07 January 2008

A short history of European plumbing - Review by Graham Bishop

Plumbers and Visionaries by Peter Norman

This is not the normal household plumbing but the hidden infrastructure that enables the European Union’s fi¬nancial system to function. Few policymakers gave it any real thought until market crises forced it to the surface in the 1980s. Then the thoughts of the visionaries turned to the creation of a monetary union – and the implications of joining together in a single modern, streamlined financial system between 12 and 15 (at that stage) national systems that had evolved over decades in response to specific national disasters.

Policymakers grappling with the ripples reaching European shores from the US subprime tsunami should delve into Peter Norman’s book to understand the reasons for the financial structures in the EU. But the appeal of the book is wider. Anyone entering the securities business today will find that its 352 pages will give them the history of the plumbing companies – often in minute (even excessive) detail – skilfully interwoven with the political, economic, financial and technological events that moulded the capital markets at the time. The general reader should not find it difficult to follow the story, which is grippingly relevant to current economic circumstances.

Part one lays the groundwork and explains why “stock exchange” is something of a misnomer. The transaction may be agreed there (though there are now many possible venues), but the vital part for the stability of the financial system comes afterwards when the security is exchanged for cash. As the annual turnover of the largest depositary (Euroclear) alone is 40 times the EU’s gross domestic product, it is easy to grasp the significance if anything goes wrong with such money flows.

The policy errors during the dollar weakness of the 1960s/70s are also explored. The US imposed taxes that drove trading of dollar securities offshore, France applied tax rates that prevented that trading developing in Paris, while Britain imposed stamp duties that pushed the final act of settlement to tiny Luxembourg and then also to Brussels. But the US dollars needed to be put to productive use, so the eurobond market sprang up to take advantage of a newly liberal climate of economic management and regulation.

The second part of the book explains the impact of several crises – starting with the boost to securitisation from the oil crises of the 1970s. The 1987 crash pushed settlement topics to the forefront, resulting in many reports on what should be done. Perhaps the most influential was from the Group of Thirty, the “seniors” of the financial world, which advocated shortened settlement times and delivery of the security versus cash payment – which effectively means using the central bank.

Norman explains how this laid the foundations for the monetary policy of the single currency to be conducted by “repo” (a sale and repurchase agreement with the European Central Bank) that made the efficiency and stability of the securities settlement system a vital cog in the smooth running of the monetary union. He also illuminates the rationale for the ECB to move closer to commercial activities by providing its own securities settlement process – Target 2-Securities – so that it reverses some of the 1990s developments and “in-sources” the provision of that central bank money.

In the third part, Norman catalogues the manoeuvrings between the two international central securities depositories (Euroclear and Cedel) and some of the national ones, as well as among the stock exchanges themselves. A reporter to his fingertips, he captures the detective thriller element of the Clearstream affair, an alleged conspiracy to thwart the presidential aims of Nicolas Sarkozy in 2004.

The final section deals with the EU response – driven by the Giovannini group reports which identified barriers to an efficient cross-border settlement system that was essential for a single capital market. After the launch of the Lamfalussy process to help foster this market, financial regulation was drawn inexorably to the European level. The ECB and the Committee of European Securities Regulators looked to formulate prudential standards for the industry, but ran into issues of commercial competition among the depositaries, agent banks and custodians.

The politicians are now turning from lofty constitutional concepts to the practical details of economy-building. So must the commentators. Politicians have made it clear that a solution for Europe’s financial markets must be delivered quickly. The follow-up book on the nuts and bolts may be required sooner than Norman thinks.                                                                                        
The writer was a member of the Giovannini group and the expert group that advised the European Commission on the Financial Services Action Plan.    

Copyright The Financial Times Limited 2008

© Graham Bishop