Brexit, the Target2 angle

Izabella Kaminska

FT | Jul 19, 2016

http://ftalphaville.ft.com/2016/07/19/2169975/brexit-the-target2-angle/

 

Everybody knows much of the City of London was vehemently opposed to Brexit because of fears of what might happen to banks’ interests if so-called “passporting” rights into and out of the European system were lost.
What is less talked about, however, is Brexit’s impact on the European payments clearing system, Target2 — and how the passporting issue connects by way of Target2 to the realm of sovereign monetary policy.
At the absolute heart of the matter is the status and treatment of payment systems worldwide, and whether or not they can really be treated as something independent and thus distinct from national monetary policy (and hence open to commercial competition) — or as integral to sovereign interests.

Long-standing eurozone watchers will of course be familiar with the intricacies, mechanics and controversies of Target2 (short for the Trans-European Automated Real-time Gross settlement Express Transfer system) in its post-global-financial-crisis phase.
Imbalances within the system — especially between creditor countries like Germany and the periphery countries like Greece — have been an ongoing source of consternation in some quarters, and a good barometer of peripheral and hence eurozone distress.
What these watchers may have forgotten, however, is how conflicting views over Target in its earliest days foreshadowed the problems of today.
From the outset Target was supposed to fulfill two objectives: providing the payment procedures the future European central bank would need to transmit its monetary policy decisions to the money markets and developing a sound and efficient payments systems in Europe. As we’ve put it before: the eurosystem was very much crafted as the Bitcoin of its day: a pioneer in terms of real-time gross settlement systems efficiency held up as the perfect digital clearing system.
With that in mind, let’s go back to 1996, three years before the eurozone went live and a time when British Prime Minister Theresa May was still working at the Association for Payment Clearing Services. This was in a preparatory role anticipating sterling’s integration with Target by way of a parallel CHAPs euro network.
Chief amongst the concerns back then was whether London could retain its competitive edge clearing funds geared for European businesses if it chose to stay out of the single currency system.
To help set the scene here’s an extract from the Economist on August 3, 1996, in which the magazine asks: Can London remain Europe’s biggest financial centre if Britain decides to stay out of a single European currency?
From the article (our emphasis):

The financial markets are now betting that monetary union will happen on time; that a core of countries led by France and Germany will join; and that Britain will not. They predict that short-term interest rates will be nearly identical in France and Germany in 1999 (see chart on next page), a likely scenario if the two countries are about to share the same currency.
British rates, however, will be 1.5 percentage points higher than French and German ones. Some City folk fear that business may then begin to migrate to the financial centres of countries that have signed up for the project. Worse, those countries that have switched to the new currency (the “ins”, in Euro-parlance) might seek to help this migration along by discriminating against the “outs”.

In the article Graham Bishop, then an adviser on European financial affairs at Salomon Brothers, predicted that in the brave new world of the euro London would become a “financial rustbelt”, a view no doubt influenced by a report issued by the Bank of France and French financial groups on August 1, 1996, suggesting that “out” banks’ access to the system should be restricted.
In other words, from the earliest days, the euro’s creation had the express intent of controlling London (and other external) financial centres’ ability to service European businesses and customers through unregulated and profligate eurodollar markets — which became a bridging currency for the multi-currencied bloc — along with monetary cohesion and payment efficiency in Europe. If London wanted to continue servicing European business, the general thinking was it too would have to be “in” the newly created eurosystem and subjected to the same rules and regulations.
For as long as the UK was “out” it was hoped London would be denied euro liquidity on equal terms, and hence would not be able to compete as effectively in servicing euro markets. European businesses had of course flocked to London-intermediated eurodollar markets because of how they had helped to harmonise trade across a multi-currency bloc — an edge which would be lost once the euro was introduced.
Overall the objective was to align interests. If the City of London was to do euro-business it would have to do it on a “skin in the game” basis, equally exposed to the consequences of its actions as the countries it was servicing. If it it chose to be “out” its access would be restricted or made more costly.
Luckily for the City, the UK did have one major bargaining chip in the negotiations: its European Union membership. For as long as Britain remained a European Union member the rules of the Single Market dictated other members could not openly discriminate against it in commercial interactions.
How Target was to be classified consequently became of paramount importance.
If Target was to be considered nothing more than a payments system operated on commercial grounds, Single Market rules would prevail, prohibiting discrimination. If, however, Target was to be viewed as part of the eurozone’s monetary policy structure, then exemptions could be provided which would allow discrimination against non-eurozone financial groups.
On one hand there were accusations that equal access for the City without equal exposure would incentivise profligate City behaviours which might jeopardise Eurozone institutions. On the other hand, there were accusations by the City that French and German banks were being unfairly protectionist.
As expected, over the course of the euro negotiations, the Bank of England argued Target was a payments system while the French and German NCBs argued Target was primarily a tool of monetary policy because the ECB was expected to use Target to control the amount of euros in the system.
Relatedly, the UK did not require banks to hold minimum reserves while the ECB was hoping to introduce them. If UK banks were given equal access despite their reserve advantage, this could expose Target to more risks in London than in the eurozone, whilst also giving London a competitive edge.
In the preparatory documents from the BoE in 1997 — before it was clear whether Britain would be “in” or “out” of the eurozone — the interests of the London financial markets were expressed quite clearly.
For example, a key issue for the BoE was the cost structure of the new Target system. If the UK was denied equal treatment, the BoE believed…:

In the event that ultimately the ECB Governing Council decides to provide inadequate access to intraday liquidity to ‘out’ central banks, a wide range of alternative sources of liquidity will be available.

A.k.a – in the event the ECB acted too prudently, or denied lender of last resort access to non-eurozone central banks dealing euro on equal terms, it was the BoE’s belief alternative sources of liquidity could be conjured up for the non-eurozone system regardless (think collateral based repo, overnight private swaps, correspondent banks or BoE cultivated foreign currency reserves). In short, the BoE believed the London system would continue servicing euro-business irrespective of whether it was in or out via the creation of a parallel euro network. More so, if it was forced to deal with discriminatory ECB behaviours it might even get somewhat creative:

In addition the full range of competing alternatives to effect cross-border payments in euro, including correspondent banking, use of overseas branches, and the EBA net settlement system, will be available from the UK. Given these options, the Bank does not believe that the questions about access to intraday liquidity within TARGET are material to the development of activity in euro in London.

The issue of how the “out” countries’ parallel systems would impact the core eurosystem thus became the debating point, especially if the national central banks were being discriminated against. From the BoE in 1997:

Second, there is a concern that external euro activity might complicate the monetary policy of the euro area.
Given free capital movements, however, it is inevitable that there will be a ‘Euro’ (ie offshore) euro market in the international financial centres outside the euro area, and this is most unlikely to be reduced by the imposition of restrictive regulations or controls.
Lack of access to RTGS facilities for dollar, yen or Deutschemark payments currently, for example, does not deter their use now in the major international financial centres. Any restrictions on access by ‘out’ NCBs to intraday credit in TARGET might simply, at the margin, change the form, and the route, by which payments and the settlement of trades in the ‘out’ Member States would be made, away from TARGET to less safe routes.
Nevertheless ‘out’ Member States might be able to help the euro area, for example, to monitor ‘Euro’-euro activity so that it could be taken into account by the ECB in setting the appropriate monetary policy for the euro area.
Third, there is an understandable desire to ensure that a level playing-field is established, so that banks within the euro area and banks outside compete fairly for euro business. The Bank is sensitive to this concern. And fourth, there may be a worry that, if there were to be some kind of financial crisis, speculative flows could be exacerbated by euro activity in ‘out’ Member States. The ECB might reasonably look to ‘out’ NCBs for assistance in ensuring that the effectiveness of any policy response which it made was not capable of being undermined because of the structure of payments arrangements in ‘out’ financial centres.

The BoE was strongly hinting here that it was in the interests of the ECB to keep British banks on side. If British banks for some reason lost out, the ECB would lose a vital source of information on the scale of euro-denominated offshore market activity, which, in the opinion of the BoE, would continue on regardless because Target, as a real-time system, would always be more onerous and costly on a capital basis.
That competing netting systems would evolve outside of the reach of Target seemed plausible. The BoE even warned that without access being given to non-eurozone EU members “any such restrictions would also have the effect of making ‘in’ banks bear a disproportionate share of the costs of obtaining intraday credit; and make less attractive the whole TARGET system, for ‘in’ as well as ‘out’ banks.”
And so it was that in July 1998, the European Central Bank, under President Wim Duisenberg, conceded. British banks would receive equal access to Target, as well as the right to pledge sterling assets such as gilts in return for borrowing euros for the benefit of their parallel euro systems. In a bid to level the playing field between UK and European banks on the reserve front, meanwhile, the ECB would offer interest on minimum reserves at compensatory market rates.
What now?
Fast forward to November 2007, and the Target system was eventually replaced by the Target2 system, which integrated all the respective NCB Target systems into one holistic platform owned and operated by the ECB, in a bid to alleviate any remaining discrepancies in the real-time euro reconciliation system. The BoE opted out. CHAPs euro was dismantled in May 2008, as volumes dried up in response.
The only problem for Target2 was that the corresponding collateral delivery and reconciliation network remained fragmented — a fact which pushed a lot of the temporal mismatch risk over into the Eurozone collateral markets, sparking all sorts of unintended failed settlement consequences.
The ECB had been planning an associated integrated system for cross-border collateral delivery and settlement for use in euro-denominated fund markets, known as T2S from the get go. Unfortunately, concerns over how the T2S system would impact competition in Europe’s top trading centres for euro-denominated securities (London being the biggest) sparked resistance from the market. Ten years later, T2S is still in the process of being rolled out.
From the ECB’s perspective, it’s not until T2S is fully rolled out that the euro will work absolutely efficiently as a risk-mitigating and frictionless platform for cross-border payment and securities settlement. If that happens Target2 imbalances might wither away, improving the fate and reputation of the euro as a cross-border clearing currency.
But with eurozone recovery seemingly dependent on a system which nationalises payments and securities in everything but name, the illusion that Target was ever just a commercial systems withers away too.
In a world of national interests, equivalence becomes the name of the game for entry and exit in out of the euro — whether that’s through correspondent systems or branch networks. But the real opportunity will come in establishing a parallel euro system, or in wooing business to alternative currency frameworks that work as well if not better than the euro, and which need never draw on ECB liquidity at all.

In short, the real war won’t be over passporting rights, it will be over nationalistic attitudes towards currency and payment frameworks.