23 March 2018

Commission to propose SBBS framework: But Temporary Eurobill Fund is very different – with wider benefits.

Politico reported on 14^th March that Vice President Dombrovskis plans to propose a legislative framework for Sovereign Bond Backed Securities (SBBS) in May -  fulfilling the commitment made in the May 2017 Reflection Paper. Politico further reports that the EU28 debt managers opposed SBBS at a March meeting – following their unanimous opposition expressed in a June 2017  letter that Politico has now published.

In my paper of 2 February “European Systemic Risk Board (ESRB) on Sovereign Bond Backed Securities (SBBS)” I commented on the ESRB paper and made the point that my plan for a Temporary Eurobill Fund (TEF) is designed to be not just a “safe asset”  for banks but achieve radically different objectives – with much wider benefits  - than the SBBS plan. The luke-warm official support for SBBS was underlined again in a recent Vox paper by Philip Lane – Chairman of the ESRB task force. As he put it “‘ivory tower’ ideas do not always work in practice” and his paper underlines the difficulties. On such a sensitive matter, it seems unlikely that Finance Ministers will overrule the powerful and unanimous advice of their own debt managers about the risks of damaging the financial `blood supply’ of all governments.

I have recently published a consolidation and update of my plan: Temporary Eurobill Fund (TEF): 30 FAQs to illustrate the radically different targets of the TEF that go far beyond the limited objectives of SBBS. The four specific objections to SBBS by the debt managers are analysed below, as well as their comments on “safe assets”. The table below also provides a simple tick-box comparison for other features.

1.Marketable volumes

ESDM critique of SBBS: Large-sized SBBS would be necessary for liquidity but that very size would itself negatively impact price formation of the sovereign bonds that would remain in the market - thus raising refinancing costs.

TEF solution:All the relevant maturities would be re-financed with global-scale, hugely-liquid TEF issues so all states (probably only with the exception of Germany) would gain from lower costs in this maturity bucket. Market perception of improved economic governance might well lower costs along the rest of the yield curve. (TEF 30 FAQs 1, 14, 20)

2. Investor incentives

ESDM critique of SBBS: Investors would need to be incentivised to invest in SBBS tranches – especially the junior one where sufficient demand has yet to be demonstrated in the light of “the unenthusiastic reaction from investors and market participants” at an ESRB workshop.

TEF solution: TEF bills are explicitly structured to be the ultimate High Quality Liquid Asset that banks are already obliged to hold. As their existing holdings of Treasury bills mature, banks/financial institutions will have no practical alternative but to re-invest the redemption proceeds in TEF bills as they will be the only eligible, prime asset. (TEF 30 FAQs 1, 18)

3. DMO co-ordination

ESDM critique of SBBS: “very high level of coordination in the timing and duration of issuance by DMOs” may harm the efficient functioning of the underlying markets. The alternative to this co-ordination may involve own risk-taking by the SBBS issuer.

TEF solution: DMO flexibility would remain as today.Re-financing with say monthly issues would involve some maturity mis-match during the month – but in the least volatile part of the curve. (TEF 30 FAQ 28)

4. Probability of sovereign default

ESDM critique of SBBS: Inevitably, consideration of the riskiness of SBBS requires a continuous analysis of the probability of sovereign default. Such necessary debates might be counter-productive to the ultimate objective of SBBS – strengthening EMU.

TEF solution: The riskiness of under two-year instrumentsis inherently lower than longer-term ones and the TEF is re-enforced by seniority. The TEF governance process itself is designed to improve economic governance and thus lower the chances of default. Moreover, the TEF is designed to lower roll-over risk – a key risk to financial stability. (TEF 30 FAQs 14, 21, 24)

Safe asset

ESDM critique of SBBS:  “the term ‘safe asset’ is to be avoided in the context of SBBS as it could lead to misunderstanding by market participants and investors”. Implicitly, it could infer that these private sector instruments in practice benefited from some sort of guarantee by the public sector.

TEF solution: The TEF is explicitly a public sector `international financial institution’ with modest callable capital but with the AAA-rated ESM as a backstop and the public sector involvement explicitly limited by an Inter-Governmental Agreement modelled on the well-known ESM Treaty. The TEF will be the `least risky asset’ in the EZ (TEF 30 FAQs 13, 18)

Comparison of SBBS and TEF

© Graham Bishop