Integration of the euro area financial markets
Speech delivered by Dr. Sirkka Hämäläinen, Member of the Executive Board of the European Central Bank, ACI, Dublin, 15 October 2001.
Ladies and Gentlemen,
I should like to start by extending my warmest thanks to the organisers for inviting me to speak here today. I very much appreciate this opportunity to meet the important players in the financial markets and to discuss with them the changing financial market environment after nearly three years of the single currency.
Overall globalisation and European integration have proceeded very much as parallel phenomena. Technological innovation and development, deregulation and the liberalisation of markets for goods and services, as well as the liberalisation of capital movements and financial markets, have linked not only the European economies, but – indeed – all of the world's economies more closely together.
Consequent efficiency gains and increased price transparency at all levels have led to an intensification of competition, enhancing the allocation of resources and, to some extent, reducing inflationary pressures. It is interesting to note that competition has not stiffened merely among corporations, but also among governments.
One of the most important elements in European integration is the widening and deepening of the euro area financial markets. Corporations, financial market players and the European Central Bank (ECB) have a common interest here, even if the motives and expected benefits differ. For the corporate sector, financial market integration means improving financing conditions with a new variety of options. For the banking system, it means possibilities for each member of the industry to operate on the same terms throughout the euro area, using all instruments without barriers. For the ECB, financial market integration is important as it enhances the efficient implementation of monetary policy and the effective and consistent transmission of its impulses throughout the euro area.
The strategic goal of the European Union, decided by the EU Council in Lisbon last year and reaffirmed in Stockholm this year, was "to become the most competitive and dynamic knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion". This is an ambitious goal that cannot be achieved unless the European Union in general, and the euro area in particular, develops financial markets that are able to channel efficiently the funds required to finance research and development, innovation, and generally to support an entrepreneurial environment. In short, we need to aim at reaping the full benefits of the single currency.
Where are we now, then, as regards the integration phase of the euro area financial markets?
I must confess that, in the first 18 months since the introduction of the euro, it was very easy to talk about this subject. It was easy to present all the areas in which progress had been made. We were in fact positively surprised by the rapid integration. Perhaps we became too optimistic about the future, but today it is more difficult to find new developments to draw attention as most of the progress was made during the first year of the euro. Compared with the extremely rapid developments we witnessed in 1999, the process towards integration seems to have slowed down considerably.
In the foreign exchange market, integration was of course achieved immediately as the national euro area currencies instantly became one currency. This is reflected in the Triennial Central Bank Survey conducted by 48 central banks and monetary authorities in April 2001 and co-ordinated by the Bank for International Settlements (BIS). It was the first comprehensive assessment of activity on the foreign exchange and derivatives markets since the introduction of the euro in 1999.
The preliminary data, which were published by the BIS on 9 October, confirmed that the euro was the second most widely traded currency in April 2001, behind the US dollar and ahead of the Japanese yen, entering on one side of somewhat less than 40% of "net-net" foreign exchange transactions, i.e. transactions adjusted for both local and cross-border double-counting. This represents a decrease of 15 percentage points compared with the aggregate share of its legacy currencies in April 1998, which stood above 50%. This decrease is mainly attributable to the elimination of intra-euro area foreign exchange trading; in 1998, intra-euro area transactions accounted for approximately 10% of net global foreign exchange market turnover.
This elimination of the intra-euro area transactions was also one of the important factors behind the sizeable decline in global foreign exchange activity. Average daily turnover in traditional foreign exchange markets was estimated to have fallen by nearly 20% from some USD 1,500 billion in April 1998 to approximately USD 1,200 billion in April 2001. The growing use of electronic brokering and the consolidation of the banking industry were additional factors contributing to the significant decrease. Despite the overall decline in turnover, several dealers indicated that bid-offer spreads and liquidity remained similar to the levels recorded at the time of the previous study.
In line with traditional foreign exchange market activity, over-the-counter (OTC) foreign exchange derivatives activity declined by more than 30%. However, overall OTC derivatives turnover, which includes foreign exchange contracts, such as currency swaps and options, and interest rate instruments, increased significantly in 2001 compared with 1998. The sum of the average daily turnover of euro-related OTC foreign exchange derivatives and OTC interest rate derivatives amounted to USD 260 billion, which is a little less than 50% of total reported OTC derivatives turnover. Interest rate derivatives accounted for the lion's share and the volume of these has now strongly increased compared with previous surveys.
This leads me to the developments in the money market. The considerable growth of interest rate instruments resulted from a strong increase in swaps and forward rate agreements (FRAs). Transactions in euro have been fostered by the creation of a large, liquid and integrated money market in the euro area. For example, swap and FRA transactions increased by 104% and 85%, respectively, between April 1998 and April 2001.
The unsecured and swap segments have for some time now been showing a high degree of integration and the BIS survey confirms that the growth in the swap market has been particularly significant. The EONIA reference interest rate has established itself as one of the most important, or even the most important, reference rate. The EONIA swap market is now considered the largest overnight swap market in the world. The market for short-term securities and the repo market, by contrast, still remain poorly integrated: even if both markets have taken some steps towards integration, clear fragmentation among the euro area countries remains.
The question is whether the lack of full integration in these two segments emanates exclusively from regulatory difficulties or if there is also a lack of co-ordination on the part of the private sector. From our regular contacts with market participants, from the surveys that take place in the context of our money market reports and from our meetings with financial market associations, such as the ACI, we understand that the most serious obstacle to integration is the fragmentation in the infrastructure. In addition to the lack of harmonisation in the trading environment and settlement systems, the differences in the legal systems are explicitly mentioned by market participants. In the legal field, bankruptcy legislation as well as laws concerning guarantees, collateral and the transfer of collateral are the main impediments to successful integration.
In the bond market, in the same way as in the money market, the euro played a crucial role in fostering the deeper and more liquid euro area bond market that we see today. We have already seen that international investors have taken advantage of this development in their search for investment opportunities and we have also seen significant issuance activity in the euro area bond market. Still, the integration of the bond market, too, has slowed down and is far from complete. We still have a clear national segmentation with liquidity differences. The impediments here are exactly the same as in the money market: the regulatory and legal framework, infrastructure differences and different market practices.
Further integration of the euro area financial markets is needed
It is clear that we need, in particular, to intensify our efforts to support internal financial market integration in the euro area. Very many initiatives and activities are involved in the process, but this process seems to be taking too long. We should clearly be able to speed it up. Resolving the legislative issues, the statutory regulation problems, which are the responsibility of governments and parliaments, is of course much more difficult at a European level, with many national interests, than at the national level. The governments of the EU Member States should, however, see the urgency of the harmonisation and the benefits for growth and well-being which can be achieved by the integration.
The ECB, as a market participant itself, shares the concern of the market in this area. As an institution with a euro-wide perspective, we are willing to support the efforts to move obstacles in this field, even if they are areas where we have no direct responsibility.
Not only the legislative efforts are important and urgent; the same holds true of the efforts in the "self-regulatory" area and in the co-ordination of market participants themselves. For example, securities settlement systems are in many cases run and used by private entities, the same as those that participate in the market. A solution in this area has to be found through a better co-ordination of market participants themselves.
An interesting example of co-operation between the ECB and market participants is the calculation of the EONIA reference rate, where market participants deemed it necessary for the calculation to be made by a third party who could receive the data on a confidential basis.
A further example is the consolidation in central counterparty clearing, where economies of scale and network externalities seem to favour a high degree of concentration. A group of major global investment banks has therefore expressed support for the idea that Europe should have only one central counterparty clearing house, which would provide a multi-currency and multi-product service. However, there is no single view, particularly within the euro area, about the infrastructure that should prevail.
The Eurosystem is carefully monitoring and analysing developments in this field. Indeed, central counterparty clearing could have implications for the smooth execution of monetary policy operations, the smooth operation of payment and settlement systems and the stability of the financial markets in general. The consolidation process adds to the complexity of the issue: on the one hand, consolidation in central counterparty clearing could help to increase efficiency in the clearing and settlement of securities; on the other hand, the potential systemic consequences of a central counterparty's failure increase with its size.
In this regard, the ECB has concluded that, owing to the potential systemic importance of securities clearing and settlement systems, the Eurosystem has an interest in central counterparty clearing and considers it essential to establish, in co-operation with the other relevant authorities, effective risk management standards.
The natural geographical scope for any "domestic" market infrastructure (including central counterparty clearing) for securities and derivatives denominated in euro is the euro area. Given the potential systemic importance of securities clearing and settlement systems, this infrastructure should be located within the euro area.
Whatever the final architecture, it is essential that access to facilities for trading, clearing and settlement should not be unfairly impeded. This policy of open and fair access should ensure the safety, legal soundness and efficiency of securities clearing and settlement systems, guarantee a level playing field, and avoid an excessive fragmentation of market liquidity.
The field of central counterparty clearing is just one case in point where we, the ECB and the national central banks, are willing to do everything in our power to support the integration process. We need a euro area financial system that offers opportunities for all participants to have access to capital on terms that will lead to the most efficient allocation of resources, hence potentially to higher sustainable growth rates. We need to see that there is an ability among market participants to co-ordinate themselves and work together in order to promote this process further. Indeed, this integration cannot be the responsibility of the public authorities alone.
Our role in the Eurosystem is to create an environment that is favourable for investment and economic activity. Mainly, we contribute to this environment by maintaining price stability over the medium term. You as market participants can achieve the necessary integration by taking advantage of the opportunities that the large financial market place of the euro area provides.