haircuts on government bonds under stress
also went up because the rise in yields reduced their collateral value. For example, when the
spread on Italian ten-year government bonds relative to core issuers rose to over
450 basis points in November 2011, the haircut for Italian government bonds was increased
by 500 basis points, leading to a posting of intraday margins about 12 times greater than in
any other preceding month in 2011. On the day of the increased haircut alone, the spread
between Italian and German government bonds rose by 60 basis points.
In addition, margin increases generally reduce the amount that a repo seller can borrow,
which might increase the seller's probability of default. This can trigger a negative feedback
loop: increases in the probability of default might cause repo buyers to increase the haircuts
imposed on the seller, which reduces the amount the seller can borrow (when it needs to
borrow subsequently), and so on.10
The ECB/Eurosystem has been successful in easing market tensions using standard and
non-standard tools. However, the underlying structural problems which relate to uncertainty
about risk, whether in the form of counterparty, credit, liquidity or redenomination risk, need
to be solved. When implemented, the Single Supervisory Mechanism will play a key role in
comforting confidence in euro area banks and re-establishing cross-border liquidity flows
within the region. Market re-integration has now started. It will succeed only if it is supported
by continued efforts by governments to bridge fiscal and competitiveness imbalances. We
can consider how the further development of market infrastructures can be an important part
of this process.
2. The role of market infrastructures
In the second part of my remarks today, I would like to consider the role of market
infrastructures.
Market infrastructures have proven very resilient to the crisis.11 Resilient market
infrastructures also play an important role in helping to address some of the issues that have
been identified in the money markets. In this regard we can usefully build on the CPSS'
analysis of areas for further development and for enhancing market infrastructures in repo
markets. The CPSS has identified seven issues directly or indirectly related to repo market
infrastructure that may affect the resilience of repo markets. I would like to pick up on two of
these seven issues now in the context of euro area money markets. The first issue concerns
"effective protection against counterparty credit risk", which I believe can be addressed to
some extent by the use of CCPs, while the second issue relates to "the inefficient use of
(high-quality) collateral due to constraints within repo clearing and settlement arrangements",
which is being addressed via collateral optimisation initiatives.
a) Role of central counterparties (CCPs)
CCPs play a major role in reducing counterparty risk, thereby mitigating the potential risks
associated with the drying-up of funding sources. First, as independent clearing agents,
CCPs are well positioned to offer effective protection against counterparty risk through the
application of consistent margin requirements to a wide range of counterparties and through
multilateral netting and risk sharing. Second, CCPs also provide enhanced transparency for
the markets they serve, which in turn facilitates appropriate risk management and may also
help to reduce excessive leverage. Third, as a result of multilateral netting, CCPs may also
free up collateral.12
Overall, provided that it is well-managed and in line with applicable regulatory and oversight
requirements, a CCP can be expected to guarantee trade execution under a wide range of
market conditions, including extreme or exceptional scenarios. This supports trading also at
times of distress when uncertainty and risk aversion may disrupt activity and exacerbate
volatility in markets.
Given the benefits of central clearing for market resilience and financial stability more
broadly, the ECB welcomes the overall increase in the share of transactions that are cleared
through CCPs. It also supports the execution of repo transactions via CCPs. In Europe,
market incentives seem sufficiently strong to favour use of CCPs, and we would not see a
need at the current juncture to advocate regulatory action to impose central clearing of repos,
as has been the case for OTC derivative transactions.
At the same time, an expanded use of CCPs should be accompanied by effective
supervision and oversight, which always needs to be kept up to date and in line with new
market developments. The global Principles for Financial Market Infrastructures (PFMIs),
developed jointly by CPSS and the International Organisation of Securities Commissions
(IOSCO) and published last April, are a key pillar in this regard. Major jurisdictions around
the world are now updating their supervisory and oversight requirements for CCPs in
response to the new PFMIs, thereby leading to an even more robust set-up for CCPs.
Another major strand of work currently underway at both international and EU level concerns
the development of recovery and resolution regimes for CCPs. In the EU, the European
Commission has recently consulted the public on a possible framework for the recovery and
resolution of financial institutions other than banks, covering CCPs and other market
infrastructures. We trust that the European framework will be closely aligned with the
respective global work of the CPSS and IOSCO.
Besides CCPs, another key infrastructure to be considered in relation to the repo market is
the trade repository.13 Trade repositories provide a comprehensive overview of the
transactions in the markets they serve, which contributes to better risk management, public
supervision and oversight as well as market discipline. The ECB actively supports the current
work to develop such a central database for the EU repo market.14 It could be established in
a joint effort by public authorities and the financial industry.
b) Collateral optimisation
Let me now turn to the second point on collateral optimisation.
As recognised in the CPSS report, the "efficient and flexible use of collateral facilitates
market participants' collateral management and can contribute to the development of liquidity
and smoothly functioning repo markets". This was considered to hold true for repo markets in
normal times as well as allowing an enhancement of the resilience of repo markets in times
of stress. The need for efficient and flexible use of collateral facilities has even become
greater in the past couple of years, taking into account the generally increasing demands for
collateral assets coming from various quarters. Efforts are therefore being made to seek out
creative and innovative ways to make better use of existing collateral in terms of making
these assets available, when and where they are needed.
Both the Eurosystem and the industry have taken a number of initiatives in this respect. At
today's conference, you will probably hear more about the many innovative solutions that are
coming from the industry in this respect, so I will limit myself to some key initiatives in which
the ECB/Eurosystem is directly involved, although naturally cooperating closely with the
industry.
The first initiative in this respect of course is TARGET2 Securities - T2S. The main objective
of establishing this single European infrastructure for securities settlement is to reduce risk
and increase efficiencies in the post-trade environment, especially as far as cross-border
settlement is concerned. This greatly enhanced process for transferring collateral across
national borders in Europe will in itself be a huge benefit to market participants - both to
cover collateralised money market transactions as well as collateralised credit operations
with central banks. Moreover, T2S incorporates several features that aim to help banks
optimise their collateral management. Once T2S goes live for example, banks will no longer
need to hold multiple buffers of collateral when settling in several European countries and
can instead use the state-of-the-art T2S auto-collateralisation and self-collateralisation
features, also on a cross-border basis.
The second initiative that I want to mention is the implementation of cross-border triparty
collateral management services within the Eurosystem collateral framework. Triparty
services, as you know, involve a triparty agent acting as a facilitator between the two parties
to the repo. Triparty services are already used within the current operational framework of
the Eurosystem, although only on a domestic basis and limited to a small number of euro
area countries (Germany, Luxembourg, France and Italy). In 2014 however, the possibility to
collateralise Eurosystem credit operations by using triparty services on a cross-border basis
will be introduced, thereby allowing for greater efficiencies in collateral mobilisation and
re-use of collateral received in triparty repo with the respective central banks of the
Eurosystem.
Another initiative with which the ECB is associated relates to triparty settlement
interoperability.15 When we refer to this, we should keep in mind that an important feature of
the European repo market set-up is the (increasing) integration between the repo clearing,
settlement and collateral management layers. While there is an increasing integration across
these layers however, there remains in some cases a certain fragmentation that limits
traders' opportunities based on the location of the collateral. Working in close cooperation
with the European Repo Council (ERC), the international central securities depositories
(ICSDs) have started to develop a triparty settlement interoperability model to support
settlement of general collateral trading cleared by CCPs. With the interoperability between
the two ICSDs' collateral management systems, market participants would avoid the
fragmentation of their liquidity pools.
The ECB is fully behind this market-led triparty interoperability initiative because of its
collateral pooling benefits and efficiencies. Moreover, it reduces the costs for triparty repos
related to collateral management, settlement and legal charges, and allows trading to be
executed regardless of the location of the collateral. Non-discriminatory, risk-based access to
and by market infrastructures is an important element of the new international regulatory
framework. With market participants increasingly moving to central clearing, the business
case for triparty interoperability is growing. Furthermore, the new CPSS-IOSCO principles for
financial market infrastructures were specifically strengthened to facilitate access and
interaction between such infrastructures.
Some of the key parties involved in this triparty settlement interoperability initiative have
started to show signs of retreating in past months. While the ECB understands the
complexity of establishing a triparty interoperability model and the substantial efforts and in
particular the investment costs required to make it work, it would like to strongly urge all
parties to continue to work together. Interoperability will bring important benefits - by allowing
a more efficient use of collateral by bringing together separate pools of liquidity. The ECB
remains ready to continue to support the triparty settlement interoperability initiative and to
help bring the project forward.
Concluding remarks
Let me conclude.
The resilience and proper functioning of market infrastructures is of paramount importance to
ensure well-functioning money markets. Public authorities and central banks have both an
interest and an obligation to ensure that market infrastructures have a high level of security
and operational performance. The market infrastructures in the euro area are performing well
in this respect and, as we have heard, there are a number of initiatives under way to further
enhance this (in particular as regards the collateralisation processes).
I would, however, urge industry representatives to further pursue the triparty interoperability
project, and seek to find ways to address the issues which have recently appeared. In
particular, where these issues are not going to be addressed by T2S, I would encourage the
industry to find a solution now. It is of great importance that collateral can flow freely,
regardless of its location.
I am confident that further improvements will be made.
Thank you.