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Working Paper 7/2007 Peter Brandner, Harald Grech, Kamran Kazemzadeh Yield Differences in Euro Area Government Bond Markets – A View from the Market A View from the Market Yield Differences in Euro Area Government Bond Markets – A View from the Market Peter Brandner *) Harald Grech **) Kamran Kazemzadeh *) Abstract: factors, with current/future budget deficits, and debt The first part of this paper offers a brief description levels exerting the strongest influence. Liquidity fac- of the structure of the euro area primary and secon- tors also seem to be of considerable importance, where- dary government bond markets and shows that a full- as regulatory factors play only a minor role. For short- fledged homogeneous market has not yet been achie- term trading activities central bank policy decisions are ved since 1999. The second part of the paper analyzes apparently more relevant than the market's long term the views of selected market participants and provides assessment of debt sustainability, which is reflected in evidence for the relative importance of macroeconomic the credit risk factors. fundamentals versus market-microstructure related The views expressed herein are those of the authors variables as determinants of observed yield spreads in and should not be attributed to the Federal Ministry of the euro area government bond market. Market parti- Finance or the Oesterreichische Nationalbank. We are cipants judge credit risk factors as the most important grateful to Erich Weiss for helpful discussions. *) Federal Ministry of Finance: email@example.com firstname.lastname@example.com **) Oesterreichische Nationalbank: firstname.lastname@example.com Contents Contents 1. INTRODUCTION 7 2. STRUCTURAL ISSUES IN GOVERNMENT BOND MARKETS 8 2.1. Electronic Trading Platforms 8 2.2. Liquidity 9 2.2.1. Number of Trading Platforms 9 2.2.2. Trading Costs 9 2.2.3. Characteristics of Well Functioning Markets 10 2.3. Transparency 10 2.4. Impact of Economic News on Price Movements 11 3. THE EURO AREA GOVERNMENT BOND MARKETS 13 3.1. Primary Market 13 3.1.1. Stylized Facts 13 3.1.2. Institutional Aspects 13 3.2. Secondary Market 15 3.2.1. MTS Trading Platform 15 3.3. Primary and Secondary Market Setup in Selected Euro Area Countries 16 3.3.1. Germany and France 17 3.4. Financial Market Regulation in the EU 17 3.4.1. Clearing and Settlement 18 3.4.2. EU Transparency Provisions (MiFID) 18 4. A VIEW FROM THE MARKET 20 4.1. The Market and Its Players 20 4.1.1. Market Activity of Our Respondents 20 4.1.2. Market Participants and their Interaction 20 4.2. Yield Spreads in the Euro Area – Stylized Facts 22 4.3. Determinants of Yield Spreads 22 4.3.1. Credit Risk 23 4.3.2. Market Discipline 24 4.3.3. Liquidity Risk 24 4.3.4. Regulatory Factors 25 4.4. Euro Area Government Bond Yields and Portfolio Management 25 4.4.1. Predictability of Interest Rates 25 4.4.2. Impact of Announcements 26 5. CONCLUSIONS 27 REFERENCES 29 APPENDIX A: PARTICIPATING FINANCIAL INSTITUTIONS 33 APPENDIX B: TABLES 35 APPENDIX C: FIGURES 39 6. THE AUTHORS 51 Informationen Working Papers are composed by staff of the Federal Ministry of Finance and other experts. They intend to stimulate broad-based discussion on topical economic policy issues dealt with at the Ministry. Views expressed are those of the author and not necessarily endorsed by the Ministry. Your comments and suggestions should be directed to: Dr. Kurt Bayer, Deputy Director General for Economic Policy and International Affairs Phone: +43 1 514 33 / ext. e-mail: email@example.com or Dr. Alfred Katterl, Division of Economic Policy Analysis Phone: +43 1 514 33 / ext. e-mail: email@example.com For complimentary copies of this Working Paper, please contact: Federal Ministry of Finance, HR Development and Internal Communications Hintere Zollamtsstraße 2 b, A-1030 Vienna, Austria Phone: +43 1 514 33 ext. 501127 Web: www.bmf.gv.at 6 Introduction 1. Introduction By eliminating exchange rate risk, the introduction of point to institutional barriers in financial markets (mar- the euro in 1999 paved the way for a full integration ket integration, competition, efficiency) which need to of the euro area's financial markets where government be tackled (e.g. improvement of debt management po- bonds would be perfect substitutes which could be tra- licies in primary and secondary markets). ded on the same yield curve. In the first eight years of Government bond yield spreads are not only a Economic and Monetary Union (EMU), however, euro matter of concern to policymakers, debt managers or area government bonds have exhibited considerable central banks, but also to portfolio managers when and volatile spreads vis-à-vis German government it comes to asset pricing and risk management. Yield bonds, which are generally considered as being the spreads represent an additional form of risk that has euro area benchmark bonds, in particular in the 10 year to be taken into account when pricing or trading, for maturity spectrum. In this paper, we analyze the de- instance, spread options that explicitly refer to obser- terminants of these observed yield spreads by direct- ved yield spreads. Another example: Since euro area ly asking market participants, mainly market makers, government bonds are regarded as being virtually for their opinion. We present the results of our questi- default-free, they are frequently used as benchmarks onnaire regarding the relative importance of macroe- for the pricing and hedging of other fixed income conomic fundamentals versus market-microstructure securities. related variables. This paper is organized as follows: Section 2 deals In theory, spreads between government bonds may with structural issues of government bond markets. result from macroeconomic fundamentals (differenti- Section 3 briefly describes the main characteristics als in the credit quality of issuers due to fiscal variables, of the primary and secondary euro area government such as the budget deficit or the debt-to-GDP ratio) bond markets. Section 4 describes the questionnaire and/or country-specific microstructure-related cha- and analyzes the answers of the respondents, and racteristics (liquidity, taxation, regulatory framework, section 5 concludes. etc.). In terms of policy-making, it is important to know what lies behind yield spreads: Whereas the first case might call for macro-economic (fiscal) policy reforms (e.g. Stability and Growth Pact), the second case might The market participants' perception of a country's fiscal vulnerability may be of particular relevance for countries with high debt levels like Belgium and Italy, where, for instance, an increase in the government bond yield spread (versus Germany) of 10 basis points leads to a rise in debt servicing costs of around 0.1% of GDP; see Codogno, Favero and Missale (2003). Another example are portfolio managers who invest in euro area government bonds with higher yields and hedge their long positions by selling German Bund futures, and thus have to bear the remaining yield spread risk (Geyer, Kossmeier and Pichler, 2004). 7 Structural Issues in Government Bond Markets 2. Structural Issues in Government Bond Markets In addition to macroeconomic fundamentals as men- In the B2B segment, electronic platforms are more tioned in the introduction market microstructure cha- widely-used than in the B2C segment. Despite the on- racteristics could indeed have a considerable influ- going shift to electronic platforms, voice communica- ence on government bond yields (in the context of the tion or a combination of electronic and voice brokering questionnaire, see section 4.3). For example, liquid still plays a considerable role. The reason is that the di- markets provide better opportunities to trade posi- rect verbal interaction facilitates the formation of trust tions at low transaction costs and with minimum pri- between trading partners, which is particularly hel- ce changes. Market liquidity may be determined by pful in recurring trading situations with exceptional differences in debt management policies and other trade sizes and frequencies or illiquid financial assets. features of the market microstructure, such as the In other words, voice brokering is more beneficial for auction mechanism, the issuance calendar, the efficien- the buyer and/or seller in terms of transaction costs, if cy of the primary and secondary market, the trading the market liquidity is low and one broker is charged venues, trading sizes, etc. (for specific examples, see with the handling of a large volume order. If, however, section 3.3). In the following subsections, we briefly the market liquidity is high, the trade sizes are small discuss key aspects of trading platforms, liquidity and and standardized and there is little market volatility, transparency in order to have a better understanding market participants generally prefer electronic trading. on the results of our questionnaire, see section 4. Hence, in large and liquid markets with stable trading conditions, electronic trading offers the advantage of easy and fast trading, thereby promoting trading vo- lumes and cutting trading costs. Electronic brokerage 2.1. Electronic Trading Platforms is therefore more common when trading "on-the-run" and benchmark issues, whereas voice brokerage is more popular in trading "off-the-run" issues and deli- Transactions can either be carried out through voice cate large volume trades. brokering or electronic trading. Electronic platforms Both kinds of platforms (B2B and B2C platforms) are dealer markets and are hence quote driven in a provide market participants with pre-and post-trade sense that trades are effected upon quotes prevailing pricing information. An interesting question is whether in the markets. Market makers act as counterparties electronic or voice brokering would be more efficient thereby providing the liquidity by quoting bid and in terms of price discovery. Dunne, Moore and Portes ask prices. The bid-ask spread depends primarily on (2006b) point out that although electronic platforms are the degree of asymmetric information between market usually regarded as more transparent and voice bro- makers, informed traders and investors as well as on kering as more opaque trading venues, this does not inventory costs. Prices – other than quoted prices – can necessarily mean that electronic trading would deliver be obtained or negotiated as a result of a long-lasting the more efficient price, i.e. a price that best approaches customer-dealer relationship or quantity discounts. the "true" price outcome. Anonymous electronic tra- Such platforms are organized as single dealer platforms ding could produce a price which is only "on average" that comprise the banks' own systems, multi-dealer-to- informative, since the price responds to all trades, dealer platforms, also referred to as interdealer or B2B whereas voice-brokering could result in a more effici- platforms, and multi-dealer-to-customer platforms ent price as traders have a vital and sustained interest also known as B2C. B2B platforms are mainly used of being mutually reliable trading partners. Hence, the for government bond trading, whereas B2C platforms nature and extent of the information could be more service government and corporate bonds with equal precisely communicated in the market by voice-broke- weight. ring. Put differently, there could be a trade-off between In general, the market microstructure literature deals with three different types of traditional financial markets: dealer markets, auction markets and hybrid markets (Degryse, 2007). In contrast to dealer markets (see above), auction markets are order driven. Trades occur when new orders arrive at the markets and they are carried out directly between investors or with brokers acting as intermediaries. Orders which are not executed are collected in a limit order book and they provide the liquidity against which market orders are effected later on. Hybrid markets combine elements of quote- and order-driven markets. Other types include Alternative Trading Systems (ATSs) which enable buyers and sellers to meet on an agency basis (there are no market makers who invest their own funds or commit to provide liquidity). Within ATSs, Degryse (2007) distinguishes three groups of networks: Electronic Communication Networks (ECNs), which allow investors to clear trades through an open limit order book (traders trade with each other directly); Crossing Networks (CNs), which cross multiple orders at a single price and do not allow orders to be crossed or executed outside specified times; and Smart Order Routing Technology (SORT), with which – based on trading criteria (e.g. best execution) – orders are routed to centralized markets. For a survey on electronic platforms in Europe, see TBMA (2005). 8 Structural Issues in Government Bond Markets a more transparent trading platform offering a less differently organized trading systems that correspond efficient price and a more opaque trading platform to their special needs. Differences in investors' tastes with a possibly more efficient price setting. (willingness to trade, degree of immediacy, portfolio Persaud (2006) points out that in the U.S.A. elec- composition effects, informed versus liquidity traders) tronic trading is far more common than in Europe: In could also lead to heterogeneous order flows. As a the U.S.A., electronic trading represents 98% of all "on- result of increased market fragmentation, bid-ask the-run" volumes, whereas in Europe, electronic bond spreads tend to widen, and price volatility is growing trading amounts only to 65%. As a possible explana- (see for instance Harris, 1993). tion, he mentions the concern over liquidity market In the same vein, Stoll (2001) argues that a choice participants could have in Europe as only one specific of different trading venues would trigger higher mar- platform (MTS, see section 3.2.1) dominates whereas ket fragmentation as it would lower the incentives for in the U.S.A. a variety of different trading platforms investors to submit orders to more than one platform exist. by decreasing probability of order execution. Hence, Electronic trading has been growing in recent liquidity would fall once more trading venues are years and continues to grow in Europe. The report by available to investors. TBMA (2005) expects a further expansion of European Yet one could also argue that, since aspects of electronic platforms as the trading platform industry competition policy have been taken into account more is currently being transformed and consolidated. In recently, a higher number of trading platforms would particular government and high-grade bonds will in- exert market pressure on the current trading platforms crease their shares of turnover on electronic platforms. and would therefore improve market quality as bid-ask By contrast, bonds with lower ratings, highly struc- spreads narrow. Moreover, while the market depth of tured cash flows, unique features and large block trades the former main market may decrease, the joint depth are likely to reduce their trading share on electronic of both markets (the "old and the "new" one) may platforms. be higher. The analysis of how intermarket competi- tion affects market quality is related to the literature on competition between traditional financial markets, see e.g. Parlour and Seppi (2003). For an overview of 2.2. Liquidity factors determining the competitiveness of a market, see Biais, Glosten and Spatt (2005). Liquidity is one of the most important characteristics 2.2.2. Trading Costs of an organized financial market and it is usually defi- ned (e.g. Campell, Lo and MacKinlay, 1997) as the abi- lity to buy or sell significant quantities of a security in Market makers provide the liquidity by accepting a quick, anonymous way with relatively little impact to buy or sell securities at the quoted price, see also on the price. The concept of liquidity comprises both section 4.1.2. The bid-ask spread is one of the major price and quantity aspects. For the various dimensions sources of trading costs; the size of the spread is in- of liquidity, see also BIS (1999). fluenced by adverse selection costs which arise for the market maker when dealing with informed traders. 2.2.1. Number of Trading Platforms Informed traders possess superior information on the true value of a security than market makers. As market makers cannot differentiate between informed and un- An important issue – in particular for regulators – is informed traders, they would, on average, incur losses. whether competition between different trading plat- The larger the proportion of informed traders and the forms would enhance liquidity and improve market higher the quality of the superior information, the quality. Earlier papers in the literature, for instance higher the necessary compensation for the market ma- Pagano (1989), Chowdry and Nanda (1991) or Admati ker and hence the larger the bid-ask spread. and Pfleiderer (1991), broadly acknowledged that as a The bid-ask spread also varies according to the result of liquidity externalities, trading generally ten- type of the security and the trade size. The larger the ds to take place in those markets that are already most volume traded, the more likely the transaction is to liquid. Hence, they argue, it is difficult to move liquidi- have an impact on the price of a security. However, ty from one trading system to another even when the in specific dealer markets such bond markets large new system is intrinsically better. Traders may prefer investors are frequently able to negotiate the price of Market quality can be measured in terms of bid-ask spreads, depth of the market, informational efficiency and price discovery. 9 Structural Issues in Government Bond Markets a security with a number of dealers, whereas smal- gistered and compared across markets and time. In a ler investors would have to accept the price quoted study on liquidity of international bonds including so- in the markets without the option of negotiating. The vereigns, corporations, banks, and supranational insti- bid-ask spread is also likely to be higher the less liquid tutions Gwilym, Trevino and Thomas (2002) find that the security is. Bond markets are a prominent example credit rating and issue size of bonds are negatively re- in this respect; illiquid bond markets tend to have large lated to the bid-ask spread, while their price volatility bid-ask spreads. is positively related. The authors' econometric analy- In addition to the bid-ask spread there are, however, sis also shows that financial and supranational issuers other sources of trading costs. These are direct costs or tend to have narrower and less dispersed spreads than order-processing costs and inventory costs. Direct or sovereign and, even more so, corporate bonds. Hong order-processing costs entail commissions to brokers and Warga (2000) also find support for the hypothe- and a tax on the trade. Inventory costs are associated sis that larger issues are more liquid and associated with the risk of an undesired inventory and the price with smaller bid-ask spreads than smaller issues. impact of a potential sale in large volumes which may Degryse (2007) notes that, in addition to regulatory market lead to an adverse increase in the bid-ask spread. reforms, the growth of Electronic Communication Networks has helped to significantly lower trading 2.2.3. Characteristics of Well Functioning Markets costs. Well-functioning markets are characterized by several features (Campell et al., 1997): First, an adequa- 2.3. Transparency te amount of timely and accurate market information, for instance, on past prices, trading volumes, current bids and offers and the amount of short sales outstan- Transparency is one of the key issues in financial ding, should be available to investors. Yet one has to markets. In general, properly functioning financial bear in mind (see section 2.3 and 3.2) that too much markets are characterized by a balance between trans- pre-transparency could also lead to a reduction in mar- parency aimed at fostering competition and protecting ket liquidity. Second, trading costs should be kept as low investors on the one hand and opacity which stimu- as possible. Tight markets, for instance, match supply lates participation of customers and liquidity providers and demand at low costs. Third, transactions should be on the other hand. An efficient market that attracts a carried out at prices that do not vary substantially from sufficiently large number of participants has to provide past prices unless new information enters the market. fairness, protection and an adequate incentive structure In other words, market participants should expect (Dunne, Moore and Portes, 2006a). The crucial point is price continuity (see section 4.4.1). Fourth, markets to determine the optimal degree of transparency. differ according to the speed with which new infor- Regarding the transparency of financial mar- mation is incorporated into the transaction prices (see kets one can distinguish between pre- and post-tra- section 2.4 and 4.4.2). Investors would typically prefer de transparency. Pre-trade transparency refers to the efficient markets, where all kinds of information are availability of information on outstanding order flows mirrored in the current transaction price. collected in the order book or dealers' quotes before Moreover, markets should be deep, i.e. a large orders are submitted. In other words, pre-trade trans- number of buyers and sellers should be willing to parency assures that market participants are aware of buy and sell at prices that do not differ too much from publicly observable prices at which they can expect the current transaction price. Market depth circum- their trades to be carried out. Post-trade transparency scribes the markets' capacity to digest large volumes of refers to information on recent actual prices and financial flows without having a significant bearing on volumes traded. Post-trade transparency enables mar- prices. A deep market is generally considered to have ket participants to compare prices and serves as an narrow bid-ask spreads, a high daily turnover and only incentive for dealers to provide their clients with the little increase in bid-ask spreads or sparse deterioration so-called "best execution price." Changing the level in prices if transactions are carried out in other than the of pre-trade and post-trade transparency may consi- best market prices. derably influence information asymmetry in the mar- In most of empirical work on market liquidity, kets. Greater transparency6 increases the efficiency of more emphasis is attached to bid-ask spreads than markets as information is more equally distributed on market depth, since bid-ask spreads are easily re- across market participants. This may alter the 6 The term "increased transparency" means that information on prices and volumes are made available to a larger audience than before and/or that more sensitive details on trades are disclosed and/or that information is released more quickly than before. 10 Structural Issues in Government Bond Markets behavior of market participants substantially and as a pre-trade transparency leads to an improvement in consequence change market quality. market quality whereas according to Boehmer, Saar Dunne (2007) mentions that the high transparen- and Yu (2005), an increase in pre-trade transparency cy of primary dealer systems is harmful to the growth would result in a deterioration of market quality. of an electronic dealer-to-customer secondary market. Gemmil (1996) analyzes changes in the level of post- The reason is that market segmentation leads to a time trade transparency and detects no liquidity effects.8 lag between customers' request for a trade and the actual order execution. The time lag and the high degree of transparency common to most electronic tra- ding arrangements can potentially lead to a behavior 2.4. Impact of Economic News on which damages market quality. For instance, if a dealer Price Movements wins an automatic request for a quote ("RFQ")7 auction, he possibly faces the "winner's curse problem." Even if the dealer wins the auction in the B2C-segment, he will Economic announcements influence bond markets, often take the opposite position in the B2B segment. If since they represent unanticipated information on the time lag between order request and order executi- the state of the economy. Market participants regard on in the B2C segment is too long and if more than one in particular macroeconomic figures as essential lea- dealer is involved, too much transparency in the B2C ding indicators. In the empirical literature, the impact segment might work against the dealer who won the of macroeconomic announcements on bond prices has auction. In other words, dealers have to face increasing been analyzed mainly on the basis of daily data; more risks stemming from their attempts to hedge positions recent research concentrates on intraday data. in the interdealer market, such risks result from dea- Earlier work on U.S. data investigated the bond lings with buy-side customers. market effects of data releases of money supply, pro- Hence, increasing transparency by regulators in ducer and consumer price indices, various leading in- the B2C segment for investor protection (e.g. through dicator indices, the trade balance and unemployment a transparent parallel electronic order book) would figures. Papers, such as Dwyer and Hafer (1989), found possibly reduce traders' readiness to permanently that data releases of money supply and producer price supply liquidity in the B2B market, which in turn may indices had the largest impact on bond prices. impact on the efficient functioning of primary markets. Another strand of the more recent literature In this context, the interests of customers and /or regu- focuses on intraday effects. Fleming and Lopez lators as well as issuers may conflict: Issuers are mainly (1999) indicate that even large changes in the U.S. interested in a well-developed B2B market – this has Treasury yield curve do not occur in times of U.S. indirectly favored a more opaque trading in the B2C economic news announcements. Such changes segment, which is possibly at the expense of customers. frequently appear to happen in periods when the In other words, a highly transparent B2B segment ten- U.S. Treasury market is not active. German bond ds to be combined with a much less transparent B2C yields fluctuate mostly during the European morning segment. But higher transparency in the B2C segment trading hours and this fluctuation is not linked to any enforced by regulators could probably seriously dama- day-of-the-week pattern or any specific data release. ge efficiency and liquidity in the B2B segment. Casey On the contrary, Fleming and Remolona (1999) and and Lannoo (2005) also conclude that too much trans- Balduzzi, Elton and Green (2001) find that the largest parency can harm liquidity. movement in U.S. bond prices occurs in days of ma- Dunne (2007) proposes to reduce segmentation croeconomic announcements. Both papers find that between the B2B and B2C platforms in government before the announcement takes place on trading days, bond markets – inter alia – by opening the B2B segment trading intensity and price volatility are low while to customers and by spreading the burden of liquidity bid-ask spreads are elevated. Fleming and Remolona provision across a wider group of market participants. (1999) declare that unemployment figures have the A more thorough discussion of alternatives goes, most significant impact on bond prices. Moreover, however, beyond the scope of this paper. they locate a substantial increase in trading volume up In the empirical literature there are only few to half an hour after macroeconomic announcements. papers that analyze the effects of changes in the level Balduzzi, Elton and Green (2001) study the response of transparency on market quality. Madhaven, Porter of U.S. Treasury bond prices to 26 different public and Weaver (2005), for instance, find that an increase in economic news announcements published throughout 7 Request for quotes ("RFQ") trading platforms are electronic platforms in the B2C-segment. Examples of RFQ platforms are BondVision, TradeWeb and Bloom- berg-Bond-Trader. 8 The three papers mentioned, however, deal with stock market transparency. Structural Issues in Government Bond Markets a day between 8:30 a.m. and 4:30 p.m. 17 out of these under which economic news is incorporated into bond 26 announcements affected the prices of the U.S. bond prices, the impact of news on bond prices occurs prices. They find that trading around announcement within a very short period of time (several minutes) times is more intense than during the normal trading after the announcement. times, leading to multiple trades every minute. Most announcements tend to be very quickly incorporated into prices (one minute or less), leading to a jump in bond prices. They also document significant and per- sistent increases in volatility and trading volume after the announcements. Bid-ask spreads widen at the time of the announcement, but revert to normal levels after five to 15 minutes. Goldberg and Leonhard (2003) observe in their stu- dy a strong influence of U.S. data on euro area interest rates – in particular on bond prices. They find that U.S. economic news has a direct and large effect on German government bond yields within an hour of its release. In contrast, similar news from the euro area had only small effects on U.S. Treasury yields (and also German yields). In their study, they found that the largest effects on both markets emerge from news on labor markets, real GDP, consumer sentiment reports and various pri- ce level indicators. Green (2004) studies the impact of trading on U.S. government bond prices surrounding the release of macroeconomic news. He finds that bond prices are increasingly subject to order flow in the first half hour following economic announcements, suggesting that the release of public information increases the level of information asymmetry in the bond market. Tra- ding activity remains high for several hours after the announcements, the level of information asymmetry, however, returns to almost the normal levels again within 15 minutes. Andersson, Hansen and Sebestyén (2006) examine the effects of various macroeconomic data releases (unemployment, industrial production, GDP, consu- mer price index, business confidence indicators) and of the ECB's monetary policy announcements on German long-term bond yields. Macroeconomic data releases cover German, French, Italian and aggregate euro area and U.S. macroeconomic data releases. The authors find that U.S. and – to some extent – euro area and national data releases have a considerable influence of German government bond yields. Yet the announcements have a stronger and longer impact, on the volatility than on the levels of bond yields. According to the brief survey of select papers, money supply, producer and consumer prices, unem- ployment figures, real GDP and industrial production, consumer and business sentiment have in most cases an influence on bond prices. With few exceptions, fis- cal variables are not considered as an impact variable, probably due to the fact that fiscal balances and debt levels are measured on a yearly basis and are hence not frequently announced. Considering the speed The Euro Area Government Bond Markets 3. The Euro Area Government Bond Markets When referring to euro area government bond mar- with 2005, the relative share of public issues dropped kets, it is important to distinguish between primary from 39% to 36% in 2006. Within the private sector, ex- and secondary markets. Both markets affect the price pansion was strongest in the market segments of asset dynamics of euro area government bonds. Whereas the backed securities (+39%), corporate bonds (+34%) and primary market is closely related to the financing need financials (+10%) in 2006. of the government and therefore ultimately provides As regards the composition of total issuance, cen- the liquidity, the secondary market is the place where tral and local governments account for the largest part market participants meet and trade the bonds that are of euro-denominated bond issues. In 2006, they carried issued in the primary market. out 39% of all euro bond issues (51% in 2002). Since The institutional setting of both markets, i.e. the 1999, central government issues have risen by approxi- issuing procedures and the structure of the clearing mately 10%, and local governments by 257%. Local go- and settlement framework and the trading facilities vernment bond issues, however, represent only a small of large and small players (market makers, brokers, fraction of all government bond issues. and investors) are essential ingredients for price deter- In 2006, euro area issues placed 98% of all euro-de- mination. Casey and Lannoo (2005), Pagano and von nominated central government issues, with Italy (31%), Thadden (2004) and ECB (2004) provide extensive sur- Germany (22%) and France (18%) contributing the veys of the European secondary bond markets, Dunne largest shares, followed by Spain (6.5%), Greece (4%), et al. (2006a, 2006b) of the primary markets. the Netherlands (3.5%), Austria (2.7%), Portugal (2.2%) Surprisingly, policymakers pay less attention to and Finland (0.9%). Ireland and Luxembourg recorded euro area bond markets than to equity markets, which no bond issuance in 2006. is surprising given the overall importance of bond Table 2 displays that in 2006, approximately 55% markets for the proper functioning of the economy (as of all issues were launched by "AAA"-rated euro area already briefly mentioned in the introduction). Since central governments, 40% by "AA"-rated and 5% by the bulk of euro area bond trading still occurs "A"-rated governments. Among the 12 countries that off-exchange, the mechanisms of bond markets are introduced the euro in 1999 and 2001 (Greece), eight often poorly understood outside the market. countries are currently carry Standard & Poor's highest rating ("AAA"), three countries an "AA" and one country an "A"-rating. With regard to issue size, 5% of the total euro 3.1. Primary Market government issuance occurred in a range between EUR 0.5 billion and EUR 1 billion per issue, 14% between EUR 1 and EUR 2 billion and 81% above EUR 2 billion per issue in 2006. Obviously, euro area central 3.1.1. Stylized Facts governments favored larger bond issue sizes in order to enhance liquidity. New benchmark bond issues gene In 2006, total gross issuance of euro-denominated rally amounted to at least EUR 5 billion. This is the bonds (euro area and outside9) amounted to EUR 1,873 minimum volume for trading on the euro MTS billion (table 1),10 thus exceeding total gross issuance of platform, see section 3.2.1. euro-denominated bonds in 1999 (EUR 1,400 billion) by 34%. By market segment, asset-backed securities and 3.1.2. Institutional Aspects local government bonds have experienced the largest expansion since 1999 (387% and 257% respectively). It is interesting to note that in 2006 the private sector The issuing policy is autonomously determined by was more dynamic than the public sector. Compared the government of each euro area member country. 9 "Outside" means recently acceded Member States, candidate countries and other emerging markets. In sum, these issues amount to approximately 2% of the total in 2006. 10 The figures on the primary market are from Commission Services (DG ECFIN database on euro-denominated bonds) and draw from publications that can be found on the website http://ec.europa.eu/economy_finance/publications/bondmarkets_en.htm. The database includes all issues of a maturity of one year or more (incl. in particular Italian and French discounted paper of usually significant issue amount). Austria, Finland, France, Germany, Ireland, Luxembourg, Netherlands, Spain. Belgium, Italy, Portugal. Greece. The Euro Area Government Bond Markets Since January 1999, several initiatives have been as the local MTS platform (see section 3.2.1), where taken to promote the proper functioning of euro area DMOs can closely monitor the activities of primary government bond primary markets, and in particular to dealers. Regarding the number of primary dealers and enhance market liquidity. Auction calendars have been MTS market makers in the different euro area coun- released well in advance to raise market transparency tries, we refer to table 3.16 and issue sizes have been enlarged. This was facilita- According to Persaud (2006), DMOs hold the ted by programs aimed at replacing old illiquid bonds opinion that only one single platform would maximize for new bonds and by reducing the issuing number liquidity. He also notes that primary dealers are often of benchmark securities. In order to attract attention small stakeholders of the local MTS systems. from a larger number of investors, some countries with Typically, DMOs rank primary dealers by perfor- traditionally smaller issuance volumes (Austria, mance criteria in the primary and secondary markets Belgium, the Netherlands, and Portugal) have partly that serve the DMOs specific interests, like minimizing substituted traditional auctions for syndication proce- the cost for the Treasury or mandatory market making dures. Countries with larger issues, like France, have on a particular platform.17 The best-performing dealers launched new products such as inflation-indexed that move on to the second stage – syndication – have bonds. Yet there are still, considerable differences in the chance to make profits compensating for any losses primary markets. Dunne et al. (2006b) find that issuan- incurred during the first stage of the auction. ce techniques in primary markets account for a good In this spirit, Dunne et al. (2006a) mention that deal of cross-country differences within the euro area is plausible to conclude that primary and probably regarding transparency, trading costs and depth. The secondary market activity is a loss leader for prima- characteristics of the euro area bond market are the- ry dealers. In turn, however, primary dealers benefit refore far more heterogeneous than for example the from having the right to participate in bond exchange features of the euro area money markets where the programs and/or to strip and reconstruct bond issues. European Central Bank (ECB) is the ultimate supplier Moreover, in some countries primary dealers enjoy pri- of liquidity. vileged access to the repo market. Other benefits for Regardless of the introduction of the euro, national primary dealers comprise advisory fees or a mandate government bond markets have still been existing in from national authorities to organize syndications, parallel. Obviously, smaller national government bond securitizations and privatizations. Furthermore, large markets must be offering some incentive for partici- banks often regard primary dealership as a matter of pation. The main reason may be the specific design of prestige. Although it is hard to measure the exact value national auction syndicate structures that already added of a primary dealer, it is a fact that governments abounded before 1999. National Debt Management and their DMOs are important clients for large interna- Offices (DMOs), which are in general – at least to tional banks. some extent – legally and constitutionally part of their Given the high importance of primary dealers and respective Ministry of Finance, act as agencies for the voice brokerage in the secondary markets, the euro government. They carry out the government's debt area government bond market has often been criticized management in line with the government policy and as being opaque. However, in recent years the extensi- financial framework in an operational way. DMOs ser- on of existing primary dealer obligations in small euro ve different objectives: In some countries, they simply area countries has led to an improvement in the trans- aim at minimizing the cost of paying the debt, in other parency in the interdealer market. Yet in the dealer- countries they endeavor to secure a healthy retail to-customer segment opacity still prevails, see Dunne market and an orderly behavior of market partici- (2007). pants. As compared to voice brokerage, DMOs prefer When issuing bonds, many DMOs rely on the electronic brokerage mainly because it enables them ample participation of primary dealers to absorb the to retrace transactions more easily which, on the one volume issued and to sell it in the secondary markets hand, facilitates the inspection of the adherence of later on. One of the obligations primary dealers have primary dealer secondary market obligations and, on to comply with in many European countries is that the other hand, reduces systemic risk. they may only trade on pre-specified platforms, such A primary dealer is officially recognized by a DMO and must participate in auctions. In the secondary markets, primary dealers must undertake quoting obliga- tions by quoting firm prices to investors and other dealers as well as displaying indicative prices on electronic systems. Primary dealers offer additional benefits to issuers, for instance, advisory services, a deep investor/customer base and promotion of the debt abroad. Belgium, Denmark, Finland, Italy, the Netherlands, and Portugal. 16 See MTS Group (2007). 17 In this respect, the relevant euro area countries are Belgium, Finland, Ireland, Italy, the Netherlands, and Portugal (EPDA, 2007). The Euro Area Government Bond Markets As a result of the increased pre- and post-trade MTS Italy (1988), MTS Amsterdam (1999), MTS Poland transparency, liquidity for trades with normal size has (2004), MTS Portugal (2000), MTS Slovenia (2007), MTS improved. However, in countries that have introduced España (2002), EuroCredit MTS, New EuroMTS, Euro- the primary dealer system, some kind of market Benchmark Treasury Bills Market, EuroMTS Linkers distortion has emerged as auction prices are frequently Market, MTS Cedulas Market, MTS Quasi-Govern- higher than post-auction prices. The reason is that ment Market, BondVision, the multi-dealer-to-client primary dealers tend to over-bid at auctions and electronic bond trading market. BondForAll, a facility typically take over large stocks in order to meet their initially comprising a segment for euro-denominated secondary market obligations. The risk arising from non-benchmark sovereign bonds issued by non-EU such large inventory building has been further passed issuers, was introduced in 2006 and complements on to the customers who are confronted with spreads trading of benchmark sovereign bonds issued by non- which are higher than normal trade size spreads. EU members via the EuroGlobalMTS (2005) market. Issuers benefited from lower yields and non-rewarded In 1999, the EuroMTS system – a pan-European market participants refrained from further auction- electronic trading platform – was launched in addition bidding. to the already existing national MTS trading platforms mentioned before. From 1999 onwards, trading activi- ties in the European government bond markets have been increasingly marked by a transition from over- 3.2. Secondary Market the-counter (OTC) trading to EuroMTS. Galati and Tsatsaronis (2001) point out that by enhancing trans- parency, EuroMTS has significantly contributed to The segmentation of the euro area government bond further stimulate EU cross-border trading. For a detai- market in B2B and B2C offers a variety of advantages to led description of the MTS trading system, see Cheung, market participants. As Dunne (2007) points out: once de Jong and Rindi (2005). a B2B und B2C setup is in place, According to Persaud (2006), MTS covers a • issuers are better off distributing new bond issues market share of 71.9% of the electronic European cash through dealers rather than to investors directly, government bonds trading, followed by HDAT (the • dealers are better off building and maintaining a Bank of Greece's proprietary system of secondary client base that is large enough to warrant the risk trading in Greek government bonds) with a market exposure they incur by providing liquidity in the se- share of 19.0%. SENAF, a Spanish platform which condary interdealer market and exists in addition to MTS Spain, ranks third (market • clients are better off routing most of their order flow share: 5.4%), Eurex Bonds fourth (market share: 3.6%) through one dealer because they can expect better and Brokertec & E-Speed fifth (market share: 0.1%). execution when they assist their dealer in keeping The range of fixed-income securities that can be trading positions hidden from competing dealers. traded on domestic MTS platforms is larger (see table 4), as it comprises on-the-run and off-the-run issues, Most secondary market trading activities occur on whereas on the EuroMTS platform only on-the-run MTS trading platforms. MTS platforms are electronic issues can be traded. Although dealers are able to interdealer trading venues, where individual investors offer a much wider range of bonds to clients in the are not permitted to trade. national MTS platforms, both platforms exist in parallel. Cheung et al. (2005) report that bid-ask 3.2.1. MTS Trading Platform spreads, quoted on EuroMTS and the national platforms, do not differ much. Neither do transaction costs vary much among large orders being traded Initially, the MTS trading platform (Mercato dei Titoli on the EuroMTS-platform and smaller orders on the di Stato) was created by the Banca d'Italia and the local MTS platforms. This observation would appear Italian Treasury in 1988 to stimulate and enhance to suggest that the national trading platforms and the trading of Italian government bonds. In 1994, the MTS centralized EuroMTS platform are closely linked to system was modified – in particular with a view to each other in terms of liquidity. improve market depth. After the privatization in 1998, Alternatively, as pointed out by Casey and Lannoo the MTS system has expanded to other Euro-denomi- (2005), tight bid-ask spreads across the MTS platforms nated markets. It has since become operational in many may also reflect the mandatory quoting obligations EU Member States with MTS Austrian Market (2003), placed on the dealers, since market-making obligations MTS Belgium (2000), MTS Denmark (2003), MTS Fin- are standardized across the system. Consequently, the land (2002), MTS France (2000), MTS Deutschland perceived depth of the MTS system may be only an (2001), MTS Greek Market (2003), MTS Ireland (2002), illusion, as liquidity is artificially standardized across The Euro Area Government Bond Markets these platforms by similar or identical market-making domestic MTS platforms (see section 3.2.1). Pagano and requirements enshrined in the Liquidity Pact. von Thadden (2004) mention the Liquidity Pact as one The Liquidity Pact is an arrangement whereby key to the success of the EuroMTS platform in terms of market participants in the primary and secondary secondary market liquidity. Casey and Lannoo (2005) markets (dealers and issuers of securities listed on and Persaud (2006), however, dispute whether the MTS) undertake various commitments to each other perceived liquidity structurally reflects the market in order to enhance liquidity and transparency (MTS condition. Group, 2003). For instance, market makers have to Pagano and von Thadden (2004) present statistics continuously post buy and sell limit-orders within on bid-ask spreads across euro area countries for the a maximum bid-ask spread, for a minimum quote period 2002/2003. Average spreads range between 2.5 amount on both sides of the market, for at least five basis points (Italy) and 4.9 (Finland). According to the- hours each day. However, since it is not guaranteed se data, the German government bond cash market is that enough customer transactions can be carried out at surprisingly not the most liquid market, the average these small spreads to make the liquidity commitments spread in the 10-year bond market is 3.2 basis points. profitable, banks endeavor to build up their client base. The reason is, as already mentioned earlier, that most Banks, however, benefit from the commitment of other of the trading in 10-year German government bonds banks, since undesired high inventories can be reduced takes place in the futures markets at the EUREX which by the liquidity supplied by another dealer under the are far more liquid than the corresponding cash mar- same agreement. Otherwise, no single dealer would be kets. prepared to bear all the risks and supply the liquidity. Codogno, Favero and Missale (2003) stress the In fact, the main reason for the dominant market liquidity relevance of a sufficiently large menu of position of MTS platforms seems to lie in the trading hedging and financing instruments, i.e. efficient restrictions imposed by national DMOs (see section futures and/or repurchase agreement (Repo) markets. 3.1.2). According to Persaud (2006), these secondary Furthermore, they point out that the proper functioning market obligations for primary dealers reduce compe- of derivatives markets enables market participants to tition between platforms. Persaud discards arguments manage and actively trade interest rate risk, thereby en- that could be raised by DMOs maintaining that compe- hancing liquidity not only in, for example, the futures tition among various trading platforms would increa- markets but also in the spot markets. In the euro area singly fragment liquidity and reduce the transparency Bund futures contracts on the German 10-year govern- of primary dealer activity. Moreover, he contests that ment bond – the de-facto euro area benchmark bond in market participants would find it difficult and costly this maturity spectrum – have assumed the pivot role. to exploit the most efficient trading opportunities and argues that evidence from financial markets rather suggests that competition between platforms has enhanced volumes, depth and market functioning as 3.3. Primary and Secondary Market U.S. experience has shown. Setup in Selected Euro Area The MTS trading system, where mainly standar- dized transaction sizes are traded, is characterized by Countries a high degree of transparency. Detailed information on order book data in real time, quotes and trans- actions are directly submitted to information systems The trading intensity on the national MTS platform(s) like Bloomberg and Reuters. If, however, large volumes varies considerably across euro area countries; it are to be split into smaller amounts, these large block depends on the issuing modalities and the secondary quantities are not displayed in the order books and market obligations placed on primary dealers, see therefore not available as information. Also, if transac- Dunne et al. (2006b). The stricter these obligations, the tions are settled bilaterally, only the two counterparties higher the volume being traded on the MTS platform(s). are known to each other, in case central counterparties Countries which favor syndicate issuance and the (CCPs) are used, total anonymity is guaranteed. imposition of secondary market obligations to primary In the euro area, liquidity of the national bond mar- dealers, experience higher turnover volumes on MTS. kets differs according to trading volumes, the amount Austria, Belgium, Finland, Italy and Portugal are coun- of outstanding issues (see section 3.1.1), the market tries that feature syndicated issuance and/or secondary makers' trading activity and the depth and efficiency of market obligations, whereas France and Germany are the secondary markets. Benchmark bonds, in particular on the other side of the spectrum. In Spain and Greece, at 5- and 10-year maturities (which are the most liquid there are no specific secondary market trading obliga- ones) are mainly traded at EuroMTS, whereas bonds tions with reference to MTS. In the Netherlands, the that are no longer benchmark bonds are traded on the DMO does not provide large benefits to primary dea- 16 The Euro Area Government Bond Markets lers through syndicated issuance and is itself frequent- syndication. Primary dealers have committed them- ly the lead runner in syndicated issues. Moreover; selves to take part in all actions to ensure a smooth there are no secondary market obligations for primary auction process. The French government bond market dealers. is very liquid; France was the first European sovereign issuer that authorized the stripping of its bonds. The 3.3.1. Germany and France French Strips market is the largest and most liquid Strips market in the euro area, see MTS Group (2005). In Germany, for instance, the German Finance Agency (Finanzagentur) does not rely on a primary dealer system or a syndicated issuance system. The 3.4. Financial Market Regulation German Finance Agency arranges regular auctions in the EU which are announced in advance through an annual issuance calendar to ensure transparency. Instead of a primary dealer system, 40 banks – the Bund Issues In 1999, the Financial Services Action Plan (FSAP) Auction Group – participate in these auctions on a was adopted, which aimed at integrating national voluntary basis. There are no secondary market obliga- capital markets into a single market for financial tions; participating banks are neither obliged to serve services in the European Union. The FSAP puts as market makers, nor do they receive any fees or any forward indicative priorities and a timetable for specific other incentives from the Finanzagentur. However, measures in order to accomplish three strategic objectives, as a result of the Bund Issues Auction Group's active namely establishing a single market in wholesale finan- market making, the secondary market in Germany cial services, making retail markets open and securing is highly liquid; see MTS Group (2005). Dunne et al. and strengthening the rules of prudential supervision, (2006, p. 43) suspect that a significant proportion of see for instance Deutsche Bundesbank (2004). trading in German government bonds occurs outside In order to accomplish financial market integration, MTS in the OTC markets. According to their analysis, the regulation of securities within the FSAP has to the existence of an opaque secondary (OTC) market take care that EU suppliers are granted equal access that is less transparent than the MTS platform might to all EU securities markets. To this end, EU Member be seen as a concession to participating banks to States have to acknowledge the rules and supervision provide liquidity at auctions. As a result of this more of the other Member States (home country control)18. opaque trading setting, bond auction prices are less Moreover, a maximum of market transparency has to distorted since there is no need for participating dea- be established to ensure that market participants are lers to show good auction performance. able to thoroughly compare quality and costs across Another important trading venue of German national financial markets, see also section 2.3. government bond trading is the EUREX Bond trading In recent years there have been increasing efforts platform. In terms of transparency, EUREX is compara- to strengthen transparency in European financial mar- ble to MTS platforms and, moreover, includes trading in kets. Regulatory issues with respect to transparency German fixed income securities other than government are dealt with under the Markets in Financial Instru- bonds, like sub-sovereign fixed income bonds of ments Directive (MiFID) framework, which lies at the the Kreditanstalt für Wiederaufbau, the European heart of the FSAP (see chapter 3.4.2). Investment Bank and the States of the German Federal Casey (2006) contributes to the ongoing debate po- Government. In addition, market participants have the licy on bond market transparency in the context of the possibility to trade government bond futures contracts MiFID and puts forward the idea whether an industry at the EUREX, which are the benchmark futures con- code of conduct may possibly be a more appropriate tracts that are heavily used for hedging purposes of avenue than legislative initiatives for introducing more any euro area government bond positions. Price transparency in the bond markets across the EU. movements of the futures contracts and the MTS cash For a detailed survey on regulatory issues of the se- markets show high correlation. curities market infrastructure in the European Union, In France, the Agence France Trésor, has installed a see for instance Kazarian (2006). regular auction system which is announced in advance and through which bond issues are placed. On some occasions, specific products are launched through 18 Home country control (also country of origin rule) is part of the Single Market law that determines which laws will apply to goods and services that cross the border of EU Member States. EU law requires that the goods or services produced in one Member State should be allowed unhindered access to markets of other Member States, the latter being allowed to apply their laws except in specific circumstances. 17 The Euro Area Government Bond Markets 3.4.1. Clearing and Settlement ment arrangements vary across countries (London Economics, 2005). LCH.Clearnet, for instance, pro- There is a broad consensus among European policy- vides clearing services to EuroMTS, MTS France, MTS makers that more efforts should be put into removing Belgium, MTS Amsterdam, MTS Associated Markets restrictions on clearing and settlement arrangements and MTS Deutschland. Cassa di Compensazione e in particular in terms of securities registration and tax Garanzia and LCH.Clearnet jointly provide clearing compliance. services to EuroMTS for Italian bonds. Transactions in Segmentation in the location of clearing and Austrian, Dutch, German, Finnish, Irish and Portuguese settlement systems has created inefficiencies in the government bonds and in quasi-government bonds are EU government bond market which are characterized settled either by Clearstream Banking Luxembourg or by a large number of cross-border transactions; the Euroclear Bank, while settlement services for trades in implementation of a euro area-wide clearing and Belgian, French, Greek, Italian, Spanish government settlement system has progressed only very slowly. bonds are provided by the National Bank of Belgium, The optimal market infrastructure solution for clearing Euroclear France, the Bank of Greece, Monte Titoli and settlement across the EU should basically cover S.p.A, and Iberclear respectively. the following areas: cost of service, stability, scalability Transnational initiatives aimed at integrating settle- and security, transparency of governance, removal of ment systems have been implemented. The merger of barriers to entry. Cedel with Deutsche Börse Clearing into Clearstream These issues have been tackled by various groups International which itself was taken over by Deutsche and/or institutions such as the Giovannini-Group19 and Börse AG in 2002 and the merger of Euroclear with the European Commission. In its report on "Cross- CBISSO and Sivocam into the Euroclear group should border Clearing and Settlement Arrangements in also be mentioned. the European Union" (Giovannini Group, 2001), the Giovannini-Group specified 15 barriers which impede 3.4.2. EU Transparency Provisions (MiFID) a more integrated and efficient clearing and settlement industry in the fields of market practice and/or regula- tion, legal certainty and taxation. The "Second Report MiFID was adopted in April 2004 by the European on EU Clearing and Settlement" (Giovannini Group, Council and Parliament and entered into effect on 2003) proposed a strategy and a timetable to remove November 1, 2007. MiFID transparency provisions these 15 barriers. Barrier 10, for instance, refers to re- entail – among others – the obligations for regulated strictions on the clearing and settlement activities of markets and multilateral trading facilities to publish the primary dealers and market makers in EU government bid-ask prices that are run through their trading bond markets. Yet EPDA20 does not consider Barrier systems, the price, volume and time of transactions 10 to be particularly burdensome in itself (see EPDA, as closely to real-time as possible. Transparency also 2006). covers pre- and post-trade prices at different order- In 2004, the European Commission prepared a book levels, for instance, the ex-post examination of the note to the European Council and to the European best execution price. Parliament entitled "Clearing and Settlement in the Equity and bond markets vary considerably as European Union: The Way Forward". Moreover, a far as their characteristics, investor base, holding standing group, the Clearing and Settlement Advisory patterns and market regulations are concerned, see the and Monitoring Expert Group (CESAME), was formed discussion in Casey and Lannoo (2005). The question to monitor progress in eliminating the 15 barriers and whether transparency requirements should be applied to provide further advice to the European Commission to the same or to a similar degree to bond and in the fields of clearing and settlement. CESAME is equity markets is currently discussed in official made up of financial experts and EU officials and has European fora. The Commission is expected to report organized regular meetings since 2004. to the European Council and Parliament on the Although the MTS group jointly controls the possible extension of the MiFID to non-equity markets various national MTS markets, clearing and settle- by March 2008. 19 The Giovannini Group is a group of financial market participants, under the chairmanship of Alberto Giovannini (chairman - Unifortune Asset Management SGR), which advises the European Commission on financial market issues. Formed in 1996, the Group's work focuses on identifying inefficiencies in EU financial markets and on proposing practical solutions to improve market integration. The Commission's Directorate-General for Economic and Financial Affairs provides the secretariat for the Group. Members of the Directorate-General for the Internal Market and of the ECB also participate in the Group's work. The Group has produced four reports. The first report on the impact of the introduction of the euro on capital markets was published in July 1997. It has been widely acknow- ledged as a driving force in forging a common approach to the re-denomination of public debt into euro and in establishing common bond market conventions for the euro area. Since then, the Group has published reports on the EU repo market, on coordinated public debt issuance in the euro area, and on EU cross-border clearing and settlement arrangements. 20 The European Primary Dealers Association (EPDA) is a division of the Bond Market Association and was formed 2004. 18 The Euro Area Government Bond Markets Compared to equity markets, more trading parency requirements would negatively impact occurs off-exchange and OTC in bond markets. Another liquidity and deter market participants from committing special aspect is that bond markets are quote-driven resources. Haas (2007) notes that while the introduc- and market makers risk their own funds for providing tion of TRACE is believed to be responsible for a sharp the liquidity. It is also worth mentioning that, compared decline in the profitability of corporate bond trading with equity markets, bond markets are characterized desks, it did not result in a notable decline in market by a higher degree of segmentation into B2B and B2C liquidity, and was accompanied by increased retail platforms. Moreover, in bond markets, investors tend investor participation. Casey and Lannoo (2005) men- to maintain a closer relationship with their dealers tion that in the U.S. the introduction of the TRACE than in equity markets, which makes dealer-to-client post-trade reporting system has reduced transaction trading inherently less transparent in bond markets, costs for retail investors who wanted to be directly see Dunne (2007). active in the markets. By contrast, the transaction costs The increasing shift of government bond trading to for institutional investors may have risen since most of electronic platforms that increases the speed and effi- the retail investments in bonds have been carried out ciency of information flows between the two segments through funds and funds generally transfer their could possibly also reduce the market quality. As could higher transaction costs to their clients by providing for example be the case where transactions between lower returns. dealers and customers become so widely known that the dealers would find it hard to get a good price in the interdealer segment. In other words, the more transpa- rent the dealer-to-customer segment, the more difficult it is for successful primary dealers to hedge their posi- tions in the interdealer segment. This could also lead to a disincentive for participation in government bond auctions. Excessive transparency in the interdealer segment could prevent customers from contacting their dealers which in turn would reduce the banks' market information from the liquidity demand side. In spring 2007 the ICMA responded to a request of the European Commission whether a market-led approach would provide a better solution to achieve adequate transparency than regulatory changes. ICMA (2007) reported that a majority of 92 respondents of a questionnaire preferred a "Price Service," which would involve publishing, at the end of the day, an average of the closing bid and ask quotes for each reportable security; and high, low and average prices for each bond trade reported to ICMA. A quarter of the ICMA respondents favored a "Single Trade Publication Ser- vice," which would involve publishing trades in large investment-grade bonds above a minimum level and below a specified upper size limit. Another quarter would prefer both publication venues. It is, however, important to note that views differed according to the impact of the "Single Trade Publication Service" on liquidity. Dunne et al. (2006b) report that – according to the interviews they carried out with market participants – transparency developments have led to a fall in per- trade profits available from trading and supplying li- quidity. Nevertheless, market participants were able to cope with the drop in trading profits by making use of improved information technology that reduced the costs of maintaining their market presence. The U.S. experience following the implementation of TRACE calls into question the concerns that trans- 19 A View from the Market 4. A View from the Market After having briefly described the structure of the collection and dissemination of information is relatively euro area primary and secondary government bond easy (see Inoue, 1999). markets, we turn to the detailed analysis of the que- In the United States government bonds are offered stionnaire we sent out to selected market participants by a single issuer. Hence, benchmark liquidity is higher (bond traders and research analysts) primarily located in the cash than in futures markets. In the euro area, in Frankfurt and London. The survey was conducted issuance is fragmented due to presence of different between June 2005 and January 2006. The questionnaire sovereign issuers. In contrast to the U.S.A., in the euro was primarily aimed at gathering opinions on possible area liquidity is higher in the futures markets determinants of bond yield spreads but it also compared to cash markets, in particular in the German covered various other aspects on government bond futures market. trading and bond price formation in the euro area For DMOs in the EU Member States, the use of government bond market. derivatives has become an important management Our analysis is based on 30 questionnaires. Re- tool in achieving their twin objectives of cost minimi- spondents carry the following job titles: 48% "chief zation and risk control. The use of interest rate swaps dealer/senior dealer", 10% "treasurer/manager", 10% has also made it possible for DMOs in the smaller euro "sales/senior sales", 19% of the respondents are " area countries to adjust the maturity of the outstanding researcher/strategist" and 13% "other", see figure 1. debt while benefiting from issuance in most liquid yield curve segments. 4.1. The Market and Its Players 4.1.2. Market Participants and their Interaction With respect to market participants' interaction in the interdealer market segment, inventory and order flow 4.1.1. Market Activity of Our Respondents play an important role: Hu and Stoll (1983) analyze the impact of inventory on trading behavior and conclude In our respondents' departments the daily turnover in that market makers with the largest long (short) the European government bond market is – on average, positions are most likely to be the first sellers (buyers). but not in each department – equally divided between Lyons (1997) analyzes market maker behavior under cash and derivatives markets. 51% of the respondents different order flow configurations and points out trade in the cash markets and 49.2% in the derivatives that a frequent selling of inventories to other dealers markets, see figure 2. Moreover, we asked our respon- ("hot potato" effect) leads to additional noise, thus dents about their average daily turnover shares in the reducing the information in interdealer trades, derivatives markets, differentiating between swaps, reducing the information content of prices and making futures and options. Note that although German and it more difficult for other dealers to derive the true French government bond yields are generally regarded price of a security. Menkveld, Cheung, de Jong (2004) as euro benchmark yields in the 10-yearr and 5-year also find evidence for an order flow effect on the price maturity spectrum, it is the euro interest rate swap formation in financial markets. According to Fleming yield curve that provides the most accurate euro bench- (2003), order imbalances have a strong positive mark yields. The majority of the purchases and sales in correlation with contemporaneous returns in the U.S. the derivatives markets occurred in the futures Treasury market. Theoretical foundations for the markets (59%), almost one third in the swap market impact of order imbalances on the formation of prices (29%) and a smaller percentage in the options market are termed "inventory effect" in the microstructure (12%), see figure 3. The overall degree of transparency literature, e.g. Spiegel and Subramanyam (1995) and is generally higher in the futures market than in the "portfolio balance effect" in the more macroecono- cash market. This may be because instruments are mic dominated literature, e.g. Cao, Evans and Lyons highly standardized and traded in exchanges where (2006). In this respect, we greatly benefited from the assistance of the Oesterreichische Nationalbank's (Austria's central bank) Section Treasury and the Oesterreichische Kontrollbank (OeKB). Two financial institutions submitted two questionnaires each, one submitted three. They were, however, filled out by different departments. We would like to thank all respondents from the financial institutions listed in appendix A. 20 A View from the Market Trading activity may have a different impact on on fundamental analysis", "undertaken for hedging bond prices depending on the prevailing market purposes", "based on chart analysis" or "based on tech- situation. In periods of high market activity the impact nical trading rules". The results, presented in figure 5, may be lower and less persistent than in periods of low show that "fundamental analysis" (34%) account for market activity. If a large player, i.e. a market maker, the largest share, followed by "chart analysis" (24%) intends to unwind a position, he may either accept and "technical trading rules" (16%). Transactions " another dealer's bid-ask spread, for instance in the undertaken for hedging purposes" encompass 20%. interbank market, or wait for his own bid-ask spread According to the answers to the question on to be accepted. competitive advantages of large versus small players, Hence, the costs for market-making are lower in 28% of our respondents named "a large customer base" periods of higher market activity when more players as the most important advantage, followed by "better in the interdealer and/or the dealer/customer segment market information" (22%) and "ability to deal in large are looking for transactions than in quiet periods when volumes" (15%), see figure 6. transactions are primarily based on interdealer These answers highlight the interdependence bid-ask spreads, see also section 2.2. The costs of of the banks' customer base with liquidity and market-making are also related to the correct anticipa- transparency. On the one hand, a large customer base tion of trade which highlights the importance of order is closely linked to better market information; on the flows in bond price behavior. If, for instance, dealers other hand, it is only an advantage in a regulatory correctly anticipate buying orders, they will also be setup where transparency is kept at a level that does able to anticipate customer transactions in the same not force a bank to reveal the complete order book. The direction and start buying in the interdealer market. In same argument with respect to the transparency level case market makers' guess goes into the wrong applies to the advantage of large banks "to deal in direction, they will have to adjust their own bid-ask large volumes". Banks with (large) open positions spread in order to correct their mistake. This can be could find it difficult to unwind these positions at good done more easily in periods of higher market activi- prices under certain market conditions. This would ty. Moreover, market makers who dispose of a bulk certainly apply to banks with a large customer base, of order flows are not forced to immediately exploit which are likely to build up higher inventories than banks their information, since the information obtained by a with a smaller customer base. As already mentioned in sufficiently large number of orders could prove to be section 2.3, higher transparency requirements would longer-lived information, in particular when there is not necessarily lead to higher customer welfare: Due to no market distress. Informed traders could distribute the risk of having built up large positions, banks could their information over a longer period of time with the reduce their participation in government bond trading. result of a larger net supply of liquidity, smaller As a consequence, liquidity in the secondary market bid-ask spreads and a smaller impact of trades on could dry up and spreads might increase as a smaller prices. number of dealers operate in the markets. In our questionnaire, we asked our respondents A large customer base might not only be about the percentage of euro government bond sales and/ important for dealers when distributing new issues or purchases either related to customer "flow business" in the secondary markets but also for primary market or proprietary trading. 49% of the total activity is issuers. DMOs that regularly issue new bonds have a related to customer "flow business" and 51% to vital interest that new issues are speedily and noise- proprietary trading, see figure 4. Customer business lessly absorbed by market participants, see also section clearly dominates the trading activities in six banks 3.1.2. As Dunne (2007) points out, for this sake, DMOs – the respective turnover amounts to 80% auf the total are heavily dependent on the services of primary turnover; proprietary trading dominates in five banks dealers. In turn, dealers that have a larger customer – the respective turnover amounts to 90% on average. base and/or clients with large investment volumes Customer business and proprietary trading is either are dependent on successfully bidding in primary equally distributed (six banks) or there is a slight market auctions or participation in syndicated auctions prevalence on customer business (five banks) or to meet the liquidity demands from their clients. proprietary trading (four banks). Because of the high competition among dealers at To find out the relative importance of fundamental primary auctions, new bond issues are frequently factors versus the weight dealers give to more market- concentrated on a small number of large dealers with driven factors (chart analysis or technical trading), we high market power. These dealers often have a large asked whether trading decisions were mainly "based customer base, since the safest way for individual This is one reason why issuers can easily impose obligations on dealers for primary market participation and liquidity supply in the B2B segment. A View from the Market customers to invest in new on-the-run issues is to stay 4.3. Determinants of Yield Spreads in close contact with a single primary dealer. This is all the more true for syndicated issues, which are frequently used by smaller sovereign European is- suers. Primary dealers that have been very active at Favero, Pagano, von Thadden (2007) raise the point bond auctions and in the secondary markets are that fundamental (credit) risk and liquidity risk, i.e. the frequently awarded lead management by DMOs, risk that a security has to be sold at an unexpected time thereby earning high fees that compensate them for of need or has to be bought at an unexpected time of over-bidding losses at the auctions, see section 3.1.2. wealth, interact with each other. The effect of this The lead managers and other syndication banks tend interaction on the yields depends on whether referring to distribute the new issues to those dealers that to current or future liquidity risks. They conclude that already have a large customer base. Smaller banks of- an increase in liquidity risk also leads to higher credit ten run short of new bond issues. risk effects. Ample future liquidity, however, would prompt market participants to invest in such liquid assets, even if the price of risk increases as credit risk has risen. Their theoretical analysis is supported by the results of the empirical part: They found liquidity 4.2. Yield Spreads in the variables (bid-ask spreads) to play a certain role in Euro Area – Stylized Facts bond yield spreads provided the interaction with fundamental risk is taken into consideration. Codogno et al. (2003) include an international risk German government bonds are usually regarded as factor, as measured by the spread between 10-year being the benchmark bonds in the 10-year maturity fixed interest rates on U.S. swaps and the yield on segment. As already mentioned in the introduction, 10-year U.S. bonds, into their empirical SURE model government bonds differ primarily in terms of the in order to explain bond yield spreads (versus German creditworthiness of the issuer, liquidity and the bonds). And they analyze whether several liquidity regulatory framework (clearing and settlement variables (bid-ask spread, trading volume, turnover procedures, tax treatment, etc.). Daily yield differentials ratios and trading intensity) can increase the explana- of 10-year euro area government bonds relative to tory power of international factors. The main finding Germany bonds are displayed in figure 7, figure 8 and of their analysis of daily data is that for most of the figure 9 for the period between 1999 and 2006. euro area countries under investigation "international Summary statistics are shown in table 5. They are risk factors" (measured by U.S. swap and corporate based on three different data sources frequently used bond spreads relative to U.S. Treasury yields) are more in empirical work (academic and policy oriented): BIS important for the determination of yield spreads than database, Reuters and Thomson Financial/Datastream. liquidity variables. At first glance, data series seem to behave in a very Geyer, Kossmeyer and Pichler (2004) reach similar way irrespective of the data base used. A closer similar results; they do not detect any impact of inspection of the data, displayed in figure 10, figure 11 liquidity variables (yield differentials between on-the- and figure 12, reveals surprisingly high and run and off-the-run issued, issue size) on the govern- unsystematic differences of the yield spreads with ment bond yields spreads in the euro area. regard to the data source used. As presented in In a related paper, Beber, Brandt and Kavajecz table 6, the differences between the three data sources (2007) study the yield spreads (relative to a common are approximately of the same order as the underlying Euro-LIBOR yield curve) and order flow for ten euro yield spread series itself. This is even more striking, area countries with active sovereign debt markets. as all respective data refer to the "10-year benchmark They document that the larger part of yield spreads is government bond". explained by differences in credit quality, although liquidity plays a certain role for low risk countries and during times of market distress. They conclude that credit quality is the driving force for bond valuation. In times of heightened market uncertainty, however, investors are primarily guided by liquidity considera- tions rather than credit risk. The question of how to define a benchmark bond is not unambiguous, see the discussion in Dunne, Moore and Porter (2007). The authors argue that in case of high current transaction costs, the negative price impact of an increase in credit risk is mitigated whereas in case of (expected) higher future transaction costs, when the security may have to be sold, illiquidity tends to enlarge the increase in credit risk. A View from the Market Brandner and Grech (2007) analyze the yield (future) tax rates", "current budget deficit", "implicit differentials of 10-year government bonds (spread pension liabilities", "debt levels", "future budget relative to Germany) for all euro area countries. deficit". All variables have a straightforward influence They used the bi-annual forecasts of the EU on the sustainability of public finances and therefore Commission and the OECD for the period 1999 to 2006. affect the risk of a country defaulting on government Within a SUR model (one equation for the EU debt. The ability to meet future financial obligations Commission forecasts and one for the OECD forecasts), depends very much on a country's current and, in they regressed the spread, measured as the average of particular, future displayed and hidden debt. Other 20 daily observations following the public announ- variables that might influence a country's credit risk cement of the forecast, on (expected) fiscal variables in the euro area, such as the current account, were not (budget balance, change of public debt), controlled for explicitly mentioned in our questionnaire but other influences like the business cycle or international included under "other". It is worth noting, however, risk factors (all variables defined relative to German). that although euro area bond markets have For most countries, they found a small but statistically experienced a considerable integration in the last significant effect of fiscal variables on the spread. years, credit ratings have remained heterogeneous. Since there is considerable variety in the evidence Italian and Greek government bonds, for instance, are of the literature on the driving forces behind these yield rated "A", Austrian, Dutch, French and German bonds differentials, we asked in our questionnaire whether "AAA", see section 3.1.1. respondents attributed the yield differentials to credit Our respondents rate "future budget deficits", risk, liquidity or regulatory factors. "debt levels" and "current budget deficit" as the The results are displayed in figure 13. All variables with the strongest influence on a country's respondents (100%) cited "credit risk factors" with an credit risk, see figure 14. Of these variables, "future average ranking of 1.3. Liquidity factors were cited by budget deficits" is supposed to be the most important 97% of the respondents with an average ranking of 1.8. one in terms of variations in the credit risk (97% of the Hence, liquidity factors also seem to be of considerable respondents, average ranking of 1.7). 70% of the importance for bond yield spreads, but appear to be respondents mention debt levels (average ranking slightly dominated by credit risk factors. Regulatory of 1.9) and 60% of the respondents quote the current factors play obviously a minor role; only 60% find that budget deficit (average ranking of 2.0). These three differences in the national regulatory framework have variables have received the highest attention and an impact on bond yields differentials, the average ran- are frequently reported in the daily financial press king being 2.9. (referring to stability programs, official forecasts, etc.) and hence, are known to market participants. The re- 4.3.1. Credit Risk maining factors ("implicit pension liabilities" and "ability to raise future tax rates") are less evident to market participants since they lack regular financial Differences in various country-specific macroeconomic reporting. Obviously, they are supposed to have a fundamentals (e.g. debt-to-GDP ratios, budget balan- minor impact on credit risk. ces) may have an impact on yield spreads in the euro Another approach to quantify the default risk area (see for instance Codogno et al., 2003). Economic premium is to analyze credit default swap (CDS) theory provides no clear answer to the effects of fiscal spreads which may provide some further information policy on (real) interest rates. Among other reasons, on the credit risk of different countries in the euro area.26 the effects depend on how forward-looking househol- Although the credit default swap market has grown ds and/or firms assess future tax liabilities. Empirical rapidly in the last years, only little empirical work on evidence is not clear cut either: Whereas the ECB (2006, credit default swap and bond yield spreads has been p.80) holds that variations of fiscal fundamentals have undertaken because of the short history of the CDS large effects on yield spreads, the empirical evidence in market history and the limited data availability. Most Balassone, Franco, Giordano (2004) raises some doubts of the empirical work covers the U.S. market, only a on such a strong relationship for the period since 1999. limited number of papers refers to European (corpo- In our questionnaire, we asked the respondents rate) bond markets. CDS retrieve their popularity from to name the three most important variables out of the the banks' and insurance companies' desire to hedge following five budgetary variables: "ability to raise their bond exposures and from hedge funds' and other 26 A credit default swap (CDS) is a specific kind of counterparty agreement which allows the transfer of third-party credit risk from one party to the other. One party in the swap is the lender or the protection buyer, facing credit risk from a third party. The counterparty, the CDS seller, agrees to insure this risk in exchange of regular periodic payments until the CDS matures or the credit event occurs. The periodic payments, the CDS spread, are defined as a certain percentage of the principal of the underlying contract. In theory, under certain conditions, the CDS spread should approximately equal the corresponding yield spread between the reference bond and a risk-free bond, see ECB (2006). If, for instance, the third party defaults, the protection seller will have to purchase the defaulted bond from the insured party. The insurer pays the insured the remaining interest on the debt as well as the principal. A View from the Market market participants' need for a liquid instrument to The Maastricht Treaty (Article 101) precludes direct speculate on credit risk.27 public debt financing by the ECB and by National Blanco, Brennan and Marsh (2005) find that Central Banks. Furthermore, Article 102 of the Treaty liquidity in the CDS market is higher than in the bond prohibits any measure that may establish privileged market, because price changes in the CDS market tend access to financial institutions for governments and to occur faster than in the bond market. Yet other papers community institutions or bodies. Markets should be like Berndt, Douglas, Duffie, Ferguson and Schranz able to assess the soundness of public finances without (2005), Longstaff, Mithall and Neis (2005) or Pan and being impaired by any legal contingency requirement Singleton (2007) prefer bond data as a more direct on a debt takeover or bailout by another euro area measure of default risk in their analysis because of the country or a community institution. The Maastricht lack of liquidity in the CDS market. According to BIS Treaty (Article 103) therefore stipulates that: (2003), in 2002 only 6% of quotes correspond to actual "The community shall not be liable for or assume the transactions; however, quotes are more than indicative, commitments of central governments (…). A member state since once submitted they are binding on participants.28 shall not be liable for or assume the commitments of central Zhu (2004) analyzes the long-term pricing accuracy governments (…)." in the CDS market relative to the bond market in the Article 103 is often referred to as the "no-bail-out U.S.A. by examining the underlying factors that clause". In a monetary union, however, there could be explain the price differentials. an incentive for one (or more) country (countries) to In our questionnaire, we asked our respondents for bail out another country, since financial distress in one their views on the relevance of CDS spreads when it country could put severe strain on the financial comes to adequately reflecting differences in the credit markets in the euro area as a whole. The credibility risk of government bond issuers. According to the of the "no-bail-out clause" is therefore an essential answers (see figure 15), 50% of the respondents believe element for the individual countries' credit risk to be that CDS spreads reflect differences in the credit risk fully reflected in their respective yield curves. while the other 50% hold the opposite opinion. 32% of Given that currently there are large differences in the respondents attributed the lack of information on the country-specific budget deficits and debt levels in the credit risk to the low liquidity in the CDS markets. the euro area, it is surprising that bond yield spreads show so little dispersion. Although yield differentials 4.3.2. Market Discipline are also affected by national regulatory and instituti- onal settings and tax rules, it is worth asking whether fiscal variables play a role in determining bond yield In general, market discipline is defined as a market spreads at all, or in other words, whether market mechanism that helps governments to keep their participants do no longer trust in the "no-bail-out- public debt at levels that market participants regard clause", as stipulated in the Maastricht Treaty. as sustainable. An increase in debt levels would be According to Balassone et al. (2004), the credibility evaluated as an increase in a country's credit risk and of the "no-bail-out" commitment remains an open thus market participants would demand a higher risk issue. In our questionnaire, we asked the respondents premium, i.e. higher interest rates. In other words, whether they agreed that the "no-bail-out" clause was sound fiscal policies would be rewarded and unsound credible or whether they disagreed. The majority of fiscal policies punished by the markets. our respondents (67%) answered "yes" and 33% ans- The ability of financial markets to assume such wered "no" which supports empirical evidence of ma- disciplinary role hinges on several factors (Lane, 1993; cro fundamentals influencing yield spreads (see figure ECB, 2006). The most important factors include a strict 16). The IMF (1997, p.192), however, concludes that "it legal framework in terms of government access to is unlikely that market participants will price sovereign debt financial markets and the exclusion of a "bail out"- as if it were corporate debt." mechanism. The legal framework should ensure that governments are not given preferential access to finan- 4.3.3. Liquidity Risk cial markets in order to finance their needs and that market participants are not obliged in any sense (directly or indirectly) to buy government bonds. As already discussed at the beginning of section 4.3, Furthermore, government bonds should not be recent empirical evidence in the literature suggests granted a more favorable tax treatment than private that liquidity variables exert only a minor influence on bond issues. bond yield spreads in the euro area (Pagano and von 27 Sovereign CDSs have the potential to supplement and increase efficiency in underlying sovereign bond markets (BIS, 2003). 28 The analysis is based on CreditTrade, one of the major trading platforms for credit derivatives. A View from the Market Thadden, 2004). As figure 17 displays, the bid-ask yield the possibilities of investors (especially pension funds spreads of the euro area government bonds remain sta- and insurance companies) to invest in foreign currency. ble below 2 basis points in the period between 1999 and Yet there are still differences in the clearing and settle- 2006, irrespective of country specific bonds. ment systems, tax regimes and market conventions. In our questionnaire, we proposed the factors In our questionnaire, we asked the respondents "bid-ask spread", "issue size", "quality of the repo to select the three most important factors in terms of markets", "existence of a derivatives market", "daily regulatory issues. The suggested options were "taxes", turnover", and "transaction volume"; then we asked "clearing and settlement", "costs of market presence" our respondents to identify the three most important and "other". The results are shown in figure 19. ones, which were "bid-ask spread", "issue size", "Clearing and settlement" was quoted by 87% of the "quality of the repo markets". Of these variables, 73% respondents (average ranking of 1.8). "Costs of market of the respondents selected "bid-ask spread" (average presence" was also quoted by 87%, the average ranking ranking of 1.6), 55% of these ranked "bid-ask spread" of 2.1 showing a slightly minor importance. Finally, first. 73% of the respondents chose "quality of the repo "taxes" was quoted by 76% (average ranking of 1.8). markets" (average ranking of 2.1). Yet only 18% of Interestingly, "clearing and settlement" seems to be these ranked it first, 55% second. The factor "issue more relevant than "taxes", although the latter receives size" is mentioned by 60% (average ranking of 1.9). As more attention in the public economic policy debate. regards the remaining factors, 40% of the respondents mentioned "existence of a derivatives market", 40% "daily turnover" and 20% "transaction volume". The results are displayed in figure 18. 4.4. Euro Area Government The answers of our respondents are in line with Bond Yields and Portfolio the empirical work of Fleming (2003). In this paper, the author measures liquidity in the U.S. Treasury market Management and finds that the commonly used bid-ask spread is the most informative tool for assessing market liqui- dity. According to his work, other variables such as quote and trade sizes are only "modest" measures and 4.4.1. Predictability of Interest Rates trading volume and frequency "poor" measures when assessing market liquidity. Predictability of asset returns is an active research It is interesting to compare our respondents' ans- topic in financial economics and econometrics. wers with the earlier discussed results of the question However, econometric research and empirical referring to the share of transactions undertaken in the evidence seem to suggest that financial asset returns cash and derivatives markets, see section 4.1.1. Institu- are at least to some degree predictable, see Campell, Lo tions which primarily deal in the derivatives markets and MacKinlay (1997). Structural aspects of securities overwhelmingly cite "bid-ask spread" as the most markets, frictions in the trading process and time- important liquidity factor, whereas financial varying expected returns as a consequence of changes institutions whose daily transactions occur predomi- in the business conditions can result in return nantly in the cash markets mention "bid-ask spread" predictability. A minimum of predictability seems to be and "issue size". indispensable for market participants as a reward for taking certain dynamic risks. 4.3.4. Regulatory Factors In our questionnaire we asked the respondents, if they thought that the market trend in the yield levels was predictable, ranging from "no predictability" to In most of the EU Member States restrictions of the "high" predictability. They had to distinguish between primary market clearing and settlement activities (see five different horizons: "intraday", "within one week", section 3.4) result either from formal and/or legal "within one month", "within six months" and "over six obligations to settle government securities transactions months". The results are presented in figure 20. While with only the local clearing system or from technical one would expect predictability to be higher for short difficulties when interlinking the local clearing and time horizons than for long time horizons, the settlement systems with systems located in other EU respondents' views on the forecasting horizon does not Member States. Similar problems exist in the secondary show a clear cut picture. markets, yet to a lesser extent. In a related question, we asked our respondents Some progress has been made: For example, the elimi- to name the most important factor(s) determining nation of several legal obstacles to cross-border trading, bond price movements according to different such as currency matching rules, which used to limit horizons: "short run (within days)", "medium run A View from the Market (within months)" and "long run (within years)". The cite "inflation" (average ranking of 2.0). Surprisingly, results are presented in figure 21. In the short run, much less weight was put on the announcements of "over-reaction to news", but also "chart analysis / tech real variables than on the announcements of mone- nical trading" and "speculative forces", albeit to a tary variables. Interestingly, only four respondents minor extent, seem to be the more relevant rationales. (13%) mention "budget deficits" with a weak average In the medium and even more so in the long run, ranking of 2.5. Obviously, certain fiscal fundamentals "economic fundamentals" is the most important factor, play a role in determining bond yields in the medium- clearly dominating all others. to long-term (e.g. relative creditworthiness of euro area government bonds, see section 4.3.1), but not in the 4.4.2. Impact of Announcements short-run trading activity. This is well in line with the results of the empirical literature that announcements of fiscal fundamentals are not supposed to have a large Economic announcements enable market participants impact on government bond prices. to learn about recent economic developments and help As also outlined in the short review of the them to adapt their expectations on the future course empirical literature in section 2.4, economic news is of macroeconomic variables. If markets are efficient, incorporated in bond prices within a very short period these announcements should influence bond markets, of time after its announcement. In our questionnaire since they represent unanticipated information on the we ask the respondents how fast they believe the state of the economy. Yet as macroeconomic announce- market incorporates new information into bond prices ments differ in terms of relevance, reliability and point when economic announcements differ from what the of release, they may exert a different influence across markets have expected. 80% of the respondents said the maturity spectrum of bond yield curves and across that unexpected news on the "central bank policy rate" international markets. would influence the bond market within "less than GDP and employment figures are frequently one minute" which is hence the predominate variable. regarded by market participants as essential leading Unexpected news on "retail sales", "GDP", "un- indicators for the future course of the economy. A employment rate", "industrial production", "business higher than expected GDP growth rate announcement climate indicator", "consumer confidence indicator" may point towards a stronger than expected upswing and "inflation" would be incorporated within "less of the short-term economic growth and may put than ten minutes", as also quoted by 80% of respon- upward pressure on real interest rates and inflation dents. For the other variables the picture is less clear expectations. Under this economic setting, central cut, see figure 23. banks would possibly react by raising monetary policy Interestingly, only few respondents assume that the rates. Despite the complex relationship between announcement of unexpected "budget deficit" news short-term interest rates – which are usually controlled actually has an impact on bond prices. If any, the by the central bank – and long-term interest rates, bond impact occurs not immediately after the announcement yields are likely to mount as well, in particular if the but after a longer period of time (more than central bank surprises the market. 30 minutes after the announcement). It seems that As already mentioned in the brief survey of the – at least for short-term trading activities – central empirical literature in section 2.4, the announcement bank policy decisions (and consequently inflationary of several macroeconomic variables is found to have expectations as a factor for the inflation term premium) an influence on bond prices. In general, fiscal funda- are more important than sustainability assessments mentals are not considered as impact variables. In our (reflected in the "budget deficit" as a determinant of questionnaire, we asked our respondents which of the the credit risk premium). economic announcements had an impact on the euro area government bond markets. The announcement variables comprised "central bank policy rate", "inflation", "money supply", "budget deficit", "unemployment rate", "consumer confidence indicator", "trade deficit", "GDP", "industrial production", "retail sales", "business climate indicator" and "political events/other". The results, displayed in figure 22, indicate that announcements of the "central bank policy rate" and "inflation" clearly dominate the other variables. More than 80% of the respondents quote "central bank policy rate" (average ranking of 1.3). More than 65% 26 Conclusions 5. Conclusions A further integration of the European government than banks with a smaller customer base. Due to the bond markets that leads to a full convergence of yields risk of having built up large positions, banks could would ascertain a more efficient allocation of funds. reduce their participation in government bond trading Moreover, properly functioning liquid government in case more transparency is enforced by regulatory securities' markets would contribute to the efficient authorities. As a consequence, liquidity could dry up conduct of the ECB's open market transactions. Finan- and spreads could increase as a smaller number of cial institutions are only able to raise liquidity in liquid dealers operates in the markets. As a conclusion, and deep financial markets without having to take higher transparency requirements would not necessa- recourse to the central bank as a lender of last resort. In rily lead to higher customer welfare. addition, bond yields embody relevant information on Since there is considerable variety in the evidence the future course of the economy in terms of inflation of the literature on the driving forces behind yield expectations and/or variations in economic activity. differentials, our main interest has been whether Following the introduction of the euro in 1999, all participants attribute the yield differentials to credit euro area government bonds should have been traded risk, liquidity or to regulatory factors. All respondents along the same yield curve. Yet in the first eight years cited "credit risk factors" with a very high ranking. of EMU, they have exhibited considerable and volatile They rated "current budget deficit", "future budget spreads vis-à-vis German government bonds. These deficits" and "debt levels" as having the strongest spreads could either be due to differences in credit and/or influence on a country's credit risk. The majority of liquidity risk or to differences in the regulatory and/ our respondents (67%) trust in the credibility of the or institutional framework. In order to analyze yield "no-bail-out" clause. This supports empirical evidence spreads in the euro area government bond market, we of macro fundamentals influencing yield spreads. sent out a detailed questionnaire to market participants Liquidity factors also seem to be of substantial impor- who are actively involved in the euro area government tance for bond yield spreads, but appear to be slightly bond market as bond traders or research analysts. dominated by credit risk factors. Regulatory factors In the first part of the paper, a brief description of obviously play a minor role; only 60% of the respon- the structure of the euro area primary and secondary dents find that differences in the national regulatory government bond markets shows that the different framework have an impact on bond yields differentials legal and institutional settings of the national capital with a rather low average ranking. With respect to markets still prevent euro area capital markets from regulatory issues, "clearing and settlement" and "costs representing a full-fledged homogeneous euro area- of market presence" seem to be more relevant than wide capital market. "taxes", although the latter receives more attention in In the second part of the paper, we turn to the the public economic policy debate. detailed analysis of the questionnaire. We present Economic announcements should influence bond results on the relative importance of fundamentals markets, since they represent unanticipated infor- versus market-microstructure related variables as mation on the state of the economy. According to the determinants of the observed yield spreads. The empirical literature, the announcement of several respondents of our questionnaire were – more or less macroeconomic variables has an influence on bond to the same extent – active in customer "flow business" prices, but in general, fiscal fundamentals are not and proprietary trading. When taking a closer look at considered as impact variables. In our questionnaire proprietary trading, the majority of banks focus on the majority of our respondents cited "central bank short-term activities ("trading"), whereas medium- to policy rate" and "inflation", whereas only few respon- long-term activities ("strategic") are also quite impor- dents assumed that the announcement of unexpected tant – to a minor extent though. "budget deficit" news actually had an impact on bond In general, the analysis of the questionnaire prices. Obviously, certain fiscal fundamentals play highlights the importance of the banks' customer base a role in determining bond yields in the medium- to for the bond markets in terms of liquidity and trans- long-term, but not in short-run trading activity. parency. On the one hand, a large customer base leads to better market information, but on the other hand, it is only an advantage in a setup where transparency is kept at a certain level which does not force a bank to reveal the complete order book. 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Appendix A Appendix A: Participating Financial Institutions List of participating financial institutions (in alphabetical order) ABN Amro Bank N.V., Frankfurt Bank of Amerika, London Barclays Bank PLC, London BNP Paribas, London Commonwealth Bank of Australia, London Commerzbank, Frankfurt Credit Suisse First Boston, London DekaBank, Frankfurt Deutsche Bank AG, Frankfurt Dresdner Kleinwort, Frankfurt DZ Bank, Frankfurt Goldman Sachs, London HypoVereinsbank, München ING Bank N.V., Amsterdam IXIS Corporate & Investment Bank, Paris J.P. Morgan Securities Ltd., London Morgan Stanley, London Nomura, London Nordea, Kopenhagen Norges Bank, Olso Pioneer Investments Management Ltd., Dublin Svenska Handelsbanken, Stockholm The Bank of Nova Scotia, London Toronto Dominion Bank, London Royal Bank of Canada, London UBS, London Appendix B Appendix B: Tables Table 1 Gross issuance of euro-denominated bonds in billion € 1999 2000 2001 2002 2003 2004 2005 2006 Total 1.399.843 1.297.087 1.471.137 1.470.954 1.767.235 1.750.862 1.719.214 1.873.449 of which Central G overnm ent 619.763 600.882 633.888 700.129 779.565 769.773 674.296 681.653 Loc al G overnm ent 11.769 17.935 36.627 42.879 45.031 38.535 50.532 42.013 A genc ies and S upranationals 59.498 51.093 62.677 68.137 87.010 86.020 83.904 81.817 O ther Is s uers 708.813 627.177 737.945 659.809 855.629 856.534 910.482 1.067.966 S o u rce : C o m m is s io n S e rvice s (D G E C FIN d a ta b a s e o n e u ro -d e n o m in a te d b o n d s ). Table 2 Gross issuance of euro-denominated government bonds and rating*) 1999 2000 2001 2002 2003 2004 2005 2006 in billion € Total 619.763 600.882 633.888 700.129 779.565 769.773 684.796 681.653 of which AAA 241.343 242.846 243.808 308.826 376.296 381.227 381.111 372.755 AA 357.868 335.953 358.501 359.098 362.559 345.913 256.653 269.661 A 1.080 3.600 18.154 27.042 30.526 35.158 39.050 35.405 BBB 4.175 2.575 3.400 2.050 5.550 2.750 1.100 750 BB 8.914 8.825 4.600 810 700 1.350 150 2.282 B 6.383 7.083 5.425 2.303 3.934 3.375 6.732 800 in percent Total 100,0 100,0 100,0 100,0 100,0 100,0 100,0 100,0 of which AAA 38,9 40,4 38,5 44,1 48,3 49,5 55,7 54,7 AA 57,7 55,9 56,6 51,3 46,5 44,9 37,5 39,6 A 0,2 0,6 2,9 3,9 3,9 4,6 5,7 5,2 BBB 0,7 0,4 0,5 0,3 0,7 0,4 0,2 0,1 BB 1,4 1,5 0,7 0,1 0,1 0,2 0,0 0,3 B 1,0 1,2 0,9 0,3 0,5 0,4 1,0 0,1 *) S tandard& P oor's S ourc e: C om m is s ion S ervic es (D G E C F IN databas e on euro-denom inated bonds ). Appendix B Table 3 Characteristics of MTS Markets for Euro Government Bonds Number of Primary Market Government Securities Dealers Makers Dec. 2004 Dec. 2005 Dec. 2006 A ustria (at) 25 22 18 14 14 B elgium (be) 16 21 48 51 48 F inland (fi) 14 21 8 9 8 F rance (fr) 20 22 162 172 154 G erm any (de) 32 30 59 61 57 G reece (gr) 21 23 22 24 24 Ireland (ie) 9 12 5 5 5 Italy (it) 23 29 90 94 86 N etherlands (nl) 13 13 31 33 29 P ortugal (pt) 15 18 20 21 44 S pain (es) 20 24 110 122 115 *) M a rke t p a rticip a n ts, n o o fficia l P rim a ry D e a le rs. S o u rce : M TS G ro u p (2 0 0 7 ). Table 4 Domestic MTS and EuroMTS Markets Domestic MTS Market EuroMTS Market EuroMTS Market euro-denominated bonds, € billion, single counted in per cent of total MTS Market Dec 2004 Dec 2005 Dec 2006 Dec 2004 Dec 2005 Dec 2006 Dec 2004 Dec 2005 Dec 2006 Austria 38.425 32.115 24.517 10.963 8.305 4.948 22,2 20,5 16,8 Belgium 177.212 178.213 126.913 20.463 16.128 7.993 10,4 8,3 5,9 Finland 78.669 57.003 36.506 16.178 13.501 5.720 17,1 19,1 13,5 France 172.910 212.811 152.601 38.123 37.729 19.156 18,1 15,1 11,2 G erm any 130.241 143.271 126.725 28.938 31.792 27.160 18,2 18,2 17,6 G reece 139.825 100.441 57.524 61.801 38.805 16.548 30,7 27,9 22,3 Ireland 6.535 5.538 5.552 5.763 5.463 3.110 46,9 49,7 35,9 Italy 1.918.116 1.595.838 1.635.754 97.303 89.398 75.803 4,8 5,3 4,4 Netherlands 84.988 79.673 66.198 11.675 7.783 8.478 12,1 8,9 11,4 Portugal 135.760 146.690 127.440 20.449 15.571 12.367 13,1 9,6 8,8 Spain 99.337 101.415 86.274 47.683 24.570 11.339 32,4 19,5 11,6 Source: MTS G roup (2007). 36 Appendix B Table 5 Yield differentials relative to Germany (in bps) 1/1/1999 to 31/12/2006 at be es fi fr gr ie it nl pt Reuters M ean: 13.53 17.25 12.82 11.23 7.38 53.55 3.70 24.58 7.96 20.08 S tdev: 11.42 11.99 12.03 10.84 5.25 53.26 11.96 8.42 6.76 12.89 FT Datastream M ean: 12.22 15.87 12.54 7.93 7.92 46.57 4.25 24.26 7.49 19.34 S tdev: 11.92 12.55 12.96 12.86 6.97 45.52 12.15 8.90 7.07 14.45 BIS Database M ean: 15.10 18.45 14.60 16.96 8.56 55.34 12.47 25.96 8.70 20.72 S tdev: 10.66 11.17 11.38 169.98 5.10 52.45 11.68 7.71 6.51 11.54 1/1/1999 to 31/12/2002 at be es fi fr gr ie it nl pt Reuters M ean: 23.61 27.84 23.84 20.98 11.87 85.79 13.78 30.06 13.83 31.21 S tdev: 6.67 6.73 6.26 3.68 3.07 59.65 5.23 7.01 2.89 7.38 FT Datastream M ean: 22.43 26.97 24.51 18.95 12.92 75.85 14.24 30.34 13.19 30.69 S tdev: 6.81 7.34 6.49 7.38 5.73 50.76 5.71 6.90 4.14 10.54 BIS Database M ean: 23.62 28.16 24.91 22.47 11.77 86.91 22.83 29.84 13.69 30.09 S tdev: 6.83 6.68 6.39 3.25 4.30 59.01 5.61 7.84 4.12 7.65 1/1/2003 to 31/12/2006 at be es fi fr gr ie it nl pt Reuters M ean: 3.46 6.66 1.80 1.48 2.90 21.34 -6.38 19.09 2.10 8.96 S tdev: 3.67 4.24 2.74 5.60 2.31 6.41 7.47 5.72 3.74 5.50 FT Datastream M ean: 2.02 4.78 0.57 -3.07 2.92 19.11 -5.73 18.18 1.80 8.00 S tdev: 5.43 3.84 2.71 5.83 3.79 6.52 7.96 6.09 4.24 7.03 BIS Database M ean: 6.68 8.79 4.39 11.48 5.37 23.84 2.00 22.11 3.76 11.36 S tdev: 6.11 4.12 2.81 240.24 3.62 5.90 4.93 5.27 4.29 5.71 37 Appendix B Table 6 Differences of yield differentials relative to Germany (in bps) 1/1/1999 to 31/12/2006 at be es fi fr gr ie it nl pt FT Datastream-Reuters M ean: -1.31 -1.38 -0.28 -3.29 0.54 -1.63 0.55 -0.31 -0.47 -0.74 S tdev: 4.97 3.93 3.56 7.08 4.56 5.61 3.38 3.35 3.42 7.96 BIS Database-FT Datastream M ean: 2.89 2.63 2.09 9.01 0.66 3.62 8.10 1.69 1.22 1.32 S tdev: 4.90 3.91 3.64 170.18 5.07 5.83 6.20 4.48 1.90 8.30 BIS Database-Reuters M ean: 1.59 1.20 1.81 5.70 1.17 1.90 8.63 1.39 0.75 0.55 S tdev: 4.63 2.22 3.20 169.71 3.58 3.06 6.66 3.89 3.82 3.91 1/1/1999 to 31/12/2002 at be es fi fr gr ie it nl pt FT Datastream-Reuters M ean: -1.18 -0.87 0.67 -2.04 1.05 -0.99 0.46 0.28 -0.65 -0.52 S tdev: 3.80 2.76 3.00 5.91 5.05 6.46 3.51 2.80 3.14 9.39 BIS Database-FT Datastream M ean: 1.12 1.23 0.34 3.42 -1.15 2.43 8.51 -0.56 0.50 -0.71 S tdev: 2.73 2.69 2.67 5.85 5.24 6.45 3.90 3.27 1.32 9.17 BIS Database-Reuters M ean: -0.06 0.26 0.99 1.40 -0.15 1.26 8.93 -0.28 -0.18 -1.25 S tdev: 3.77 1.94 3.23 2.57 3.46 3.66 5.00 4.02 3.34 3.79 1/1/2003 to 31/12/2006 at be es fi fr gr ie it nl pt FT Datastream-Reuters M ean: -1.44 -1.88 -1.23 -4.55 0.02 -2.22 0.65 -0.91 -0.30 -0.96 S tdev: 5.92 4.78 3.82 7.88 3.94 4.60 3.25 3.74 3.68 6.22 BIS Database-FT Datastream M ean: 4.66 4.03 3.82 14.59 2.46 4.74 7.69 3.92 1.93 3.34 S tdev: 5.85 4.40 3.66 240.47 4.18 4.92 7.85 4.42 2.11 6.77 BIS Database-Reuters M ean: 3.23 2.14 2.62 10.00 2.48 2.53 8.33 3.05 1.66 2.35 S tdev: 4.82 2.07 2.97 239.91 3.20 2.13 8.00 2.92 4.04 3.13 38 Appendix C Appendix C: Figures Figure 1 You are currently working as re s e a rc h/ o the r s tra te gis t 13% 19% s a le s / s e nio r s a le s 10% tre a s ure r/ ma na ge r c hie f/s e nio r 10% de a le r 48% Figure 2 In your department, the daily turnover in European government bond trading activity takes place in the derivatives cash m ark et m ark et 50.8% 49.2% 39 Appendix C Figure 3 The share of average daily turnover in the derivatives market (with respect to European government bonds) options 12% sw aps 29% futures 59% Figure 4 The percentage of European government bond sales/purchases related to s ho rt te rm "tra ding" 28% c us to me r "flo w pro prie ta ry bus ine s s " tra ding 49% 51% me dium to lo ng te rm "s tra te gic " 23% 40 Appendix C Figure 5 Trading of European government bonds is based on / undertaken for others 6% technical trading rules 16% fundam ental analysis 34% hedging purposes 20% chart analysis 24% Figure 6 Select the three most important (competitive) advantages of large players – compared to small players – in the European government bond markets a large custom er base 28 better m arket inform ation 22 ability to deal in large volum es 15 low er operating costs 8 prim ary dealership 7 experienced traders 7 accessibility to global trading platform s 6 ability to offer new structured products 3 ability to influence bond prices 1 access to repo m arkets 0 relation betw een front- and back office 0 sm aller counterparty risks 0 other 2 0 % 5 % 10 % 15 % 20 % 25 % 30 % Appendix C Figure 7 Yield (10Y) differential relative to G erm any (D E ) / S ourc e: R euters AT BE ES FI 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 FR GR NL IE 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 IT PT 50 50 40 40 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 Figure 8 Yield (10Y) differential relative to G erm any (D E ) / S ourc e: T hom s on F inanc ial (D atas tream ) AT BE ES FI 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 FR GR NL IE 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 IT PT 50 50 40 40 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 Appendix C Figure 9 Yield (1 0 Y) differe ntia l re la tive to G e rman y (D E) / BIS D a ta b ase AT BE ES FI 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 FR GR NL IE 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 IT PT 50 50 40 40 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 Figure 10 Difference of benchmark (10Y) yield differential relative to G ermany (DE) / T homson F inancial (Datastream)- Reuters AT BE ES FI 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 FR GR NL IE 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 IT PT 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 Appendix C Figure 11 D iffe ren ce o f b ench m a rk (1 0Y) yie ld diffe re ntial re la tive to G e rman y (D E) / BIS D a ta ba se - R e u ters AT BE ES FI 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 FR GR NL IE 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 IT PT 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 Figure 12 D iffe re n ce o f b e n ch m a rk (1 0 Y ) yie ld d iffe re n tia l re la tive to G e rm a n y (D E) / BIS D a ta b a se - T h o m so n F in a n cia l (D a ta stre a m ) AT BE ES FI 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 FR GR NL IE 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 -30 -30 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 IT PT 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1999 2000 2001 2002 2003 2004 2005 2006 1999 2000 2001 2002 2003 2004 2005 2006 Appendix C Figure 13 In th e in teg rated E u rop ean cap ital m arket, g overn m en t b on d s (eu ro area) are su p p osed to b e p erfect su b stitu tes. D ifferen ces in p rices are m ain ly d u e to: P lease ran k th e top 3 ("1"-"2"-"3"). 25 1 ,0 1,3 1 ,2 20 1 ,4 1,8 number of namings (bars) 1 ,6 "average" ranking (line) 15 1 ,8 2 ,0 10 2 ,2 2 ,4 5 2 ,6 2,9 2,9 2 ,8 0 3 ,0 credit risk factors liquidity factors regulatory factors other # o f "1 " # o f "2 " # o f "3 " Ø Figure 14 W ith resp ect to cred it risk, w h at are th e th ree m ost im p ortan t factors? P lease ran k th e top 3 ("1"-"2"-"3"). 14 1 ,0 1 ,2 12 1 ,4 numbe rof namings (bars) "average" ranking (line) 10 1 ,6 1,7 1,9 1 ,8 8 2,0 2 ,0 6 2,4 2 ,2 2,5 4 2 ,4 2 ,6 2 2 ,8 0 3 ,0 future budget debt levels current budget ability to raise implicit pensions other deficit deficit (future) taxes liabilities # o f "1 " # o f "2 " # o f "3 " Ø Appendix C Figure 15 Do you think that credit default swap (CDS) spreads adequately reflect differences in the credit risk of European government bond issuers in the euro area? no because of low liquidity 32% yes no 50% 51% no because of other reasons 18% Figure 16 T h e M aastric ht treaty contains a "no bail-out clause", w hich m eans E M U participants are not liable for another participant's debt. Do you believe the "no-bail-out clause" to be credible? no 33% yes 67% 46 Appendix C Figure 17 B id-a s k s pre a d (bp y ie ld), 1 0 y 3 .0 2 .5 AT 2 .0 BE DE ES 1 .5 FR NL 1 .0 IE IT 0 .5 PT 0 .0 1999 2000 2001 2002 2003 2004 2005 2006 Figure 18 W ith resp ect to liq u id ity, w h at are th e th ree m ost im p ortan t factors? P lease ran k th e top 3 ("1"-"2"-"3"). 14 1 ,0 1 ,2 12 1 ,4 1,6 number of namings (bars) "average" ranking (line) 10 1 ,6 1,9 1,8 1 ,8 8 2,1 2 ,0 6 2,4 2 ,2 2,3 2 ,4 4 2 ,6 2 2 ,8 0 3 ,0 bid-ask spread quality of the issue size existence of a daily turnover transaction other repo markets derivatives volume market # o f "1 " # o f "2 " # o f "3 " Ø 47 Appendix C Figure 19 With respect to regulatory issues, what are the three most important factors? Please rank the top 3 ("1"-"2"-"3"). 12 1 ,0 1 ,2 10 1 ,4 number of namings (bars) 1 ,6 "average" ranking (line) 8 1,8 2,1 1,8 1 ,8 6 2 ,0 2 ,2 4 2 ,4 2 ,6 2 3,0 2 ,8 0 3 ,0 clearing and settlement costs of market presence taxes other # o f "1 " # o f "2 " # o f "3 " Ø Figure 20 If you believe the market trend in the level of yields is predictable, please assess the predictability for each horizon. ("1" indicates no predictability, "5" indicates high predictability) (average displayed below ) w ithin one m onth: intra day: 2.3 2.7 w ithin six m onths: 2.3 w ithin one w eek: 2.7 over six m onths: 2.5 48 Appendix C Figure 21 What is (are) the single most important factor(s) that determines (determine) bond price movements in each of the three horizons listed? sh o rt ru n m e d iu m ru n 100 % 100 % 90 % 90 % 80 % 80 % 70 % 70 % 60 % 60 % 50 % 50 % 40 % 40 % 30 % 30 % 20 % 20 % 10 % 10 % 0 % 0 % E conom ic C hart B andw agon O v er-reaction S peculativ e O ther E co no m ic C ha rt a na lyse s B a nd w a go n O v e r-re a ctio n S pe cula tiv e O the r fundam entals analyses / effects to new s forces fund a m e nta ls / te chnica l e ffe cts to ne w s fo rce s technical tra d ing trading lo n g ru n 100 % 90 % 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 0 % E co no m ic C ha rt B a nd w a go n O v e r-re a ctio n S pe cula tiv e O the r fund a m e nta ls a na lyse s / e ffe cts to ne w s fo rce s te chnica l tra d ing Figure 22 In yo ur o p inio n, whic h o f the fo llo wing e c o no m ic anno unc e m e nts have a larg e im p ac t o n the E uro p e an g o ve rnm e nt b o nd m arke t(s )? P le as e rank the to p 3 ("1 "-"2 "-"3 "). 20 1,0 18 1,2 1,3 number of namings (bars) 16 1,4 "average" ranking (line) 14 1,6 12 1,8 2,0 2,0 10 2,0 2,3 2,2 8 2,2 2,5 2,5 2,5 2,3 6 2,4 4 2,6 2,7 3,0 3,0 2 2,8 0 3,0 P y n s it or er er it r te te pl to D le tio fic ic th th at ra ra G p sa ca ef fla de ic su /o /o y t d di en d il ts ts lic in e et ta ey in in en en d m po dg re on tra e ce oy ev ev at bu k m en pl im an al al em fid ic ic cl lb lit lit n un s ra co es po po nt n er ce si m bu n su co # o f "1 " # o f "2 " # o f "3 " Ø 49 Appendix C Figure 23 How fast do you believe the market incorporates new information into bond prices when the following economic announcements differ from what the markets have expected? c e n tra l b a n k p o licy ra te re ta il sa le s GDP u n e m p lo ym e n t rate 100 % 100 % 100 % 100 % 80 % 80 % 80 % 80 % 60 % 60 % 60 % 60 % 40 % 40 % 40 % 40 % 20 % 20 % 20 % 20 % 0 % 0 % 0 % 0 % less than less than less than ov er less than less than less than ov er less than less than less than ov er less than less than less than ov er 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in in d u s tria l p ro d u ctio n b u s in e s s clim a te in d ica to r consum er confidence indicator in fla tio n 100 % 100 % 100 % 100 % 80 % 80 % 80 % 80 % 60 % 60 % 60 % 60 % 40 % 40 % 40 % 40 % 20 % 20 % 20 % 20 % 0 % 0 % 0 % 0 % less than less than less than ov er less than less than less than ov er less than less than less than ov er less than less than less than ov er 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in m o n e y s u p p ly tra d e d e ficit b u d g e t d e ficit p o litic a l e v e nts/o th e r 100 % 100 % 100 % 100 % 80 % 80 % 80 % 80 % 60 % 60 % 60 % 60 % 40 % 40 % 40 % 40 % 20 % 20 % 20 % 20 % 0 % 0 % 0 % 0 % less than less than less than ov er less than less than less than ov er less than less than less than ov er less than less than less than ov er 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 1 m in 10 m in 30 m in 30 m in 50 The Authors 6. The Authors Peter Brandner is Senior Adviser in the Directorate General for Economic Policy and Financial Markets at the Federal Ministry of Finance, Austria. Previously he was Economic Adviser to the Austrian Minister of Finance, Research Associate at the Austrian Institute of Economic Research (WIFO) and the Institute for Advanced Studies (IHS), Vienna, and Assistant Professor at the University of Vienna, and worked as an economist at the Oesterreichische Nationalbank. His research areas and publications cover, among other things, monetary and fiscal policy, and financial markets. He serves as an expert to the Government Debt Committee. Harald Grech is an expert in the European Affairs and International Financial Organizations Division of the Oesterreichische Nationalbank (OeNB). Previously he worked in the Treasury and the Economic Studies Division of the OeNB. His research areas and publica- tions are related to exchange rate economics and finan- cial markets. Kamran Kazemzadeh previously worked as a lawyer and as a compliance officer in an international investment bank in London. Later on he joined the Economic Policy Division of the Federal Ministry of Finance in Vienna. He has worked in several fields of macro and micro policies, including globalisation issues and financial services. Currently he is on leave. Literatures The Working Paper Series: Arnd Einhaus, Edith Kitzmantel, Anton Rainer (2006). Ist die Einkommensbesteuerung geschlechtsneutral? Working Paper 2/2006. Verena Farré Capdevila, Ulrike Mandl (2007). Europäische Wirtschaftspolitik: Die Integrierten Leitlinien 2008- Kurt Bayer (2006). Growth and Employment through 2011. Working Paper 6/2007. Innovation. Working Paper 1/2006. Wolfgang Nitsche (2007). Die Europäische Investitions- Ulrike Mandl (2005). Stand und Entwicklung ausge- bank in der EU und in Drittstaaten: Wirtschafts- wählter Bereiche der wissensbasierten Wirtschaft in politische Einschätzung und Strategieoptionen. 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