The role of securities in the execution of monetary policy

Written by Athanasios I. Patsikas

Lawyer (LLM)

Monetary policy refers to the actions taken by the monetary authorities to affect the supply and cost of money and credit1. It is the strategic cornerstone on which States or International Organizations base the economic balance wanted, in order to achieve price stability and fight inflation. The ultimate target for monetary policy is for the purchase power of money to be protected. In other words money is not supposed to lose its value, so that economy can function properly. A stable currency consists of three pillars: a) value, b) durability, c) consistency. If these standards are met we might talk about price stability or about what the currency buys, the case being that the same quantity of goods and services bought today is the same as tomorrow. This fundamental task-art has been attributed to central banks. They have to monitor the economic activity through accurate and timely statistics for trade, employment, investment production and to determine if the economy needs more or less money flow. So money supply is the “raison d’ etre” of monetary policy. This money supply policy is exercised through market operations, known as consensual transactions which rely on the pricing of financial assets such as bonds and loans to increase or decrease money flow. What the case appears to be is that the dna chain code of these transactions contains the element of securities, on which the financial and economic reality is based. This is the topic of the present essay. It deals with the inextricable connection between monetary policy and securities and the legal aspects of how the first is exercised through the latter.

We have to admit a very important position concerning money circulation and financing. Money (almost) never moves physically. It is an adjustment of contractual liabilities between the banks that takes place. It is not tangible money (notes or coins) but digitally accounted money in the form of securities. The intermediation system in the (investment) securities market is the instrument that has eliminated the need for paper transfer as soon as all these transactions are recorded electronically. As a consequence, the phenomena of immobilization and dematerialization came to play the most significant role in the game of monetary standards, as they placed liberalization of capital movements in a much more solid finance base.

The view that the central bank should conduct a-price-stability-orientated monetary policy was forcefully advocated by Volcker: “The vacuous admonition that a monetary authority be all things to all men-for growth, full employment and stability-risks confusion and misunderstanding of what a central bank can really do”. Previous requirement of that is to have sound public finances. This happens by the time the State can acquire bond market access. In fact, corporations or governments finance their activities by issuing stocks or bonds which are purchased directly from the issuing corporation or public entity. This is considered as primary market which provides investors their first chance to purchase a new security (initial public offering-IPO)2. Once the securities are sold to the public through the primary market, any subsequent sales of bonds takes place in secondary markets, such as NASDAQ or New York Stock Exchange3.

The practice that the ECB follows to accomplish its goal to avoid inflation by ensuring the stability of the value of the currency is very enlightening. It may accomplish that in the following ways:

A) By regulating the supply of currency to the real economy, in a way to maintain the equilibrium between money supply and economic activity (sales of goods, production, services, and investments). When the economic activity rises, the ECB will open the liquidity tap and channel money to the real economy. When the economic activity drops, the ECB will remove money from the real economy. Obviously it cannot violently force people to return the money to the ECB.

B) By involving itself in market operations, the ECB offers incentives through the banking system and with the use of financial assets (bank deposits, bonds, stocks-securities). For example, if the ECB wishes to remove money from the real economy, it will offer the National Central Banks a 1% interest rate to transfer their deposits to the ECB, so that the bank will prefer that compared to giving loans with 0,5% rates. On the other hand if the ECB now wishes to channel money to the real economy, it will offer the National Central Banks 0,1% interest rate, in order to push the bank to opt for giving loans with the 0,5% rate.

As far as loans in exchange of liquidity is concerned, the National Central banks become creditors of the borrowing institutions and holders of security rights in full title to any assets offered as collateral4. The security rights remain with the NCB at least until maturity of the loan and usually longer as the assets frequently serve as collateral for future operations5.

Another example is through bonds – as in the first case, the ECB will issue a bond with a very lucrative rate so that the National Bank will buy it – in the second case, the ECB will buy a bond from the National Central Bank. The whole operation falls within the scope of the Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements6.

Markets’ operations are also conducted through repurchase (repos) and securities lending transactions7. If a bank needs money to, either give loans to businesses (good scenario) or to pay depositors who want to withdraw their money (bad scenario), creates a portfolio of financial assets (for example 100 loans) pricing it 3 million euro. The ECB will buy the portfolio at the price of 2,8 million. The above bank now has the money supply needed. On maturity date, the repo will either be renewed (if the ECB wants to increase the liquidity in the real economy) or the bank will buy the portfolio back (if the ECB wants to reduce liquidity), especially by the time that the ECB observes that there is the risk of inflation (more than 2%).

The ECB only provides “incentives” on a consensus basis and does not “force” these transactions. A monetary policy that would unilaterally exercise its sovereign power in order to transact would be unthinkable and considered as some sort of taxation, leading to the reduction of the internal value of the currency (who could imagine a Government saying that “for every 100 euros you have, 10 euros are confiscated”). As a result, when it comes to monetary operations, the NCBs act as “branches” of the ECB.

On the contrary we must not forget that since monetary practice has been transferred from the political influence scope into the independent technocrats-specialists field8, the monetization of government debt is strictly prohibited. For example, article 125 TFEU sets the so-called “no bail out” clause with the meaning that the European Central Bank cannot buy government bonds in order to finance the debt of a Member State. The ECB cannot finance Governments. It may only provide indirect support by offering guarantees to potential investors who are allowed to purchase bonds of a country, by promising that should the investor wish to get rid of the bonds at a given time, the ECB will buy them at the same price the investor bought it, as long as the country has sound and sustainable public finances, even within the framework of a Memorandum of Understanding. In other words, the ECB cannot lend directly to any public entity of any government because if it acts so, mathematically the increasing money supply will cause inflation. It can only guarantee European bonds so that the government bonds in Europe can be purchased in the market in a low interest rate the case being that the traders feel confident and they do not seek to be paid immediately.

Even, in that situation of debt-crisis that Eurozone has fallen into, the ECB seems to have indirectly deviated from the above flag-rule by establishing certain Financial Stability Mechanisms able to issue bonds with zero risk limits in an attempt to correspond to its fundamental mandate9 to prevent the currency from destabilization and fight a possibly upcoming threatening inflation within the Eurozone. These measures are unorthodox because they are outside the catalog of conventional monetary measures that central banks in the ESCB apply10. The ECB argues that these measures are justified by a need to “address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism” and are therefore covered by its mandate in Article 18 of the Protocol11. It is by far true and intriguing that Eurozone’s situation emerging through sovereign debt crisis and how EU handle(s)d the problem is a perfect field to study monetary policy and the significance of securities.

The ECB has adopted several instrumentations to correspond to the financial crisis since its appearance (in September 2008) as defensive tactics to keep a stable, regulated and solvent banking system so that money can circulate not for the shake of shareholders but for the deposits and the monetary function of Eurosystem inter alia the “Covered Bonds Purchase Program” and the “Securities Market Program”12. It is more than evident that banking and monetary stability go hand-in-hand, despite the fact that bank regulation was imagined as an enterprise distinct from monetary policy in the Eurozone area13.

The Covered bond Purchase Program commenced in July 2009 both on the primary market and on the secondary market14. According to the decision of the ECB of 4 july 2009 on the implementation of the covered bond purchase program ECB/2009/16(2009/522/EC), OJL 175/18 (4 July 2009), the CBPP had four objectives: “a) promoting the ongoing decline in money market term rates, b) easing funding conditions for credit institutions and enterprises, c) encouraging credit institutions to maintain and to expand their lending to clients, d) improving market liquidity in important segments of the private debt securities market). The first program covered 60 billion euros of bonds from July 2009 to July 2010; the second program was launched in November 2011 for one year and it covered eligible covered bond purchases for 40 billion euros15.

In addition, a 3rd private sector assets program of CBPP3 was announced on 4 September 2014 as the Introductory Statement to the Press Conference of the President of the ECB Mario Draghi stipulated: “The Eurosystem will purchase a broad portofolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against euro area non-financial private sector under an ABS purchase program (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel the Eurosystem will also purchase a broad portofolio of euro-dominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase program (CBPP3)…”

In addition to the above, the EU established EFSF (later transformed to ESM) to facilitate financing of indebted (or semi indebted) MS. This entity issues bonds with underlying claims that are guaranteed by the rest Eurozone MSs16. Furthermore the EFSF is entitled to buy sovereign bonds of Eurozone countries for the purpose of avoiding soaring yields on those bonds, thereby ultimately preventing default17. These purchases may take place in the secondary and on an exceptional basis as stated in the EFSF Guideline on Primary Market Purchases of November 29, 2011, the primary market18.

In addition, it is indeed very interesting to examine how the situation of Greek debt crisis and the Private Sector Initiative (PSI) program affected monetary policy in an event of the largest debt restructure (56%) with no precedent in history of mankind. Back in 2012, the Greek debt (unsustainable public finances) was covered by securities (bonds) in its entirety and had completely eliminated the prospect of the comparable risk free investment. In other words, the financial markets had lost confidence in the Hellenic Republic in the course of investment business. The average of market transfer transaction is calculated every day and it is the market itself which decides which investment is to be considered risk free. This task falls upon the Credit Rate Agencies which make technocratic assessments based on statistics and evaluate whether the governments can pay back their loans promptly and fully. In simple words, when people sell bonds at any price they may find, the effective yield elevates and accordingly pushes away possible investors. It is important here to underline the big mistake of financial markets with the European Debt Crisis in general. Their actors believed that the debt was common in the whole Eurozone and that ECB was supposed to bail out the indebted States! Evidently, no one had given a slight glance at the Maastricht Treaty and subsequently at the “NO bail out clause”19. Finally, a bond exchange program that covered 93% of Greek debt was orchestrated by the IMF. Greece’s debt at the time was held by investors from the private sector (both foreign and domestic). The initial securities wereexchanged with new ones that contained: a) smaller interest rates, b) lengthening of the maturity date up to 25 years, c) a small haircut on the principal amount (nominal value). The PSI granted the Hellenic Republic collateral benefits, so practically foreign investors simply lost their money. The Greek banks (which were investors to the Greek bonds) were recapitalized by the Greek Government through new loaning and the Greek pension funds (which were also investors) were also compensated by the Greek Government through new loaning. According to the Greek law that governed the bonds before the exchange, if the majority of the bondholders of percentage of 51% agreed for the exchange to happen, that agreement would be binding for the rest of the bondholders. In a percentage of 93% of the bonds were covered by Greek law and investors were bound by it, so it was practically easy to reach such a majority percentage. Only 7% were covered by English law, and these were paid in full. The above facts have been called as “Collective Action Clauses” and they are based on a qualified majority of bondholders which agrees to a proposed restructuring of the bond obligations, so that all bond be modified20. In the end, all the bondholders participated in the PSI program and all the new bonds were covered by English law .The PSI was very successful since it dropped Greek debt by 53%.

The role of securities in the execution of monetary policy is by far the ultimate sine qua non condition for the power to control money supply and amplify the stability of a currency. The Central banks use securities as if they are money-like, in order to provide liquidity and to regulate cash flow and at the same time maintain the prices stable. Securities are the moving power of economy, the cause and the effect of competitiveness, the blood cell of liquidity circulation in a body of Central banking system. They are seen as such by the Geneva Unidroit Convention on Substantive Rules for intermediated securities [Article 33 par. 3(b)] and the Directive 2002/47/EC [Article 4(5)], as their treatment has impressive prerogatives as far as the effective liquidity in insolvency proceedings is concerned. This so called liquidity has to deal with free convertibility that makes a currency strong in the course of capital market liberalization, by the time that the financial collateral creditors keep a cross finger move in an insolvency situation through which time claw back rules and freeze time periods may be circumvented in the expense of the general body of creditors. The target is simple. Securities are equal to liquid assets and they are used to reduce major systemic risk of financial markets. In conclusion, one could say that securities are just like the smile in Mona Lisa’s face. It is considered to be a smile only if the Central bank charges less money to be involved in a repo transaction. If not, it is just a poker face.

1Rosa Maria Lastra, “International Financial and Monetary Law”, 2nd Edition, p. 37, par. 2.25

2 http://www.investopedia.com/terms/p/primarymarket.asp  

3 http://www.investopedia.com/video/play/primary-market/

4 See, e.g., GENERAL TERMS AND CONDITIONS OF THE DEUTSCHE BUNDESBANK: BANKING REGULATIONS, ch.

V, nos. 1(1), 2(1), 3, 13, 23(1) (2011), available at http://www.bundesbank.de/Navigation/EN/Service/Services_for_banks_and_companies/OMTOS/General_information/Terms_and_conditions/terms_and_ conditions.html

5 See Hofmann, supra note 56, at 460-64.

6DIRECTIVE 2002/47/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 6 June 2002 on financial collateral arrangements (OJ L 168, 27.6.2002, p. 43), Explanatory Statement No (12): “The simplification of the use of financial collateral through the limitation of administrative burdens promotes the efficiency of the cross-border operations of the European Central Bank and the national central banks of Member States participating in the economic and monetary union, necessary for the implementation of the common monetary policy. Furthermore, the provision of limited protection of financial collateral arrangements from some rules of insolvency law in addition supports the wider aspect of the common monetary policy, where the participants inthe money market balance the overall amount of liquidity in the market among themselves, by cross-border transactions backed by collateral.” And Article No 1 par. 1,2(b): “This Directive lays down a Community regime applicable to financial collateral arrangements which satisfy the requirements set out in paragraphs 2 and 5 and to financial collateral in accordance with the conditions set out in paragraphs 4 and 5.

2. The collateral taker and the collateral provider must each belong to one of the following categories: a)…,

(b) a central bank, the European Central Bank, the Bank for International Settlements, a multilateral development bank as referred to in Annex VI, Part 1, Section 4 of Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) (1), the International Monetary Fund and the European Investment Bank;

7 DIRECTIVE 2002/47/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 6 June 2002 on financial collateral arrangements (OJ L 168, 27.6.2002, p. 43), Explanatory Statement No (3): “A Community regime should be created for the provision of securities and cash as collateral under both security interest and title transfer structures including repurchase agreements (repos). This will contribute to the integration and cost-efficiency of the financial market as well as to the stability of the financial system in the Community, thereby supporting the freedom to provide services and the free movement of capital in the single market in financial services.” And No (13): “This Directive seeks to protect the validity of financial collateral arrangements which are based upon the transfer of the full ownership of the financial collateral, such as by eliminating the so-called re-characterisation of such financial collateral arrangements (including repurchase agreements) as security interests”

8 Report to the Council and the Commission on the Realization by Stages of Economic and monetary union in the Community, “Werner Report, 8 October 1970”.   

9 Art. 127 TFEU

10 On the differences between conventional and non-standard (unconventional) central bank measures, see Lorenzo Bini Smaghi, Member, Exec. Bd. of the ECB, Keynote Lecture at the Int'l Ctr. for Monetary and Banking Studies: Conventional and Unconventional Monetary Policy (Apr. 28, 2009), available at http://www.bis.org/review/r090429e.pdf. For typical conventional measures, see id.at 2.

11 For its justification of the SMP, see the Decision of the European Central Bank of 14 May 2010 Establishing a Securities Markets Programme, supra note 75, 2010 O.J. (L 124) 8, Preamble (3). See also Press Release, European Cent. Bank, ECB Decides on Measures to Address Severe Tensions in Financial Market (May 10, 2010), available at http:// www.ecb.int/press/pr/date/2010/html/ pr100510.en.html.

12 see Decision of the ECB of 14 May 2010, ECB/2010/5/(2010/281/EU), OJ L 124/8 (20 May 2010)

13 22 Transnat'l L. & Contemp. Probs. 9 Transnational Law & Contemporary Problems, FROM GLOBAL FINANCIAL CRISIS TO SOVEREIGN DEBT CRISIS AND BEYOND: WHAT LIES AHEAD FOR THE EUROPEAN MONETARY UNION?

14 Rosa Maria Lastra, “International Financial and Monetary Law”, 2nd Edition, p. 258, par. 7.41  

15 See John Beirne “The Impact of the Eurosystem’s Covered Bond Purchase Program on the primary and Secondary Markets” ECB Occasional Paper Series No 122 (January 2011)

16 See Framework Agreement, supra note 30, pmbl., ¶ 2, at 2.

17 A legal analysis of the Eurozone crisis, 18 Fordham J. & Fin. L.519

18 See Maximizing the Capacity of the EFSF: Terms and Conditions, EFSF (Nov. 29, 2011), http://www.efsf.europa.eu/attachments/efsf_terms_of_reference_ maximising_the_capacity.pdf.

19 TFEU Art. 125  

20 On majority provisions in Collective Action Clauses following the English law model, see Lachlan Burn, Bond Issues Under U.K. Law: How the Proposed German Legislation Compares, in DIE REFORM DES CHULDVERSCHREIBUNGSRECHTS 219, 238 (Theodor Baums & Andreas Cahn eds., 2004) (Ger.). On American law style collective action clauses, see Lee C. Buchheit & Mitu Gulati, Sovereign Bonds and the Collective Will, 51 EMORY L.J. 1317, 1329 (2002).