Speech by John Townend, Director for
Europe
To the BBA Conference on 'The Euro and
the UK National Changeover Plan', 30 March 2000
The
Potential Changeover in the Wholesale Markets from Sterling to Euro
In a speech to a BBA Conference today on 'The Euro and the UK National Changeover Plan', John Townend, Director for Europe at the Bank of England explains the implications for the wholesale financial markets, if the UK Government in due course decides to join EMU. His four key messages are:
- If the UK were to join EMU, the wholesale sterling markets would change to euro at the entry date, in much the same way as in the first wave countries
- City planning for this is in good shape
- The necessary central projects with the longest lead times (CHAPS, DvP) are already being implemented in any case
- The necessary euro-specific investment to enhance systems, in individual financial institutions as well as at the Bank of England, could if necessary begin some 12 months before entry
I should like to begin by first congratulating the British Bankers’ Association for its initiative in organising this conference today, which you might consider rather brave in the circumstances. But I think it entirely appropriate to mark the Government’s publication of the updated National Changeover Plan in this way, and I am sure we are all grateful for the Economic Secretary’s explanation of its context and content. And second I should of course congratulate you, a commendably large audience, in your farsightedness in attending this conference.
The organisers have neatly placed me on the programme between the Minister and representatives of the banks. This is a familiar position for the Bank of England, since in many areas we stand at the interface between the public and private sectors. And it is particularly appropriate on this occasion, because of the responsibility which the Bank has been given under the Government’s National Changeover Plan to ensure that the City is prepared for the euro, when and if the time comes. It makes sense to cover the changeover in the wholesale financial markets first, because this will happen at the very beginning of the changeover, immediately the sterling:euro exchange rate would become locked.
A good deal of work, both within the Bank and within the major private sector financial institutions, has already been undertaken on the wholesale financial market changeover. I am going to talk primarily about substance, describing the main expected features of the changeover, but let me say a few words first about process, about how the necessary planning is being carried out.
The process of City changeover planning
During 1998 and the early part of last year, we harnessed the market practitioner expertise being brought to bear on the preparations to use the euro as a foreign currency, to identify also the main changes that would subsequently be required to convert the sterling markets into euro in the event of UK entry. I chaired a broad informal City group which we called the Wholesale Markets Working Party, whose work culminated in a detailed report which we promulgated in our Practical Issues publication last June.
We decided last summer formally to reconstitute this working party as the City Euro Group, to help carry forward the necessary planning and preparations. It is important that our work here in the City is fully integrated with the changeover in the wider economy, so that together it forms a coherent whole; and we were very pleased therefore that the Treasury accepted the City Euro Group as one of the working groups within its project structure. Coherence is achieved through the many interconnections within this structure – for example I chair the City Euro Group and sit, along with the BBA, on the Treasury’s Project Management Group as well as the Business Advisory Group, and the Governor of course, as well as the President of the BBA, sits on the Chancellor’s Standing Committee.
We have tried to make the City Euro Group a truly representative pan-City body by including representatives of all the main financial associations, some 60 people in all; and we meet three or four times a year. The two main purposes of the Group are to identify the key issues and to ensure that they are pursued, including through a number of sub-groups; and to communicate the state of the developing planning and preparations as widely as possible, so that market firms are fully informed about the context within which they need to prepare.
In planning our own preparations in the UK for possible entry, we are keen to learn as much as we can from the first wave. In the Bank of England, we are in regular contact with our counterparts in the European Central Bank, and the national central banks within the euro area, to see what lessons we can learn from their experiences, taking into account that our own circumstances as a potential second-wave entrant might be different. It is also useful to stay in touch with the three other EU countries in the same position at present as the UK – Denmark, Greece and Sweden - on their own developing preparations.
Let me move now to substance. I would like to talk first about the lead-times for wholesale market preparations; second, about the transformation that would be needed to the technical framework for implementing monetary operations; and third, about some of the major aspects of the conversion of the financial markets themselves.
Lead-times for wholesale preparations
So first of all, the lead times for preparing the wholesale financial markets. Clearly, preparing for the euro is not an unfamiliar task in the City. We were all involved in the preparations for launching the euro at the beginning of last year. And from a technical point of view, these preparations were an unqualified success. London was well prepared, and the euro is already heavily used across London’s international markets. We quantified the scale of this euro activity in our latest edition of Practical Issues; and explained the quiet confidence among market firms that, to date, London has fully maintained its market share.
Even so, the task of converting the sterling markets to euro would require as intensive and extensive preparations as those in the run-up to the euro’s launch. On that occasion, meticulous planning and implementation paid off, and we would expect market firms here to follow a similar approach if the UK were to join. The banking system would be at the heart of the changeover, and all the major City institutions would be heavily involved.
On the wholesale side, there would be no room for slippage in the preparations: they would need to be fully complete and ready for operation by the date of entry. We reckon that, in general, some 12 months would be needed to implement these preparations, assuming prior planning and market consultation. So implementation would need to start no later than one year before the entry date.
In some cases, it may be prudent to allow more than a year. That is certainly the case in the payments area. A high volume wholesale domestic system for making euro payments would be needed if the UK were to join EMU; but delivery of this was estimated to have quite a long gestation period, as long as two years. We are therefore very pleased that the clearing banks have decided in any event to upgrade CHAPS sterling on to the same basis as already used by CHAPS euro, since this would make the transition to euro usage for large-scale domestic payments much easier. Besides the central CHAPS system, which from entry would transmit payments entirely in euro, banks would need to be able – probably within their own internal systems – to convert sterling receipts and payments into euro, and vice versa, consistent with their probable legal obligation (as in the first wave).
Separately, work is also under way to enhance delivery-versus-payment, by introducing settlement of securities in CREST against payment of central bank funds in real time in CHAPS. This work is not just relevant to sterling, but also to the euro. It will meet the ECB requirement that, by 2002, only such systems will be eligible for use in TARGET and Eurosystem liquidity provision.
Besides these central long-duration projects to upgrade CHAPS and enhance delivery-versus-payment, there is little sign at this point in time of the major financial institutions beginning the necessary investment to develop their own internal systems for the euro. That is not surprising; but nor is it necessary for them to begin yet, on any reasonable estimate of the prospective date for entry, given that completion of the wholesale financial market preparations should be possible within one year. And the important point is that planning, to understand the detail of the changes needed if the time comes, is well advanced.
Within the Bank of England, we have been through much the same internal planning exercise as the commercial banks. We have analysed carefully the changes which the Bank would need to make for UK entry. We are continuing with our planning work, and we are also proceeding to implement those IT projects that we need to implement anyway, irrespective of whether the UK joins EMU, but in a ‘euro-friendly’ way. On this basis, we are confident that we too could be ready for entry within a period of twelve months, come the day.
Changes in the monetary policy operational framework
What then about the changes that would be required, if the UK were to join EMU, in the operational framework for implementing monetary policy, from our system at the Bank of England to the Eurosystem?
I should emphasise that these changes would be purely technical. The fundamental objectives of both operating systems are identical: namely, to secure short-term market interest rates in line at all times with the interest rate which the central bank in each case judges appropriate. So what we are talking about here is not a change in objective, but simply technical changes in the way they are delivered. Perhaps the best way to explain these technical changes is to describe the similarities and differences between the two systems at present.
First of all, the similarities. Both the Eurosystem and the Bank operate as a regular lender to credit institutions, using market techniques. In both cases, the provision of liquidity takes place on a secured basis, against a wide range of collateral: the Bank of England in practice already accepts a wide range of euro-denominated high-quality collateral in its sterling liquidity provision. And the main monetary policy instrument in both cases is a regular refinancing operation with a two-week maturity.
Those are the main similarities. There are also a number of differences. First, the Eurosystem imposes a 2% reserve requirement on credit institutions, which has to be met on average each month. By contrast, the Bank simply requires at present settlement banks in the UK not to let their accounts at the Bank go into overdraft each day; so there is no reserve requirement and no averaging. And the settlement banks are a much narrower group than those subject to reserve requirements in the Eurosystem.
Second, the Eurosystem makes two standing facilities continuously available. These facilities enable credit institutions at their own initiative either to deposit at a sub-market rate any excess liquidity with their national central bank, or to access additional liquidity at a penal rate to make up any shortfall. By contrast, the Bank of England offers no comparable facilities, though we do of course lend overnight.
Third, as the Eurosystem imposes reserve requirements on average over a month, and provides continuous standing facilities, it can deploy market operations far less frequently than we do. Whereas we conduct our operations at least twice daily, Eurosystem market operations are conducted weekly, with an additional monthly operation.
Fourth, as all credit institutions in the Eurosystem are subject to reserve requirements, they all also have the right to become a central bank counterparty, if they fulfil certain eligibility criteria. In the UK, counterparty status is not restricted to banks: other institutions, such as securities houses, can apply for counterparty status too. But the Bank’s qualifying functional criteria are more narrowly defined, and there is a requirement to be an active participant in the money market, so there are many fewer counterparties here at present than in the largest euro-area countries.
Finally, the Eurosystem can make use of both fixed and variable-rate tenders in its main refinancing operations. By contrast, the Bank uses only fixed-rate tenders when providing liquidity. And the Bank would have to introduce the Eurosystem monthly longer-term refinancing operation, for which there is no equivalent at present.
If the UK were to join EMU, our system would need to change to conform to the operational framework used by the Eurosystem. Of course, many UK banks already have experience of dealing with the Eurosystem through their branch operations within the euro area. All the same, we would need to prepare for the changes carefully, and each credit institution in the UK would need to take responsibility itself, with its customers and correspondents, for ensuring that it was well prepared.
Conversion to the euro in wholesale financial markets
Apart from these changes in the operational framework for implementing monetary policy, the other main change in the wholesale markets, as a result of UK entry, would of course be the conversion from sterling to euro denomination.
How would the changeover in sterling markets work, if the UK decided to join? Wholesale market trading would be expected to switch more or less completely from sterling to euro from the entry date itself, in the same way as for the national currencies in the first wave.
As with the first wave, we expect that the locking of the euro-sterling exchange rate on entry would immediately be followed by a ‘conversion weekend’. During that weekend, many outstanding amounts in sterling would be converted into euro at the official conversion rate. Just as at the start of last year, there would be a great deal of work to do that weekend. Ideally, a long weekend would be available, as with the first wave. There are mixed views about whether it would be helpful for entry to take place at a quarter (or year) end, as in the first wave; or whether it would be better to avoid quarter-ends so as not to clash with the end of standard accounting periods. The precise entry date would of course be part of the official UK negotiations for entry. But we would be interested in hearing your views about whether or not a quarter-end would be desirable, and the reasons. Similarly, no decision has yet been taken on whether there should be co-ordinated market-wide testing ahead of entry. We would again be interested to hear your views on the potential benefits and costs involved.
Nor have decisions yet been taken about whether, when or how to redenominate gilts. But in practice we would expect over the conversion weekend all gilts to be redenominated, in other words their nominal values would be changed from sterling to euro. Our soundings of market practitioners indicate strong support for making the necessary calculations at the level of the investor holding, by each stock account, and rounded to the nearest euro cent. Subsequently, gilts would be transferable in the market place in multiples of one euro cent nominal.
Although gilts would be redenominated over the conversion weekend, that does not mean that other, non-Government, sterling debt would necessarily be redenominated. Nor is it expected in general that sterling money market securities would be redenominated. Because of their relatively short maturity, they would run off quite quickly after entry, and then simply be replaced by new euro-denominated issues. That is not of course the case with most bond issues. We think that legislation might be helpful to enable non-Government issuers to redenominate their sterling bonds into euro without explicit investor consent, as in many first-wave countries, providing investors’ interests were safeguarded. But no decisions have yet been taken on this. In any event, issuers would need to consider carefully whether any benefits from redenomination might justify the costs inevitably involved.
Whether nominal values of securities were redenominated into euro, or remained in sterling, we would expect that, from entry, trading in the wholesale markets would be conducted in euro. And throughout the wholesale markets, issuing and trading of financial instruments in euro would be expected to conform to the agreed harmonised euro market conventions, including for calculating accrued interest. That would entail some changes from the position now, primarily in the money market. In addition, the BBA would need to decide how to replace sterling LIBOR; and the brokers’ association how to replace SONIA. In both cases, the market would be consulted.
In the equity market, some companies might want to switch their share prices from sterling to euro ahead of entry, particularly once it became clear that the UK would join. It is not clear how far this process would go. All remaining share prices quoted in sterling would be expected to convert to euro over the conversion weekend in time for post-entry trading. FTSE International has indicated that its UK indices would continue to be calculated in sterling until UK entry, unless before then the majority of UK companies were trading in euro; and it would continue to make available a sterling equivalent index at the prevailing rate for so long as any companies in the index continued to be quoted in sterling. Separately, the DTI is hoping by the summer to begin consulting the market on draft legislation to facilitate changing the currency of share capital. This would allow a company to decide to convert the nominal value of some or all of its share capital into an equivalent value denominated in a different currency, including euro.
Outstanding questions relating to the changeover
That in outline is how we would expect the changeover from sterling to euro in the wholesale markets to work. But these are working assumptions, since no decisions have yet been taken. And many decisions would of course be required, both about the detail and legal framework for the changeover in general and about many specific aspects of the wholesale market changeover itself.
There are also a number of technical aspects of the wholesale market changeover which are still under discussion within the City Euro Group. I would like briefly to mention four. First, we are aiming, with the help of relevant market experts, to describe in detail how the changeover would be expected to work for each wholesale sterling market. For example, we want to avoid using phrases like ‘settling as dealt’, for sterling transactions which may be entered into before the conversion weekend but completed after it, since they raise more questions than they answer. We intend to explain the implications where trading in a financial instrument switches to euro whilst its nominal value is left in sterling; and whether deals arranged before entry in sterling are expected to be converted to euro over the conversion weekend and settle in euro, or to remain in sterling.
Second, a sub-group of the City Euro Group has been considering what should happen to the consideration on outstanding trades in CREST’s system at entry; and also whether new ISINs should be issued when gilts are redenominated. On the first issue, the sub-group’s recommendation is that, where securities like gilts would be redenominated, CREST would convert the consideration as well, so that both sides of the trade would settle in euro. This would be consistent with the approach adopted in the first wave. For equity trades, where redenomination would not be expected to take place at entry, there would be a ‘grace period’ allowing outstanding trades to run off. This grace period would be 25 days, which is the maximum settlement period allowed on the London Stock Exchange. At the end of the grace period, CREST would convert the remaining trades to euro.
On the second issue, new ISINs would not strictly be necessary, assuming redonomination to the nearest euro cent, since this would leave unchanged the economic value of securities holdings. But a change may be more convenient for firms’ back offices. There are different views, but equally plenty of time to resolve them through a process of market consultation before any decisions are taken.
Third, another sub-group has been looking at the preparations needed for the changeover in fund management. Many of these would be similar to other financial services. But there are some questions which are more or less specific to fund managers. In the case of unit trusts, pricing and accounting information during the transition period would be expected to be denominated in the base currency of the scheme, with the timing of the change at the discretion of the fund manager. In the case of pension funds, trustees would be free to choose whether to require accounts to be prepared in sterling or euro during the transition period. But the NAPF’s recommendation would be that pension funds should normally account in euro for both management and published accounting periods starting after UK entry. While there is a consensus on these issues, there are still questions to be resolved on how to account for book costs, and how to measure investment performance covering periods before and after entry.
All these are technical issues. There is one more fundamental area, which is being looked at in another sub-group. This is the linkages between the changeover in the wholesale financial markets and in the retail financial sector. This work is designed in part to confirm that the wholesale preparations, necessary for the entry date, can be completed independently of the rest of the banks’ preparations to provide retail financial services in euro. This would then introduce an extra degree of freedom into the retail changeover, so that this could be completed if desired some time after entry.
Conclusion
Let me conclude by leaving with you four messages:
- If the UK were to join EMU, the wholesale sterling markets would change to euro at entry, in much the same way as in the first wave.
- City planning for this is in good shape.
- The central projects with the longest lead times (CHAPS, DvP) are already being implemented.
- Investment to enhance systems, in individual financial institutions as well as at the Bank of England, could if necessary begin some 12 months before entry.
We will keep you up-to-date with the evolving City preparations through a number of channels, including the City Euro Group, the Bank’s Practical Issues publication, and through our website, which we intend to make a central source of information on financial sector euro preparations.
I am confident that by keeping the pot of City euro preparations simmering, we can when necessary bring it to the boil at the appropriate time.
