Guy Quaden: The integration of the euro government bond market -
standstill or restart?
Keynote address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Third
Annual European Government Bond Summit, Brussels, 24 October 2008.
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Ladies and Gentlemen,
It is a great pleasure for me to be the guest speaker at this third annual European
Government Bond Summit. Even in these turbulent times, I hope that you still enjoy your
dinner and will have time to attend the conference tomorrow. Its programme looks very
interesting indeed, and closely reflects the current difficulties in the financial markets.
The primary dealers community is now, maybe more than ever before, of great interest for
central bankers. Indeed, one of your main missions is to make sure there is enough liquidity
in the government bonds secondary market. Proper functioning of this market is crucial to
ensure liquidity for financial institutions, via the collateralised interbank market among others.
And this market has become increasingly important since liquidity in the unsecured interbank
market has been drying up. Owing to the high distrust among market participants, banks are
still facing acute borrowing restrictions. This lack of market liquidity is one of the main
problems with which central bankers are confronted at the moment. The Eurosystem has
adjusted its distribution of liquidity - and will continue to adjust it for as long as necessary -
to ensure that solvent banks have continued access to liquidity and to keep the
very-shortterm rates, in particular the overnight rate, as close as possible to the policy rate. The
Eurosystem has assumed an increasing intermediation role during this period of turbulence.
With its actions and the guarantees offered by individual governments, conditions are in
place for a pickup in confidence and a gradual reduction in tensions on the money market.
Since the beginning of the financial turmoil in the summer of last year, the ECB Governing
Council has made a clear distinction between liquidity management and its monetary policy
stance, which is signalled by the interest rate on the main refinancing operations. The
dramatic worsening of the financial crisis since the collapse of Lehman Brothers radically
modified the outlook for growth and, as a consequence of lower commodity prices and
faltering domestic activity, our assessment of risks to price stability as well. Therefore, the
coordinated interest rate cut of 50 bp on 8 October was appropriate for the euro area. The
Governing Council has thus shown that, without prejudice to its main objective of
guaranteeing price stability in the medium term. it can also use its interest rate policy to help
alleviate financial tensions and sustain confidence and economic activity.
Also from a monetary policy viewpoint, a properly-functioning secondary government bond
market is very important. Allowing for the existence of a "risk-free" yield curve, it plays a
crucial role in the transmission of monetary policy. Indeed, while the Eurosystem has only a
direct influence on very-short-term money market rates, households and firms look mainly at
medium- and longer-term rates when taking consumption and investment decisions.
Consequently, when the Governing Council of the ECB reacts to disturbing shocks in order
to maintain price stability in a medium-term perspective, it is interested in seeing monetary
policy impulses effectively transmitted along the yield curve. Moreover, the Eurosystem's
monetary policy strategy aims at firmly anchoring inflation expectations and minimising the
inflation risk component of long-term interest rates. In this respect, government bond markets
provide useful information on inflation expectations. Through their pricing of long-term
government bonds, primary dealers thus contribute to the efficiency of monetary policy. Of
course, we are well aware that the whole transmission process is now impaired by the
banking crisis and we have to counteract these disturbances.
Last but not least, I am very pleased that the organiser of this summit, the European Primary
Dealers Association, sees promoting integration of the EU government bond markets as its
mission. Your association is therefore an active agent of financial integration. I would like to
devote the rest of my speech to this issue. Firstly, I will remind you that the Eurosystem, too,
has a strong interest in promoting such integration. Secondly, I will give a short overview of
the current state of financial integration in the euro area, focusing on the government bond
market. Thirdly, I will discuss several initiatives recently taken by the Eurosystem to foster
financial integration, with special emphasis on the second generation of the Eurosystem's
collateral management system, the so called CCBM2.
Apart from its particular importance for the conduct of monetary policy, financial integration is
highly relevant to other Eurosystem tasks. It is fundamental to the Eurosystem's job of
promoting the smooth operation of payment systems, which in turn relates to its great
interest in the safe and effective functioning of securities clearing and settlement systems.
Furthermore, by permitting risk-sharing and diversification, by enhancing depth and liquidity
of financial markets, integration also contributes to safeguarding financial stability. We are
nevertheless aware that spill-over effects and contagion increase with financial integration.
So, it will probably be a major challenge in the coming years to accurately gauge this
dimension, as borne out by the growing importance of cross-border financial institutions. In
recent weeks, when the financial turbulence was at its fiercest, it became clear that a revamp
of prudential supervision in Europe will be an essential element of the reforms necessary to
avoid a repetition of such a dramatic turmoil.
Finally, by encouraging more efficient allocation of resources, financial integration acts as a
prerequisite for realising Europe's full economic potential, that is raising the potential for
stronger non-inflationary economic growth, as highlighted in the Lisbon Strategy.
For all these reasons, the Eurosystem has always been a strong supporter of the European
financial integration process and we have monitored developments in the different segments
very closely. The tenth anniversary of the ECB, a few months ago, gave us the opportunity to
take stock of the achievements in European financial integration over the last decade. We
were proud to conclude that significant progress has been made and that the single currency
has acted as a major driving force.
The progress that has been achieved nevertheless differs across market segments. The
money market, in particular the interbank market for unsecured deposits, can be considered
as a single area-wide market - also its current difficulties ignore national borders! But the
segment for short-term debt securities (commercial paper and certificates of deposit) is still
fragmented. I would like to remind you that, in order to try and close this gap, the Eurosystem
is supporting the private STEP initiative which aims to develop a pan-European short-term
paper market.
A considerable degree of integration has also been achieved in corporate bond and equity
markets. By contrast, while the euro-area banking markets for wholesale and
capital-marketrelated activities also show clear signs of integration, retail banking markets have so far
remained fragmented.
Undoubtedly, the euro-area government bond market is the segment - apart from the
unsecured money market - that has reached the highest degree of integration. The removal
of exchange rate risks, the drop in transaction costs and the disappearance of currency
restrictions for investors and intermediaries have pushed up cross-border bond holdings. Let
me mention the case of my own country. At the end of June this year, the proportion of
Belgian linear bonds held by foreigners reached 55 p.c. In the case of Treasury certificates,
foreign holdership came to 73 p.c. at the same moment in time, which reflects the strong
foreign demand generated by the relative scarcity of short-term euro-denominated public
securities which were accorded a good rating by the credit rating agencies.
The primary dealer community, which has become more and more diversified, has been
highly supportive of these developments. Looking for instance at the situation in this country,
only 3 of the 16 primary dealers active on the Belgian government securities market, are
actually Belgian! Financial institutions active in the main financial centres of the world (New
York, London, Paris, Frankfurt) are now contributing to a successful widening of the investor
base for securities issued by the Belgian Treasury.
Besides growing market integration, the long-term tendency towards more sustainable public
finances, across all member states, has also helped achieve close convergence of
government bond yields among EMU countries. For many euro-area nations, government
bond yield spreads vis-à-vis the German Bund declined from the introduction of the euro until
mid-2007, when they were just a few basis points.
While government bond yields are increasingly driven by a common factor, local factors
continue to play a role, however. The financial crisis we are going through has shed some
light on the remaining gaps in the euro-area bond markets. Strong flight-to-quality flows have
been accompanied by a sharp widening of intra-euro-area government bond yield spreads.
In the euro area, the ten-year sovereign spreads vis-à-vis the German benchmark have
reached levels not seen since the start of EMU (this morning: Italy 88 bp, Spain 56 bp,
Belgium 53 bp, France 26 bp). A common shock - namely, the sharp increase in risk
aversion in global markets - thus led to different responses in the government bond market.
The underlying factors behind this increase in bond yield spreads are multiple. The German
Bund certainly benefited from its high liquidity - favoured by a highly-performing futures
market - a strong plus in these turbulent times. Credit risks were also a factor - although not
the main one - behind the increase in bond yield spreads, as corresponding credit default
swap spreads also widened. Here in Belgium, the long drawn out discussions about the
country's institutional future have long hampered the formation of a stable government. All
this uncertainty has taken its toll on the financial markets; the credit default swap rate for
Belgium increased somewhat, compared with Germany's rate. These increases have been
quite modest, though, which seems to indicate that the markets believe - as I do - that these
difficulties could be solved without far-reaching financial consequences. More recently, the
problems confronting some of our main financial institutions have also had some influence.
The Belgian government - like several other European governments - had to recapitalise
those institutions, which pushed up the outstanding public debt, and thus also the credit
default swap rate for Belgium, which is now some 26 basis points higher than for Germany.
Anyway, as I said before, the increase in spreads vis-à-vis the German Bund is a general
phenomenon. One may fear that the recent financial turbulence will lead to a standstill or
even a setback for European government bond market integration. So it might be useful to
consider some initiatives to relaunch this integration process. Here, we can refer to several
reports written by the Giovannini Group.
In a report presented in 2000, this Group addressed the issue of "Co-ordinated public debt
issuance in the euro area", arguing that the decentralised approach to public debt issuance
was an obstacle to full market integration. Different options for greater co-ordination were
discussed, including the creation of a single euro-area debt instrument backed by joint
guarantees, an option that could be beneficial for smaller member states, currently paying
liquidity premiums. Unfortunately, the Group did not start any concrete specification of such
options. I nevertheless notice that tomorrow you will be bringing up the subject of common
issuance again. Maybe your summit will give new impetus to this idea.
In two later reports (2001 and 2003), the Giovannini Group focused on clearing and
settlement infrastructures in the EU. It described clearing and settlement as an essential
feature of a smoothly functioning securities market, providing for the efficient and safe
transfer of ownership from the seller to the buyer. It identified a number of barriers to efficient
cross-border clearing and settlement.
Since the start of EMU, the ECB has taken a good many initiatives to provide payment and
settlement facilities that foster market infrastructure integration and ensure the highest
standards of efficiency and safety.
First of all, I would like to mention TARGET, the real-time gross settlement system for the
euro, which, since its launch in January 1999, has contributed to the integration of euro-area
financial markets, by providing its users with an area-wide payment infrastructure. In
response to the growing demand from financial institutions for more advanced and
harmonised payment and settlement services across Europe, the Eurosystem decided to
migrate from TARGET as a system of systems, to a single shared platform, TARGET2,
where the rules of the different legal systems are harmonised to the greatest possible extent.
Let me now say a few words on the second of these ECB initiatives: the so-called CCBM
(Correspondent Central Banking Model). As you know, all Eurosystem credit operations have
to be adequately collateralised by eligible assets. Moreover, the Eurosystem's operational
framework stipulates that counterparties can only obtain credit from the national central bank
in the country in which they are located, and that any Eurosystem counterparty should be
able to use any eligible asset as collateral. Thus, a specific mechanism had to be established
to enable the cross-border use of collateral, regardless of the location of the asset or the
counterparty.
Against this background, the Eurosystem introduced the CCBM in 1999 in parallel with
TARGET. Through the CCBM, counterparties obtain credit from their "home central bank"
based on collateral provided to another Eurosystem central bank and this "correspondent
central bank" holds the collateral on behalf of the home central bank. In the current
framework for the delivery of collateral, the CCBM provides for a common cross-border
procedure, while national collateral delivery procedures are still not harmonised.
The CCBM has proved to be a success, as the cross-border use of collateral has increased
significantly. However, market participants have found some drawbacks in this system which
mainly relate to the lack of standardisation of existing procedures, both domestically and at
cross-border level. Against this background, the Governing Council decided in March 2007 to
review the current Eurosystem collateral handling procedures. In July 2008, it has decided to
launch a single technical platform - called CCBM2 - and assigned the development and
operation of CCBM2 to the National Bank of Belgium and De Nederlandsche Bank.
CCBM2 will first and foremost provide a harmonised level of service, thus facilitating
interaction between the Eurosystem central banks and their counterparties. While the CCBM
was built for the cross-border use of collateral only, CCBM2 will provide a single set of
uniform procedures both on a domestic and a cross-border basis.
CCBM2 will handle all eligible collateral, marketable as well non marketable. It will
consequently allow to manage securities but also incorporate functions for the use of credit
claims as collateral. Furthermore, CCBM2 will support the two currently used collateralisation
techniques (pledge/pooling and repo/earmarking) and will be able to accept collateral
through all eligible Securities Settlement Systems.
While CCBM2 is first and foremost a collateral management facility for the Eurosystem (a
"Eurosystem back office"), it will at the same time bring new opportunities for Eurosystem
counterparties to reduce back-office complexity and cost and optimise their collateral and
liquidity management with the Eurosystem. By harmonising procedures related to the
Eurosystem credit and collateral management, it will also create a level playing field. In order
to ensure that CCBM2 is fully in line with counterparties' needs, the Eurosystem is
developing this new facility in close cooperation with market participants themselves.
If we look to the future, CCBM2 will also be implemented in a way that changes in the
collateral framework, such as the acceptance of new asset types or the introduction of risk
control measures, can easily be taken up. As you know, the acceptance of a wide range of
assets eligible as collateral is a structural feature of the Eurosystem's operational framework.
Nevertheless, last week, the ECB Governing Council decided to extend it further until the end
of 2009, to make sure that solvent banks can get the liquidity they need. This temporary
measure is liable to increase the risks taken by the Eurosystem in its refinancing operations.
Adequate risk control measures will be applied in order to limit those risks.
Finally, as a third initiative aimed at better market infrastructure integration, the Governing
Council decided, back in July, to launch the TARGET2 Securities (T2S) project. T2S will be a
technical platform for central securities depositories for the settlement of euro securities in
central bank money, thereby bringing together securities and cash settlements within Europe
on one efficient single platform. On a more technical level, T2S will remove the differences
between conducting domestic and cross-border settlements within Europe and will act as a
catalyst for the integration of the European post-trading financial sector. It will also foster
competition and harmonisation in post-trading by providing equal and less costly access to a
common settlement service. Through the single platform, economies of scale can be fully
exploited, while at the same time the safe and smooth settlement of securities transactions in
central bank money is ensured.
Subject to certain conditions, almost all euro-area central securities depositories, accounting
for a very large share of settlement activity in the euro zone, have reacted very positively to
the initiative. For the further development of T2S, the Eurosystem will continue to cooperate
closely and transparently with these depositories, their users and other relevant
stakeholders.
Once implemented, the three so called "second-generation" services, TARGET2, CCBM2
and T2S, will represent a quantum leap forward in the integration and quality of the euro
area's core infrastructure. These initiatives enhance the harmonisation efforts through the
removal of Giovannini barriers, thus reinforcing the Lisbon Strategy.
I am sure that market participants - and especially the primary dealers - will recognise the
opportunities these Eurosystem initiatives present so that we can work together for truly
integrated euro financial markets, capable of withstanding turbulence in future.
Ladies and Gentlemen, thank you for your attention and I wish you a pleasant and very
interesting meeting tomorrow.