The Euro causes the elevation of the fixed income market to a pan-European level and playing field in many (but not all) respects. While the European Commission’s Second Banking Directive and Investment Services Directive should have already created a single European market in financial services by the late 1990s, in practice obstacles remained. One such obstacle are the so-called currency matching rules, or national regulations bearing on the portfolios of pension funds and insurance companies to restrict holdings of assets denominated in foreign currency (and other assets that were deemed risky). Table 3.2 lists the currency matching rules for the assets under managements of pension funds and life insurance companies that prevail in the late 1990s in the eleven first EMU-entrant countries. Together with restrictions on the size of equity and property holdings and the prudent man rule oftentimes originating from the same regulations, the currency matching rules made these funds, whose asset base is very substantial in many countries in Europe, strong natural buyers of domestic government debt. Much is made of the impact of
Table 3.2
Currency-matching rule for European pension funds and insurance companies8
Pension Funds Life Insurance
Austria 50% 80%
Belgium No 80%
Finland 80% 80%
France No No
Germany 80% 80%
Ireland n.a. n.a.
Italy 33.3% 80%
Luxembourg n.a. n.a.
Netherlands No 80%
Portugal No 80%
Spain No 80%
Source: Danthine et al (2000, Table 3.2) who cite the European Commission (1997), IMF (1997) and the OECD (1998) as sources
7 Apart from the ECB, who through various reports (2004, 2007, 2010) has continued to describe the changes in the Euro bond markets, studies such as Cappiello et al. (2006) and De Santis and Gerard (2006) set up a more analytical framework. 8
The figures provided in Table 3.2 are broadly over various asset classes. Adjaoute et al. (2000, Table 2.4) also outline the national restrictions of portfolio investments of life insurance companies and pension funds but for fewer Euro zone countries (Germany, Spain, France, Italy, and the Netherlands only) from which it is evident that many countries have a limit on the allowable percentage of foreign assets held but that this limit may differ per type of asset.
EMU on the currency matching rule, as the adoption of the single currency means that under the same rules the government debt and other securities from the Euro zone immediately come within the scope of these funds. There is evidence that portfolios holdings of domestic government bonds of these institutional investors shifts away from their home currency to a diversified cross-holding of government debt within the monetary union, as indeed is the case for other investors operating under fewer restrictions.9 The flip-side of the same coin also causes national debt management agencies to rethink the market position of their government debt and loss of privileges that come with being the main supplier of risk-free debt in their home currency. National treasuries become more keenly aware that in a post-EMU environment they need to compete more for the same “domestic” investor base. They start to better coordinate issuing calendars to avoid being in the market at the same time, but at the same time revise issuing strategies to make their debt more attractive. The latter involves in the majority of Euro area countries the offering of better liquidity through larger size issues and designated primary dealers, lengthening of the maturity profile and in some cases the offering of special products such as inflation-linked bonds.10 With that, sovereign issuers play to the demand of institutional investors whose funds under management face upward pressure from an ageing population and desire to match long-term liabilities with assets, in part indexed to inflation. The ECB calculates that the outstanding Euro-denominated public debt securities as a percentage of all public debt securities actually also increases slightly from 2000 to 2002 for all Euro countries apart from Finland, from 74.5% to 77.7% for the Euro area as a whole (ECB 2007, Table 5).
The Euro-denominated bond market, led by the government bond sector, gains instant
momentum. The quick redenomination of existing government bonds into the new single currency creates a critical mass of Euro securities. This is added to by a larger size and stock of domestic bonds from participating sovereigns. These are issued in a more harmonized fashion. Central trading platforms such as MTS, the activity of primary dealers and a more seamless link with the derivatives markets all result in more liquid trading conditions than before. There is anecdotal report that the Euro bond markets gained as much in liquidity as it did in its overall size in the early years under EMU. In the words of the ECB who publishes a first comprehensive study on the Euro Bond Market in December 2004, the Euro-denominated bond market “has since [its inception] become much larger and more liquid than the national markets of the
9
Galati & Tsatsaronis (2001, pp 20-21) state that in the absence of a complete matrix of flow-of-funds statistics on international portfolio shifts any evidence can only be partial, but are nevertheless able to detail that German institutional investors and Italian mutual funds appeared to have increased their purchases of Euro-denominated foreign securities between 1995 and 2000. For German investors, Euro-denominated assets account for more than 70% of the € 175 billion of total gross outward portfolio investment for the two year period 1998-99 and 60% for 2000. For Italian mutual funds, the share of Euro area bonds in the overall bond portfolio increases from 8% in 1995 to 23% at the end of 2000.
10 The ECB states that in the segment of debt securities with a maturity of over ten years, public sector issuers account for more than 50% of these instruments in the years 2003-2006. Some countries like France are already issuing domestic inflation-linked bonds prior to EMU, but bonds linked to Euro zone inflation become more popular instruments thereafter, in particular in France and Italy and occasionally even in Germany and Austria (ECB 2007, p 14).
participating member states were in the pre-EMU era” (ECB 2004, p 8). Due to the more esoteric nature of the bond markets, where securities rarely trade via a stock exchange, there is unfortunately no single set of statistics that capture this better liquidity. The limited data that is available for European bonds is patchy and mostly in terms of turnover and trading volumes and bid-ask spreads. Galati and Tsatsaronis (2001) cite turnover data from Euroclear for selected European government bonds. This data shows that the average daily turnover of the most actively traded bonds from the French, German and Dutch governments noticeably increases between 1998 and 2000. The establishment of MTS as the B2B trading platform for Euro government bonds forces larger size and hence more liquid issues. Also the volume on most of its platforms increases, at least in the first half-decade of EMU. This can be seen from Table 3.3, where annual trading volumes on the domestic MTS markets and EuroMTS are compared for 2001 and 2005. The MTS markets in Belgium, France and Germany have all grown. MTS Italy and EuroMTS appear to have gone somewhat in reverse, but both are due to lower volumes in Italian long-dated government bonds (BTPs) which distorts the picture somewhat. MTS Germany is small by comparison to MTS Italy and that is because the preferred inter-dealer platform is Eurex Bonds. On this platform, which trades mostly German
government securities but also German covered bonds and other European government and agency bonds, the average daily volume is on an upward trend between 2001 and 2007. This is shown in Figure 3.1. The existence of successful futures and options contracts, again on Eurex, has provided investors a low cost margin based trading mechanism for German government bonds. Trading volumes thereof provide another piece of evidence on enhanced market liquidity. Figure 3.2 shows that the annual volume traded in the Euro Bund 10-year future contract rose strongly between 1998 and 2007, as did the average annual openinterest on Eurex-traded futures and options on Euro-denominated debt securities (reported in Table 3.4). This highlights another special feature of the European bond markets, which is that the liquidity
Figure 3.1
Daily average volume, single-counted, traded through EUREX Bonds (€ mn)
Table 3.3
Annual(ized) trading volume, single-counted, on MTS markets and EuroMTS
(in € mn) Jan’01 – May’02 2005 MTS Belgium MTS France MTS Germany MTS Italy EuroMTS MTS Spain MTS Portugal MTS Netherlands 174,458 166,278 50,744 2,411,100 654,866 n/a n/a n/a 178,213 212,811 143,271 1,595,838 302,940 101,415 146,690 79,673
Source: Eurex Bonds (figures read from a chart and reproduced) Source: Cheung et al (2005, Table 3) for 2001-2002 figures, ECB (2007, Table 14) for 2005 figures
0 100 200 300 400 500 600 700 800 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 3.2
Annual volume in traded contracts in EUREX-traded Euro-Bund Future (€ mn)
Table 3.4
Average annual open interest on EUREX-traded derivatives on Euro debt securities
Futures Options (in € bn) 2002 2003 2004 2005 2006 194 221 297 369 450 146 210 203 235 278
Source: Eurex Source: ECB 2007, Table 11 (Eurex)
of Euro government bonds is not just in the real securities markets but also in its related derivatives markets, and increasingly so according to the data shown here. Lastly, a further study on the Euro bonds and derivatives markets by the ECB in 2007 claims on the basis of declining bid-ask spreads that liquidity conditions have improved significantly. This study calculates that the bid-ask spread of Euro government bonds declines from around 0.08% in 2003 to 0.05% in 2006 and quoted spreads of corporate eurobonds from 0.38% to 0.24% over the same period (ECB, 2007). Each piece of data needs to be treated with caution when looked at in isolation.11 Taken together though, they are consistent with a broader, deeper and more liquid bond market under the Euro, certainly compared to the situation in Europe before the single
currency. The growing liquidity in the Euro bond market invites others to join in with their issuance. The securities data in the next section will show that the market grows quickly as a result.
Though the majority of Euro government bond supply is placed through auctions, occasionally syndications of banks are deployed by sovereigns for two reasons. First, to keep banks incentivized to act as good primary dealers and secondly to reach a broader investor distribution. Hence investment banks that are not from the home turf are deliberately included in the syndicate to reach investors in the far corners of the Euro zone. This marks a sharp diversion from practice under the old legacy currency markets. The same trend occurs among non-sovereign issuers who rely exclusively on syndications of underwriters for the placement of their international bonds with investors. Overall, while in the years between 1996 and 1998 40% of the volume of bond underwritings issued by borrowers of a specified nationality in the Euro area and denominated in Euro (legacy) currency are won by bookrunners of the same nationality, that percentage drops to 18% in 1999-2000 (Galati & Tsatsaronis, 2001, Table 3).
11 The clearing of bond transactions is highly dispersed in Europe and while there has been consolidation of clearing activity, an increased turnover on Euroclear may also partially reflect an increase in its market share. MTS is an inter-dealer trading platform and growing volumes can also be due to reduced voice-broker activity. Eurex Bonds has added securities to its trading platform over the years and increased volumes are likely to partially reflect this.
- 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 40,000,000 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Table 3.5
Bookrunners of Euro Liquid Bonds: 2007 versus 1999
Q1-4 1999 Q1-4 2007
Rank Deal Value (€ mn) No. % Share Rank Deal Value (€ mn) No. % Share
1. Deutsche Bank 47,642 245 10.7 1. Deutsche Bank 65,259 196 9.2
2. Dresdner Kleinwort 30,991 177 7.0 2. Barclays Capital 46,598 151 6.6
3. BNP Paribas 28,455 104 6.4 3. Societe Generale 39,482 100 5.6
4. ABN AMRO 28,014 146 6.3 4. Citi Group 38,901 108 5.5
5. Intesa Sanpaola 27,079 185 6.1 5. JPMorgan 35,949 104 5.1
6. Unicredit Group 20,618 168 4.6 6. BNP Paribas 35,301 105 5.0
7. Commerzbank 19,867 136 4.5 7. ABN AMRO 30,855 92 4.6
8. JPMorgan 17,487 76 3.9 8. HSBC 32,537 99 4.4
9. Morgan Stanley 17,184 77 3.9 9. UBS 28,867 85 4.1
10. UBS 17,021 65 3.8 10. Merrill Lynch 26,881 69 3.8
Source: Dealogic
Attracted by the much larger and more liquid market and lower barriers to entry, it soon becomes economically attractive for non-European banks, particularly US banks with a substantial investment banking division, to build up capacity and presence in EMU’s fixed income markets. Table 3.5 shows that whereas in 1999 the first seven places in the bookrunner league table for liquid Euro bond issues are occupied by large European banks, in 2007 two American banks break through to the top five of the same ranking.
Thus the advent of the Euro raises the level of fixed income markets that are segregated along national currency lines to a Euro-wide level. For investment funds portfolio constraints are relaxed and the investment opportunity is broadened. Likewise for borrowers, who had both previously been more confined to their national markets, the investor base is widened. This creates a pan-Euro level playing field for all and the investment banks who serve them.