To some extent, central banks have partly narrowed this gap between demand and supply by providing financial intermediaries with the safest and most liquid assets of all: their own liabilities, in the form of deposits and reserves held by banks. The importance and usefulness of this function is illustrated by the significant amounts still outstanding in the Eurosystem deposit facility or in the form of non-compulsory reserves. It is, indeed, in the essence of central banks’ historical function to step in when dislocations in financial markets appear and to contain long-lasting damage to the economy. If they fail to act, then self-fulfilling expectations could lead to panic and financial dislocation. A good example is the situation in the euro area in the second quarter of this year. Week after week, there were growing signs of a perceived “convertibility risk” between different parts of the euro area. However unfounded, these self-fulfilling fears destabilised capital flows and led to the rapid and increasing segmentation of financial and credit markets. Financial conditions were increasingly divergent across the euro area, irrespective of the quality of borrowers and the level of policy rates. If left unchecked, this process would have rendered monetary policy totally powerless to combat both inflation and deflation, if either of these risks had materialised. This was, for the Eurosystem, an unacceptable situation. It led the Governing Council to announce in September the introduction of the Outright Monetary Transaction (OMT) programme, whereby the Eurosystem may purchase government debt with a maturity of up to three years.

Necessary conditions for bond markets To develop a domestic bond market, we need three essential components:  1  BIS Review 30/2000  First, there must be a deep and liquid government bond market to serve as a benchmark against which corporate papers can be priced. To ensure that the government bond market can continue to provide the benchmark yield curve, the supply of government bonds must be regular, predictable and transparent. In short, the framework of the budgetary process as well as debt management operation must support the continuing supply of bonds through operations such as automatic refinancing or refunding of maturing debt. Tools such as re-opening of benchmark issues, government bond buy-back schemes or repurchase operations are also essential for the efficient functioning of debt management operation. Second, there must be adequate infrastructure, both legal and operational, to support the trade and transfer of instruments and funds. Operational infrastructure includes such things as a delivery versus payment system that is safe, rapid and efficient to ensure finality of fund transfers. An efficient bond registration system is also essential to provide legal protection of ownership of bonds. Rules and regulations to support trading and financing operation such as repurchase agreements, securities lending, short positioning as well as hedging practices are all essential elements. Third, there must be a pool of market participants comprising both intermediaries such as dealers or inter-dealer brokers as well as end-users such as mutual funds, provident and pension funds, insurance.