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1.3.2.1.1. What is the importance of financial markets for the European economy?

In modern economies, monetary and financial considerations play a key role for the operation of the productive sector, commercial transactions, public sector activity, and asset management as well as in international relations. The European Union is no exception. By creating the single currency, it aimed at eliminating exchange rate fluctuations whose volatility interfered with intra zone transactions and at the same time to promote the integration of the financial sector. It represented the implementation of the undertakings contained in the European Single Act to create a Europe wide market and to ensure a strong foundation for the euro based on an efficient internal market.

1.3.2.1.2. What is the financial market?

The mobilisation of savings in order to finance the economy is carried out essentially through two channels:

• Intermediated Financings: it consists mainly of bank loans in which the bank acts as principal, i.e. the contractual counterpart of the borrower and the depositor.

• Disinter mediated Financings: it consists mainly of the issuing activity carried out in capital markets bringing together issuers and investors.

The financial market (or capital market) consists of the various structures that intervene in the execution of disinter mediated transactions. Issuers and investors act for their own account with the technical support of intermediaries acting as agent. The financial market attracts a considerable share of private savings. It is the physical or virtual place where supply and demand of capital meet and where deals are transacted which create financial flows.

Driven by computerisation and an ever growing reliance on the Internet, the financial sector is one of the key beneficiaries of innovation. It has led to an ever increasing offer of financial products – together with their derivatives – aimed at satisfying the needs of participants and facilitating risk management, inherent in all investments.

The operation of the market relies on infrastructures dedicated to trading (stock exchanges, trading platforms), clearing and settlement of orders, delivery and safekeeping of securities often dematerialised, as well as the routing of funds (payment systems).

Financial markets are subject to Laws, Directives and Regulations aimed both at the financial products and the behaviour of participants. They are formulated at European and National level as well as by professional associations.

They are also subject to discussion at international level to ensure harmonisation and fluidity of transactions in an expanding global market. In the conception, implementation and enforcement of these rules, national Regulators play a prominent role, and, with regard to the euro market specifically, national Regulators have created standing consultation bodies.

1.3.2.1.3. What are the key elements of financial markets?

Participants can be classified in three categories:

• Counterparts acting as principal for their own account include individuals, institutional investors and issuers

• Intermediaries acting as agent between principals. In some instances they can act also as principal when executing a client order and then belong to the first category.

• Regulators who draft the rules and Supervisors that ensure their enforcement.

Actors can either meet physically or virtually (pc banking – on line markets – electronic dealing platforms)

The financial markets can also be subdivided according to the type of services offered by the intermediaries:

• Wealth management: asset management, insurance

• Execution or intermediation services: issuance, brokerage, transaction structuring

As previously mentioned one should also consider the basic financial institutions: banks and insurance companies. The provision of risk coverage by the latter constitute an “intermediated”* service distinct from capital market services. However, as institutional investors, managing a substantial amount of private savings in the form of life insurance contracts, they play a significant role as actors in financial markets.

1.3.2.1.4. How does one measure capital market efficiency?

Efficiency of financial markets is measured by their capacity to deliver services at the lowest cost for the user while providing maximum security and liquidity. It shall therefore be subject to factors such as:

• The size of the market (in value) for each service provided (liquidity factor)

• The number of participants (competition factor)

• The quality of the infrastructure which is a function of the capital invested by intermediaries to facilitate execution of transactions.

• The harmonisation of market conventions

• The integration and weight of regulation.

1.3.2.1.5. What is the importance of financial market efficiency with regard to economic performance?

Financial market efficiency is measured as a function of financial transaction costs in general and of the cost of funding companies in particular. It is therefore a significant factor of competitiveness.

The introduction of the euro has contributed to the reduction of costs within the European Monetary Union (EMU) by eliminating both foreign exchange costs and risks. Furthermore integration of payment systems is leading progressively to the lowering of costs associated with cross border transactions. More generally, within the European Union, the integration of financial markets has increased their size as well as the number of participants leading to a commensurate improvement in liquidity and to a shrinking of dealing margins. On the regulatory front, the “Financial Services Action Plan” implemented by the Commission has led to significant progress towards harmonisation and integration.

However, the efficiency of European financial markets still suffers from the burden of fragmentation due to differing legal and fiscal regimes from one country to the next. This situation explains that transaction costs in Europe remain higher than in the United States.

1.3.2.1.6. What have been the main steps towards the integration of European monetary and financial markets before the euro?

One should first recall that under the financial system prevailing prior to 1914, financial markets, though of a considerably more modest scale, were, in fact, significantly more integrated because currencies circulated freely being differentiated solely by their metal content (gold or silver). The breakdown of the gold standard, which did not survive the great depression of the 1930’s, led to the fragmentation of financial markets which came to coincide with State borders. In addition to exchange rate fluctuations between currencies, regulation and in particular exchange controls inhibited the free movement of capital after the end of the Second World War.

It is only progressively that these controls were lifted starting in the 50’s and that market forces once again created links between financial centres. They remained however strongly oriented towards the home market despite a continuous strengthening of the cooperation between political and monetary authorities within the International Monetary Fund (IMF)* and the Bank for International Settlements (BIS)* as well as between finance Ministers with the object of managing monetary and financial chocks generated by the progressive liberalisation of capital flows.

This cooperation deepened in parallel between European countries. Its relevance concerning economic policies was already mentioned as a subject of common concern in the Treaty of Rome of 1957. As of 1958 already, the European Monetary Agreement (see: The forerunners of the euro chapter 1.2.1.) opened the door to the possibility of framing intra European exchange rate fluctuations within preset limits. In 1964 a Committee of Central Bank Governors of the EEC was established. After the suspension of the convertibility into gold of the dollar which had since 1944 served as world reference to set official exchange rates and the further shelving in 1973 of the fixed (but adjustable) exchange rate system, European Governments adopted in 1979 the European Monetary System (see: chapter 1.2.2), which limited exchange rate fluctuations between EEC Member States within preset margins. Though the system proved difficult to manage, it served as an irreplaceable trial run prior to the launch of the single currency by demonstrating the need to anchor the currency on the convergence of the macroeconomic performance of each of the participating States.

1.3.2.1.7. What is the “Eurodollar” market?

The Eurodollar market was born in the 1960’s. Its purpose was to recycle dollar holdings accumulated by non American residents outside of the jurisdiction of the American financial regulatory framework. It was mainly dedicated to the financing of debt instruments (bonds or bank loans) denominated in US dollars. A new stage in its development was reached by extending the use of this “supranational” market to other currencies, primarily the German Mark but also the ECU. The progressive opening of the domestic US market to foreign borrowers – followed by other domestic markets – slowed down recourse to the international “offshore” market. This was appealing to the financial authorities of most countries. Indeed, the offshore market facilitated tax evasion. Starting negotiations in the 1980’s, it was only in 2003, after the launch of the euro, that an agreement between European Member States on the taxation of interest income was reached.

1.3.2.1.8. What is the impact of EMU on these markets?

The events described here above led to the drafting and ratification in 1993 of the Maastricht Treaty, then to the creation of the euro, a currency adopted by ten Member States starting in 1999 and joined by three additional Member States since then. The currency is managed by a Central Bank structured in a federal mould: the European System of Central Banks (ESCB) which consists of a new centralised institution the European Central Bank (ECB) and of the Central Banks of participating Member States which manage the interface between the “Eurosystem” and their respective national banking and financial communities. Member States are subject to a single monetary policy decided independently by the Governing Council of the ECB.

With EMU, a new phase accelerating the harmonisation and integration of financial markets started in participating Member States. Bond markets were the first to integrate after conversion into the euro of securities denominated in national currencies, creating the largest market for European public debt securities. Issues by private entities followed shortly. Cross border payment systems are being adapted progressively mainly due to pressure brought to bear by the Commission. Concerning equities, a vast movement of mergers between stock exchanges was initiated and is still being played out. In this area integration is not limited to the eurozone but includes also the British and American markets demonstrating the true globalisation of world capital markets. In parallel, at Community level, there is also an important legislative and regulatory activity framed within the so called “Lamfallussy” process (see: chapter 1.3.2.3).

1.3.2.1.9. What are the advantages of the euro for companies?

Corporations are in general great beneficiaries of the euro. Recent European history has shown that persistent economic disequilibria lead to periods of over- and under evaluation of national currencies which, if they persist, hinder cross border commerce. In a market where there is free movement of capital and goods, companies located in countries with a “strong” currency can see their competitiveness shrink regularly: capital inflows strengthen their currency on the exchange market to the point where companies can no longer compete with those located in “weak” currency countries. This phenomena is however largely compensated by a lower rate of inflation in “strong” currency countries which rapidly restores the equilibrium in favour of the latter.

The Euro and the financial markets, interview of Chris Huhne, economist.

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On the other hand, “weak” currency countries suffer from high interest rates needed to slow the flight of capital implying higher financing and investment costs.

Though this type of phenomena continues to occur on world markets, as demonstrated by the impact of globalisation, the introduction of the euro has considerably reduced financial the impact on companies of such distortions. Indeed, while foreign exchange transactions linked to cross border trade concerned on average 30% of GNP in EMU Member States prior to the launch of the euro, this has now been reduced to around 10% sheltering 2/3 of cross border trade from exchange rate fluctuations.

Companies benefit also from the greater simplicity in treasury management, from price transparency, from an access to an international capital market, from an improved international payments system and from the prestige of the euro which , in time, should allow to increase substantially the invoicing of international transactions in euro rather than in US dollars, reducing commensurately foreign exchange risks. At the same time, the greater price transparency and the widening of the internal market for goods and services intensifies competition and stimulates productivity gains. These developments are accompanied by greater labour mobility and delocalisation of plants.

Concerning taxation, harmonisation is still at an embryonic stage as setting taxes – corporate taxes on profits, sales taxes (VAT) or taxes on financial instruments (investment income) – remains largely the responsibility of each Member States. The main objective is to avoid unfair competition based on discriminatory taxation. An agreement among Member States was reached leading to the phasing out of “special tax regimes” that were aimed at attracting foreign investment and imposing that, in the future, national and foreign companies are subject to similar taxation. This does not limit the possibility of fiscal competition between Member States (similar to that prevailing in the United States) by allowing freedom to set national tax rates for individuals and corporations, as long as they are uniformly applied with the State.

Within the eurozone, large companies are prime beneficiaries of improved clearing systems which are among the most advanced worldwide. Furthermore, lower financing costs and improved liquidity* allow them to accelerate their consolidation. As of 1999, le value of mergers and acquisitions in the eurozone exploded to € 638 billion compared to merely € 272 billion in 1998. These amounts have long since been exceeded and the trend continues in 2007.

To summarise, it can be said that the euro has led to increased competition but has simultaneously created additional opportunities for dynamic and well prepared companies. An improved grip on monetary factors has reduced the impact of distortions that continue to plague markets outside of Europe.

1.3.2.1.10. What are the advantages of the euro for banks?

The greatest burden of costs linked to the introduction of the euro was shouldered by the banking sector. They were forced to invest heavily in order to be able to handle the new currency on behalf of their clients. During the transition period (1999-2001), they had to provide accounts in both the euro and the old national currencies in order to meet client requirements. This was a major shift, in particular for large countries which had become accustomed to hold accounts exclusively in their home currency for the majority of their customers. Banks in non participating countries were also made to adapt their accounting systems to meet the demand for euro denominated accounts in parallel with local currency accounts. Major procedural changes were required including: the adoption of a uniform international standard for account designation, the harmonisation of transfer documentation, the replacement of obsolete payment methods such as cheques for instance to facilitate international payments.

Banks also lost part of their profits linked to foreign exchange operations between national currencies that participated in the euro as well as to the issuance of securities denominated in those national currencies for which they often had a monopoly. The introduction of the euro leads to a weakening of national protectionist regimes and increases competition while also favouring mergers and cooperation agreements between banks. During the early years, those losses were only partially compensated by the development of the euro and the expansion of the European capital market.

In the long run, deregulation and liberalisation of the banking sector should lead to improved profitability. The elimination of distortions and the greater fluidity in cross border payments should contribute to stimulate economic activity. Already, several European banks have reached a critical size that allows their full participation in the globalisation of the financial sector.

1.3.2.1.11. Who controls the banks inside EMU?

The Maastricht Treaty gives no mandate to the ESCB concerning the control of the banking sector. The Council of the ECB Governors has in this respect only a consultative role. It is for this reason, and also because the Eurosystem should act as lender of last resort in the event of a banking crisis, that the Council is advised by an ad hoc expert group.

In the eurozone, the task of controlling banks is separated from the obligations imbedded in the ESCB and remains within the purview of national sovereignty. Depending of the country, this task can be delegated directly to the national Central Bank (Belgium, Spain, France, Italy, Netherlands etc.) or to the Central Bank in cooperation with an independent government agency (Germany). In the United Kingdom, country remaining outside of the eurozone, these controls are entrusted to a completely independent government agency (the Financial Services Authority (FSA), with no links to the Central Bank.

Also to be noted is the differences between countries where supervision of banks and insurance companies is separated (France) and where they are entrusted to the same body (United Kingdom).

“One of the greatest obstacles to integration is the absence, in many areas of financial services, of a clearly defined regulatory framework that is applied uniformly.” “The major orientations of economic policies for 2001” – European Economy n°72, 2001.

1.3.2.1.12. What impact has the euro had on capital markets?

Even though from technical and especially legal points of view, capital markets remain fragmented both in the EU and the eurozone, the emergence of the single currency, managed by a single Central Bank has been a magnet for international operators. Financial integration was immediately visible by the alignment of short term interest rates applicable to liquidity management and a near perfect convergence of long term interest rates applicable to public debt securities and those issued by major listed borrowers. By eliminating the possibility of intra zone foreign exchange crisis and their repercussions on domestic interest rates, the euro ensured the emergence of historically low interest rates both within the eurozone and in those countries that are intimately linked to it. This outcome was also the result of low worldwide inflation, of the growing share of cheap goods originating from emerging countries but also by the discipline enforced through the Stabilisation and Growth Pact linking the Member States participating in the eurozone. It remains nevertheless a remarkable feat that the eurozone has benefited for the last eight years of unprecedented monetary stability despite the significant fluctuations of the US dollar and the oil price.

Thanks to the euro, Europe has at last its own major capital market. Within one year after its launch, the value of international bonds issued in euro had practically reached the level of those of similar nature issued in US dollars (it is worth recalling that ECU denominated issues ranked third in the world in 1992). Since then the market has continuously expanded: In broad numbers, the gross value of euro denominated bond issues of more than two year maturity which amounted to € 650 billion in 1998 and €800 billion in 1999 reached nearly €1500 billion as of 2004. Gross value of US dollar denominated similar issues were respectively €800 billion, €1000 billion to level off at between €1200 and 1300 billion after the year 2000. The euro has therefore taken the lead in international issuance.

It can also be noted that concurrently with the introduction of the euro, the share of non bank issuers (corporations, local and regional government authorities etc.) having recourse directly the capital market increased significantly demonstrating an enlarged accessibility. Between 199 and 2001, the share of bonds issued by corporations had increased by 50% to reach 1/3^rd of all private issues, equivalent to their share in the US dollar market. Issues by financial institutions stagnated and public sector issuance remained dominant with a 57% share of bond issuance denominated in euro. The share of non European issuers remained low with less than 10%. Average size of issues also expanded regularly (+ 23% over two years).

The number of issuers who subject their securities to a rating, necessary to gain recognition outside national borders, more than doubled between the end of 1999 and the end of 2001. These ratings, as well as, incidentally, the evaluation of listed equities, are more and more frequently based on European wide comparisons rather than on national criteria. One also believes that the significant increase in the size of individual issues demonstrated that it was now possible to satisfy the appetite of the large multinational corporations for sizeable amounts needed for investments or takeovers without recourse to the US market.

Finally, regional governments have also benefited from an easier access to the bond market. The share of local agency issuance within public sector issuance increased from 10 to 13% over two years, significantly through the issuance by the German Länder.

Illustration 1.3.2.a : Type d'émetteurs d'obligations en EUR

As a result of this new capital market, the less developed countries of the zone also found their access improved: they were either able to finance their growth despite a current account deficit without any fear of devaluation (Portugal) or, because of the removal of that threat, more easily retain domestic savings for local investment (Ireland, Spain Greece).

It is true that most of the developments noted here above were also apparent in other international markets and can therefore not be ascribed exclusively to the euro. However, without the euro, these trends would be less significant and Europe would remain far behind the American financial markets.

The dividends derived from this star performance by European bond markets is, on the one hand, a reduction in interest charges and, on the other, a narrowing of the risk premium associated with the quality of issuers accessing the market, both factors leading to a considerable reduction in debt servicing. In some highly indebted countries (Belgium) the reduction in debt servicing costs has contributed to a significant reduction in the debt/GDP ratio. In others (Italy, France) increases in indebtedness have been absorbed without difficulty, despite the limitations set out in the Maastricht Treaty and the Stability and Growth Pact.

1.3.2.1.13. How have Stock Exchanges fared?

With regard to equities, all eurozone stock exchanges converted their quotations into euro on January 1 1999, creating the first “all euro” financial sector.

From “public service” institutions, the European stock exchanges have progressively transformed themselves into privately owned “for profit” service providers. They have not been immune to the consolidation trend that is affecting all sectors of the European economy, in the wake of the worldwide trend towards the globalisation of markets. There is no doubt that the integration of the internal market and especially of the capital markets has underpinned this trend inside the EU. Euronext was created on a “federal” model linking the exchanges of Paris, Brussels, Amsterdam and the LIFFE in London, to become the second largest exchange in Europe (in front of Frankfurt). On the other hand, Euronext and Deutsche Börse failed to merge as the vertical integration of the Frankfurt exchange differs substantially from the Euronext model. The London Stock Exchange is Europe’s largest exchange and remains at the centre of predatory moves by rivals, including American exchanges.

The recent European Directive on financial markets, MiFID (Markets in Financial Instrument Directive), will enter into force in January 2008 and may result in a fall in market share of traditional exchanges by allowing major financial institutions to clear internally client orders or enticing them to cooperate in the creation of electronic dealing platforms. The Directive imposes greater transparency in the execution of customer orders. The aim is also to reduce dealing costs.

The increased competition suffered by stock exchanges can only accelerate their further consolidation. Euronext and the New York Stock Exchange have come together which reinforces the need for the broadening of the transatlantic dialogue in regulatory and supervisory matters.

1.3.2.1.14. What is the current state of the European venture capital market?

Venture capital is aimed at financing small and innovative entrepreneurs, often coupled with the provision technical assistance. The expansion of this sector implies a dedicated infrastructure, a clear definition of rules for the operation of the market and the oversight of their implementation. This market is much more mature in the United States where it benefited from the opening of this market segment to the pension fund and mutual fund markets. Market homogeneity in the US favours also diversification of venture capital funds and greater specialisation. The total amount of venture capital invested in Europe amounted to € 47 billion (2005 data). The flows showed a significant increase starting in 2004, remaining however far lower than in the US (about half). In this segment of the market, expertise is of greater importance than availability of capital. As a result of differing legal environments, the cost of creating a company remains on average ten times more expensive than in the US. With appropriate accompanying measures, the euro should help the European market to follow in the steps of the US thanks to market integration and the ensuing specialisation.

The European Investment Fund (EIF), an affiliate of the EIB, was given the mandate by the Amsterdam Council (1997) to contribute to the expansion of this sector in order to create employment, and by the Lisbon Council (2000) to promote venture capital in the development of the information society and new technologies. Market participants have welcomed these initiatives as it contributes to the diversification of their investments. In parallel, the European Commission has implemented an investment capital action plan (Icap) aimed at facilitating the access to venture capital by small and medium sized enterprises (SME) and developing entrepreneurial spirit in Europe.

For more information on this sector, it is recommended to consult the Webb site of the European Venture Capital Association (EVCA) http://www.evca.com and that of the National Venture Capital Association http://www.nvca.org

Reference is also made to: Profitability of venture capital investment in Europe and in the United States ISSN 1725-3817; European Commission Brussels, 2006 http//ec.europa.eu/entrepreneurship/financing/docs/efs report pdf

1.3.2.1.15. What is the situation of micro-finance?

Micro finance is a closely related area to venture capital. Banks that are undergoing consolidation are aiming at improving profitability and are becoming less accessible to SMEs and micro-enterprises. This trends has even extended to some of the savings banks (credit-unions in the United Kingdom, Raffeisen in Germany) who traditionally are oriented towards servicing local needs. This phenomena has been partially compensated by banks such as Triodos, “ethical” banks and micro finance institutions such as the “Association for the right to economic initiative” (Adie in France) which is dedicated to the financing of sectors bypassed by commercial banks. These banks and associations back the founders of micro enterprises (between 1 and 10 employees, but in general only one) in funding their initiatives through loans without guarantees and the provision of technical assistance. These entities were conceived on the model of the Grameen Bank initiated by Muhammad Yunus* in Bangladesh in his fight for the eradication of poverty. The number of micro enterprises employing one person is estimated at around 10 million to which should be added 8 million employing less than ten people, and 1.3 million who employ between ten and seventy five people. In Africa and Europe the use of micro credits has been introduced by Maria Nowak*. The number of such companies within the EU benefiting from these types of financing is estimated at between 100.000 and 150.000 annually. This sector, which has replaced the traditional banking sector as well as shrinking public support, is undergoing rapid expansion and encourages unemployed or otherwise excluded citizens to create their own undertakings to escape the “unemployment trap”. Exchanges of “best practices” between Member States are also leading to development of initiatives on the French Adie model (Belgium, Italy and several Central European countries). Micro finance constitutes an answer for liberal economies wishing to limit social exclusion.

Pour une recherche plus approfondie voir : http://www.adie.org et http://www.eif.org

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1.3.2.2.1. What types of infrastructures underpin financial markets?

The execution and settlement of financial market transactions as well as the free flow of capital rely on the existence of dedicated infrastructures. Some are of a technical nature while others concern the regulatory framework to which financial institutions as well as publicly offered products are the subject.

The efficiency of clearing systems* is crucial to the smooth functioning of capital markets. One distinguishes those that concern monetary transfers and those dedicated to the clearing and settlement of securities transactions.

1.3.2.2.2. How do cross border high value payments in euro take place?

High value transfers (minimum € 1 million) between banks use the “Trans-European Automated Real-Time Gross Settlement (TARGET) system, which was especially created for the euro and is one of the most modern worldwide. Transfers take place in real time (debits and credits are simultaneous) as expressed by the abbreviation RTGS (Real Time Gross Settlement). Transfers are gross, i.e. in full for each payment, rather than through daily or periodical netting of balances outstanding between operators. In 2005 the daily volume handled by TARGET amounted close to € 2 trillions. Its market share represented 90% in value and 60% in number of transfers in euro using high value payment systems. It ranks therefore among the largest payment systems worldwide alongside Fedware in the United States and CLS (Continuous Link Settlement), a system dedicated to the settlement of foreign exchange transactions. Target should be replaced towards the end of 2007 by TARGET 2 which will offer throughout the eurozone a de novo uniform infrastructure instead of providing the interface between existing national platforms having each their own technical standards.

1.3.2.2.3. Which organisations have played a key role in the reduction of cross border payments?

The privately owned clearing system, run by the “Banking Association for the Euro” (ABE, located in Paris) already active for payments in ECU and validated by the EMI for the euro, upgraded its performance with the introduction of “Euro 1”. In 2005, it linked the seventy most important European banks and handled on average nearly 170.000 transactions daily, totalling € 170 billions (i.e. four times more than for the ECU). It concerns a system dedicated to high value payments.

See: www.abe.org

SWIFT is the industry-owned co-operative supplying secure, standardised messaging services and interface software to over 8,100 financial institutions in 208 countries and territories. SWIFT members include banks, broker-dealers and investment managers. The broader SWIFT community also encompasses corporations as well as market infrastructures in payments, securities, treasury and trade. Over the past ten years, SWIFT message prices have been reduced over 80%, and system availability approaches 5x9 reliability — 99.999% of uptime.

See: http://www.swift.com/

The “single payment area” (SEPA) will allow customers to perform scriptural payments in euro to the order of any beneficiary, wherever located within the eurozone, through the use of a single account and a uniform set of payment instruments. All retail payments in euros carried out through these instruments will be considered as “domestic” removing any differentiation between national and cross border payments within the eurozone. SEPA is built around the single currency: a unique set of payment instruments (transfers, withdrawals and payments by cards); efficient operating infrastructures; common technical norms; a harmonised legal base and the common development of additional services addressing customer needs.

The recent adoption of the Directive on payment services, which still requires transposition into national legislations aims at providing a single legal framework applicable to all participants and governing relations between payment service providers. The European Payments Council (EPC*), established in 2002 to implement this ambitious project will define the new rules and procedures applicable to payment instruments denominated in euros.

Implementation stages will be as follows: as of January 1 2008, payment instruments designated by the EPC (direct debit and transfers) shall be offered to all users by banks within the eurozone (end of implementation stage); end 2010 the substitution of old national payment instruments by European wide instruments is made irreversible.

See: http://www.europeanpaymentscouncil.eu/content.cfm?page=sepa vision &

http://www.ecb.int/paym/sepa/htm/links.en.html

Also: ECB/ Quarterly bulletin August 2006: The evolution of large payment systems in the eurozone.

http://www.ecb.eu/pub/pdf/mobu/mb200608en.pdf

and: BCE Quarterly bulletin March 2007 : Financial integration in Europe,

http://www.ecb.eu/pub/pdf/mobu/mb200703en.pdf

1.3.2.2.4. What about small value cross border bank transfers?

Foreign exchanges commissions used to amount to approximately € 20 billion annually. It represented a significant burden to the efficient operation of the European economy, representing 0.5% of EU GNP (source EU information August 1995).

The introduction of the euro removed this specific cost by eliminating foreign exchange transactions for intra eurozone payments. However, cross border payments have remained too expensive for small amounts (retail transactions), by far higher than the cost of national transfers. The Commission has made regular appraisals of this situation and has requested that individuals and small enterprises be treated on an equal footing inside the boundaries of the eurozone.

Cross border transfers raised three different types of problems:

• Their execution takes more time than national transfers.

• They implicate generally several banks and different processing and computer systems leading to increased invoicing costs.

• National payment systems where not compatible and necessitated expensive interface mechanisms. Sometimes funds got lost in the international banking circuits (uncompleted transfers) and their recovery by the initiator proved often difficult.

The SEPA and the EPC (see here above) were created by the banking industry and the Commission to overcome these difficulties. They aim at standardising procedures, concerning debit and credit treatment of current accounts, the formatting of transfer messages and handling of card payments. Within this uniform framework, banks have developed products and services that meet their specific client demands. The process, initiated in 2003 involves the use of International Bank Account Numbers (IBAN), composed of four segments of four digits, all numbers except for the first two of the first segment which are the two letters identifying the country and a Bank Identification Code (BIC) is made up of 8 capital letters. With the use of these codes, cross border transfers follow the same procedures as those used for national for national transfers for the same cost and the same timeframe.

Payment cards can be used anywhere with the eurozone.

1.3.2.2.5. Why are clearing and settlement systems for securities dealing important?

The efficiency of clearing and settlement procedures for securities transactions is crucial for the smooth functioning of capital markets. They constitute the pipes through which financial flows are channelled. They form the link between the buyers and sellers of securities. The process involves four main stages as follows:

• Confirmation of the trade details

• Settlement of the transaction in conformity with the respective obligations of the buyer and the seller.

• The transfer of the funds

• The delivery of the securities.

Cross border transactions require access to the national systems for securities safekeeping and clearing. Intermediaries, executing clients buy and sell orders, must therefore act as correspondents between different countries. Clearing and settlement infrastructures for cross border transactions remains thoroughly fragmented inside the EU.

A consultative group was created by the European Commission (the Giovannini group) to examine the obstacles to cross border clearing and settlement of securities transactions. It presented several reports, the first of which, in November 2001 identified some 15 barriers. Ten of these concern technical or economic practices, two are linked to national differences in taxation and three relate to legal protectionist rules.

This fragmentation of clearing and settlement procedures inside the EU was a source of complications inducing excessive costs for pan European investors which are incompatible with the objective of creating a fully integrated European financial market. Urgent action was required to remove these barriers.

1.3.2.2.6. Are financial markets in the eurozone sufficiently integrated?

With the launch of the euro, the money market was instantly unified thanks to TARGET, system described here above, allowing transfers of the currency between banks in real time. Bond markets aligned also fairly rapidly leading to the establishment of a single yield curve throughout the entire eurozone from day to day rates through long maturities for similar quality securities. Operators have integrated these features, and to the extent that, exceptionally, spreads widen, arbitrageurs quickly wipe out these distortions. On the other hand, retail banking and in particular loans and savings instruments other than bonds (such as mutual funds) remain largely national. Equities present a mixed picture: large companies and multinationals are often listed on several markets where prices are virtually identical at all times; many companies choose, however, to limit their listing to their country of incorporation.

Securities are legal claims subject to the legislation of the country of issue. They are, more often than not, dematerialised, i.e. represented by bookkeeping entries into accounts. These accounts are held for each security by a depositary who manages them on behalf of the issuers. Investors also hold accounts either directly with a depositor or with a financial intermediary who will in turn maintain accounts with depositors; these accounts register the securities owned by the investor.

Up until the 1990’s, each country felt bound to own a national stock exchange which was operated as a public service entity in tandem with a central national depositary. The exchange also often provided a payment and delivery mechanism that cleared and settled the daily trades executed on the exchange. It ensured that payment took place on the appropriate value date (normally 5 business days except for trades on the forward market that were subject to periodic settlement) against the delivery of the securities, meaning triggering the transfer of the securities in the accounts of the central depositary.

The Single European Act followed by the introduction of the euro necessitating the creation of an integrated market as well as the general trend towards globalisation of financial markets that led to the sharp increase in cross border transactions, rendered this fragmented system totally inadequate.

A first step emerged as a result of the development of the Euromarkets (first in USD, then in DM, ECU, etc.) in the late 1960’s which led to the creation of two privately run European central depositaries having their own clearing and settlement mechanism, based one in Brussels (Euroclear) and the other in Luxembourg (Cedel) the latter having merged since with the Deutsche Börse in Frankfurt under the name Clearstream.

1.3.2.2.7. Why are the current clearing and settlement arrangements inadequate for the eurozone?

The euro implies the internationalisation of securities transactions at eurozone level, which in turn calls for an integrated clearing and settlement system downstream from the actual dealing (see here above chapter 1.3.2.1.13. on stock exchanges). However, securities transactions in Europe remain largely captive of vertical “silos” which perpetuate the fragmentation of markets. This structure that was adequate for the operation of national markets becomes a severe obstacle to their increasing internationalisation. The diversity of service providers, the incompatibility of their computer systems impose costs on cross border transactions that are far in excess of those prevailing in the United States.

In the US, systems have been made compatible, their number severely reduced and the depositary function conducted by a single entity.

Within the EU, efforts have been made to harmonise standards to facilitate interface between participants but much more is needed to achieve real integration. The ECB has contributed significantly to this objective within the framework of the upgrading of TARGET. It will include a specific module dedicated to the settlement of securities transactions called “TARGET 2 Securities” It consists of a central platform which ensures the completion of euro denominated transfers and the simultaneous information to depositaries so that they may register the movement of securities between accounts in their books.

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1.3.2.3.1. What is the impact of national legislations on financial markets?

Each country has its own legislation. At the tip of the pyramid of laws one finds a Constitution or an equivalent “fundamental Law”. Ordinary laws, governing social and economic relations, are based on principles that can vary from one country to another. Europe is, for instance, split between those countries inspired by Anglo-Saxon tradition in which the law grants wide powers of initiative to the judge and shows a strong pro-business bias, while other countries favour written law where the aim is to cover all aspects by legal texts (laws and regulations) which implies a more rigid and compulsory frame for commercial transactions, but that may contribute to increase their security. The fragmentation of the legal framework applicable to capital markets is a weakness for Europe and leads to additional costs, each operator needing the assistance of lawyers and advisors competent in the different national legislations that regulate their counterparts and the contracts or securities deriving from their activities.

It is also a constitutes a severe problem for investors located in other parts of the world who wish to invest in Europe and is the source of errors of interpretation causing often difficulties to resolve conflicts that may arise.

Globalisation of financial activities is exerting pressure on national authorities to work towards harmonisation. Little progress takes place spontaneously. It will have taken a full generation of debate to pave the way for the introduction of fiduciary responsibility modelled on the British “trustee” concept which was adopted recently by France. Despite the efforts of the European Commission, it has so far been impossible to harmonise bankruptcy law though it has long since been achieved in the US.

In Europe there are two channels open for integrating financial law. The first consists in the adoption at European level of Directives that are then transcribed into national legislation by the Member States. The second emanates from the decisions of the European Court of Justice whose jurisprudence becomes mandatory for all Member States, creating an embryo of European case law.

1.3.2.3.2. What are the practical barriers to the integration of financial markets?

Other factors, distinct from legal constraints, are also at work:

• Differences in tax regimes

• Protectionism favouring national companies, banks or products.

• Cultural factors such as the weight of politics or of the public sector in business affairs as well as differences in corporate cultures (differing concepts of good governance and ethical behaviour).

In the daily operation of markets, many other barriers exist:

• The lack of a European wide regulatory framework even though some of the national legislations are notoriously deficient.

• The differing implementation of supposedly harmonised rules because of the lack of a common interpretation.

• The coexistence of a multiplicity of dealing systems, clearing and settlement systems for securities examined here above.

• The underdevelopment of retirement regimes financed either by capitalisation (each generation financing its own retirement) either by distribution which implies a “national” approach (the working force pays for the retirees) which creates problems when facing a trend of aging population (see chapter2).

On the other hand, harmonisation of accounting standards is well on track, even if this recent reform is not yet part of daily practice.

1.3.2.3.3. What is being done by European authorities to make good these flaws?

It is therefore essential to continue the harmonisation of the rules that apply to market professionals, to the way they operate and to the products they handle. That is the objective undertaken by the Commission and the Member States since 1998. The Lisbon Council adopted in March 2000 the Financial Services Action Plan (FSAP) which was completed in 2005. It has inspired the drafting of a series of Directives that have been implemented concerning several aspects of the financial markets: transparency of information (Prospectus Directive); take over rules (after a great deal of soul searching); ethics (Market abuse Directive); security of banking operations (collateral); MiFID (see above) etc. A European corporate statute has been adopted, but instead of replacing national statutes, it remains optional and in practice limited to multinational companies.

Furthermore, as innovation accelerates under the pressure of globalisation a considerable effort has been undertaken to accelerate procedures for adapting rules and regulations to the new financial techniques that are subject to rapid change, be it through the adoption of new Directives or of texts governing their implementation and operating procedures. Indeed, the Council of Economic and Finance Ministers of the EU (ECOFIN Council of July 2000) mandated a committee of 7 “Wise Men” under the leadership of Baron Alexandre Lamfalussy*, to draft proposals on new working methods.

This Committee filed its report in February 2001 and was approved by the Council in Stockholm the following month. It drew attention on the fact that the hopes for a positive outcome of the FASP remained dim as a consequence of the slowness with which European authorities adopt and thereafter implement European legislation (failure of the intergovernmental method). More than two year were needed (mainly because of the requirement of unanimity in financial matters) in order to approve a Commission proposal and a further eighteen months were necessary to transpose Directives into national law. These delays constituted a minimum and were in practice often longer. The length of time needed to implement measures to reduce the cost of cross border payments constitutes a prime example of this situation.

The Committee of Wise Men concluded that the existing measures for harmonising and adapting financial regulation were flawed in several major respects: too slow, too rigid, producing too many ambiguities and failing to distinguish between broad framework principles and detailed implementation procedures.

The new procedure suggested by the Wise Men organises proposals relating to financial markets on four levels according to their scope.

Broad framework principles belong to the first level and follow the standard legislative procedure (draft proposals of the Commission submitted for approval to the European Council and the European Parliament). At level 2, two new standing Committees were created: the European Securities Committee (ESC) and the Committee of European Securities Regulators (CESR) which assist the Commission in framing the rules implementing the decisions taken at level 1. At level 3, the CESR drafts practical recommendations in areas not covered by Community legislation. These orientations are common to all national Regulators as they reflect a consensus reached within the CESR. Level 4 concerns the implementation at national level which need to take account of local constraints (law, taxation, reporting requirements, supervision, etc.) The Commission watches over the accuracy of the transposition of the Directives into national legislations and over their implementation.

The European Parliament blocked the adoption of the Report in 2001, fearing that the proposals weakened its democratic control of the financial sector. It favoured a procedure based on the adoption of more detailed Directives specifying compulsory regulatory measures and leaving less room for interpretation by the Member States.

In February 2002, an agreement was reached based on the so called “von Wogau”* compromise.

Karl von Wogau

The European Parliament was ready to accept the recommendations of the Committee of Wise Men on the condition that the proposed procedure was periodically reviewed. Parliament was granted a period of three months to contest measures adopted by the CESR.

This procedure has since been extended to cover the banking sector.

1.3.2.3.4. What kind of appraisal can be made with regard to these new procedures?

It is too early to form a detailed judgement on the performance of a structure that, taking into account the time needed for its implementation, is still in its early stages. One can nevertheless easily perceive the risks of derailment that are imbedded due to the forcefulness with which Member States seek to protect national interests, often under pressure of their administrations. Furthermore, the negotiators seek to include in the texts of the Directives a maximum of detail to comfort national preferences, despite the fact that level 1 should be limited to the statement of principles so as to allow level 2 rules to follow flexibly and speedily the evolutions and innovations in financial engineering.

Level 3 concerns the transposition of Directives at national level. This exercise is carried out under the scrutiny of the members of the CESR which have taken part in the drafting of the relevant texts. However, some national administrations continue to interpret these texts in ways that national barriers, which are supposed to be removed, continue to inhibit cross border transactions.

The enforcement of the rules by the Commission, that is part of level 4 responsibilities, remains difficult to implement in practice as Member States oppose strong resistance to interference by Brussels. This is no different than what happened on another level in the well publicised case concerning the Stability and Growth Pact. It would be useful if infringements of financial market rules, collated in particular by the “Lamfalussy league*”, would be subject to similar publicity so that pressure by public opinion could be brought to bear against Member States that fail to adhere to rules to which they have themselves contributed.

See: Progress on the “Lamfallussy League” table.

http://ec.europa.eu./internal_market/securities/docs/transposition/table_en.pdf

1.3.2.3.5. What are the conclusions to be drawn from this analysis?

The internal capital markets of the EU are well integrated as shown by available financial data. It is particularly so within the eurozone as witnessed by the uniformity of the yield curve. However, on a technical level, the market remains fragmented. The clearing of barriers to cross border movements, created by the heterogeneity of rules and systems, lead to high transaction costs which reduce market efficiency as a whole. However, this weakness has been clearly identified and progress has been made, even if it is judged to slow. Eliminating differences between the various legal systems will prove more arduous, though even there a positive trend is emerging.

One should also note that the” Lamfalussy procedure”, aiming initially at the securities markets, was extended in 2002 to cover the full scope of financial activities and in particular the banking and insurance sectors. Thus, for example, the procedures described here above contributed to achieve the harmonisation of banking security and supervisory rules (Basle II) and are also applied in other financial areas such as insurance where the Regulators meet regularly following similar procedures as those established for the banking sector.