Money, Credit and Banking

Lecture 4

Zihao LIU
Lecturer in Finance,
Tilburg University/Erasmus School of Economics
Outline of today

◼ Chapter 5 of book DSW (financial markets)

◼ Chapter 7 of book DSW (payment systems)
◼ Tutorials
❑ Exercises

❑ A mini-case study

2
Questions?
◼ Mentimeter survey:
❑ What are your expectations of today’s lecture?

3
 Chapter 5 DSW
European Financial Markets
Learning objectives – chapter 5
◼ Explain the purpose and structure of financial markets

◼ Describe the essentials of the euro money market, including its

functions and main interest rates

◼ Explain how the monetary policy of the ECB affects the euro money
market

◼ Discuss the most important developments in the bond market since

the start of the monetary union

• Discuss the most important developments in the equity markets

since the start of the monetary union
• Describe the essentials of the derivatives market
• Describe the foreign exchange market.

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 Financial markets:
functions and structure

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Functions
▪ Financial market: a market where individuals issue and trade
securities
▪ Securities: fungible, negotiable instruments representing
financial value (categorised in debt and equity securities)

Main functions:
▪ Price discovery: the market facilitates the dissemination of
information (pre-trading)

▪ Trading mechanism: market provides a mechanism to

facilitate agreements by linking buyers and sellers (trading)

▪ Clearing and settlement arrangements: the agreements are

executed (post-trading)

7
Amsterdam’s first exchange building
(Hendrick de Keyser Exchange)

Zihao LIU Money, Credit and Banking 8

Functions
▪ Financial market: a market where individuals issue and trade
securities
▪ Securities: fungible, negotiable instruments representing
financial value (categorised in debt and equity securities)

Main functions:
▪ Price discovery: the market facilitates the dissemination of
information (pre-trading)

▪ Trading mechanism: market provides a mechanism to

facilitate agreements by linking buyers and sellers (trading)

▪ Clearing and settlement arrangements: the agreements are

executed (post-trading)

9
Participants in financial market
Participants can be classified by their motive for trading (not
mutually exclusive)
▪ Public investors: ultimate owners motivated by return on
holding the securities and include private individuals and
institutional investors, such as pension funds, insurance
companies, and mutual funds

▪ Brokers, who act as agent for public investors motivated by

commission fees for their services (they do not own
securities)

▪ Dealers, who trade on their own account motivated by profit

from trading securities (living from the bid-ask spread – see
next slide)

10
Participants in financial market
Participants can be classified by their motive for trading (not
mutually exclusive)
▪ Public investors: ultimate owners motivated by return on
holding the securities and include private individuals and
institutional investors, such as pension funds, insurance
companies, and mutual funds

▪ Brokers, who act as agent for public investors motivated by

commission fees for their services (they do not own
securities)

▪ Dealers, who trade on their own account motivated by profit

from trading securities (living from the bid-ask spread – see
next slide)

11
Trading mechanisms
▪ Quote-driven systems (dealer markets)
• Dealers quote ‘firm’ bid-ask prices (at which he is prepared to deal)
• Stock markets give privileges for dealers (administrative procedures and
market information)
• Buyer pays ask price (pa); seller receives bid price (pb)
• Bid – ask spread: s = pa – pb for dealer
• Dealer needs to keep inventory (costs and risks)

▪ Order-driven markets (auction markets)

• Participants issue instructions for specific actions (buying or selling at
pre-specified price)
• Order book which is regularly cleared (automatic trading matching)
• Limit orders (max / min price) and market orders (best available price)
• Highly formalised with clear auction rules to ensure orderly and fair
trading

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Trading mechanisms
▪ Quote-driven systems (dealer markets)
• Dealers quote ‘firm’ bid-ask prices (at which he is prepared to deal)
• Stock markets give privileges for dealers (administrative procedures and
market information)
• Buyer pays ask price (pa); seller receives bid price (pb)
• Bid – ask spread: s = pa – pb for dealer
• Dealer needs to keep inventory (costs and risks)

▪ Order-driven markets (auction markets)

• Participants issue instructions for specific actions (buying or selling at
pre-specified price)
• Order book which is regularly cleared (automatic trading matching)
• Limit orders (max / min price) and market orders (best available price)
• Highly formalised with clear auction rules to ensure orderly and fair
trading

13
Hybrid markets
▪ IT advances have spurred development of order-driven markets,
which tend to be more transparent
• Smart trading rules (software) with fast computers (hardware)
allow almost instantaneous matching of orders

• Euronext uses an order-driven trading mechanism with a

centralised electronic order book

▪ Hybrid markets combine features of quote- and order-driven

markets
• The London Stock Exchange’s premier electronic trading
system combines electronic order-driven trading with liquidity
provision by market makers
• Bond markets tend to be more quote-driven (dealers)

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Hybrid markets
▪ IT advances have spurred development of order-driven markets,
which tend to be more transparent
• Smart trading rules (software) with fast computers (hardware)
allow almost instantaneous matching of orders

• Euronext uses an order-driven trading mechanism with a

centralised electronic order book

▪ Hybrid markets combine features of quote- and order-driven

markets
• The London Stock Exchange’s premier electronic trading
system combines electronic order-driven trading with liquidity
provision by market makers
• Bond markets tend to be more quote-driven (dealers)

15
Stock markets vs. (collateralised)
debt/money markets

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Money market

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Money market
Money market
▪ Market for short-term funds, with maturity up to one year
▪ Strongly influenced by monetary policy of ECB (see Chapter 4)
▪ Dominated by credit institutions (i.e., banks), which use it for liquidity
management

Money market segments

▪ Unsecured segment: money borrowed without collateral → credit risk
▪ Secured segment: repurchase agreements (repos) whereby asset is
sold against money, while the seller has right and obligation to
repurchase the asset at specific price on future date → no credit risk

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Money market
Money market
▪ Market for short-term funds, with maturity up to one year
▪ Strongly influenced by monetary policy of ECB (see Chapter 4)
▪ Dominated by credit institutions (i.e., banks), which use it for liquidity
management

Money market segments

▪ Unsecured segment: money borrowed without collateral → credit risk
▪ Secured segment: repurchase agreements (repos) whereby asset is
sold against money, while the seller has right and obligation to
repurchase the asset at specific price on future date → no credit risk

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The working of the money market
On the central bank side (see Chapter 4)
▪ Reserve requirements to be fulfilled on average over a one-month
maintenance period
▪ Open-market-operations general instrument to steer interest rates
▪ Standing facilities to provide / absorb liquidity when unforeseen
shocks (insurance mechanism at penalty interest rates)

On the market side

▪ Euro short-term rates (ESTER): effective overnight reference rate for
euro for unsecured segment
▪ Euro interbank offered rate (EURIBOR): unsecured benchmark rate
for maturities of 1 week up to 1 year
▪ EUREPO: repo market reference rate for secured segment in euro

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The working of the money market
On the central bank side (see Chapter 4)
▪ Reserve requirements to be fulfilled on average over a one-month
maintenance period
▪ Open-market-operations general instrument to steer interest rates
▪ Standing facilities to provide / absorb liquidity when unforeseen
shocks (insurance mechanism at penalty interest rates)

On the market side

▪ Euro short-term rates (ESTER): effective overnight reference rate for
euro for unsecured segment (more in next slide)
▪ Euro interbank offered rate (EURIBOR): unsecured benchmark rate
for maturities of 1 week up to 1 year
▪ EUREPO: repo market reference rate for secured segment in euro

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Euro short term rate (ESTER) replaced EONIA
at 1 January 2020
▪ Euro overnight index average (EONIA) calculated as a weighted
average of rates reported by a panel of large banks; number of
banks has fallen in recent years

▪ ESTER expands the sample of banks obliged to report; is calculated

based on daily confidential information. Different calculation rules,
middle 50% of volume-weighted transaction

▪ Transition was coordinated with financial sector since more than

€20 trillion in interest rate derivatives and securities is linked to
EONIA. ECB started to publish ESTER by October 2019

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Money market: daily turnover, 2018 (in € billion)
• Reported based on transaction-by-transaction information from the 50
largest euro-area banks
• The unsecured interbank money market has still not recovered from the
financial crisis

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Bond markets

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Bonds
▪ Bond is a debt security that promises that payments will be
made periodically for a specified time (maturity ≥ 1 year)
▪ Economic and monetary union (EMU) → start of pan-
European euro bond market

Bond market segments

▪ Government bonds (central, regional, and local
governments)
▪ Bank bonds (issued by banks and other financials)
▪ Corporate bonds

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The 17th Century Bond That’s Still Paying Interest
◼ In 1648, a water board
(Hoogheemraadschap Lekdijk
Bovendams) floated a perpetual
bond to raise money for the
construction of a series of piers to
regulate the flow of a river and
prevent erosion.

◼ The bonds were priced at 1,000

guilder each, which is worth about
$500 in today’s price, and had a
perpetual interest rate of 5%. The
rate was later reduced to 3.5%
and then 2.5% during the 17th
The paper addendum to the original bond that is
century itself.
made of goatskin

◼ The Yale University bought it in

2003 for roughly $27,000
Zihao LIU Money, Credit and Banking 26
Bonds
▪ Bond is a debt security that promises that payments will be
made periodically for a specified time (maturity ≥ 1 year)
▪ Economic and monetary union (EMU) → start of pan-
European euro bond market

Bond market segments

▪ Government bonds (central, regional, and local
governments)
▪ Bank bonds (issued by banks and other financials)
▪ Corporate bonds

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Bonds by issuer (2017, € trillion)
▪ Debt securities issued by public authorities still form
the most important market segement (except for China)
▪ Bank bonds (financials) rank the second

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Bonds by issuer (2017, € trillion)
▪ Europe and Japan have less corporate bonds than US
and China
▪ Development of corporate bond market is a challenge
for Capital Markets Union

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Gross issuance of bonds in euro area
2012-2018 (€ billion)
• The non-government bond market in the euro area is
dominated by bank debt securities

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Government debt management
▪ Euro had major impact on government debt managers
• Large and deep market without exchange rate risk
• From dominant national players to small / medium players
• Competition among debt managers for investors

▪ Aim is to ensure financing of government at lowest possible cost

with acceptable risks (diversification of maturities)
• Increased liquidity → larger issues (€ 5-20 bn) in multiple tranches
• Issuance more predictable and transparent → auction calendars
• Primary dealers and bank syndicates to issue new government
debt (to reach more non-domestic investors)
• Electronic trading platform (e.g. EuroMTS) for secundary trading

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Government debt management
▪ Euro had major impact on government debt managers
• Large and deep market without exchange rate risk
• From dominant national players to small / medium players
• Competition among debt managers for investors

▪ Aim is to ensure financing of government at lowest possible cost

with acceptable risks (diversification of maturities)
• Increased liquidity → larger issues (€ 5-20 bn) in multiple tranches
• Issuance more predictable and transparent → auction calendars
• Primary dealers and bank syndicates to issue new government
debt (to reach more non-domestic investors)
• Electronic trading platform (e.g. EuroMTS) for secundary trading

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Term to maturity of euro-area governmnent debt

▪ Low interest rates lead to a rise in the shares of fixed-

rate, long-term issuance in gross marketable borrowing

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Term structure
Yield curve is based on government bond yields and influenced by:
▪ Expected short term interest rates
▪ Term premium (risk premium, higher for longer maturities) →
term spread (usually positive, but not always!!)
▪ Credit risk premium depends on risk of default by borrower
▪ Liquidity premium is spread between liquid and less liquid bond

Note:
▪ Liquidity is the ease with which investor can sell or buy a bond
immediately at a price close to the mid-quote (average of the bid-
ask spread)

▪ Yield differentials (spreads) are measured against benchmark

of German bonds (Bunds)

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Term structure
Yield curve is based on government bond yields and influenced by:
▪ Expected short term interest rates
▪ Term premium (risk premium, higher for longer maturities) →
term spread (usually positive, but not always!!)
▪ Credit risk premium depends on risk of default by borrower
▪ Liquidity premium is spread between liquid and less liquid bond

Note:
▪ Liquidity is the ease with which investor can sell or buy a bond
immediately at a price close to the mid-quote (average of the bid-
ask spread)

▪ Yield differentials (spreads) are measured against benchmark

of German bonds (Bunds)

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Euro area yield curve (2008-2018, %)
▪ The term premium leads to a positive term spread, i.e., the spread of yields
of bonds with longer maturity over those with shorter maturity of a “normal”
yield curve

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Euro area yield curve (2008-2018, %)
▪ The yield curve has shifted down due to the unconventional ECB policies
▪ A negaive yield curve often signals investor expectations of a slowing
economy or potential recession

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Corporate bonds
▪ Corporate bonds have grown since start euro, but still low
• Outstanding stock increased by around 3.6 times since 2002 (next
slide)
• Six countries (France, the UK, the Netherlands, Germany, Italy, and
Luxembourg) accounts or about 80 percent
• During 2009-2016, the European corporate bond market
compensated for the decrease in corporate bank loans
• SMEs still mostly rely on bank loans, due to bond market barriers
related to size, reporting requirements and ratings
▪ Corporate bond yields compared to government bond yields
• Yields are generally higher (with same ratings) → higher credit risk
• In particular, yields on lower rated issuers are higher (also related to
business cycle)
• Trade-off between liquidity and transparency (quote-driven
market)

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Outstanding amounts of long-term debt securities issued by
non-financial corporations (NFCs), EU28, 2002-2017

39
Corporate bonds
▪ Corporate bonds have grown since start euro, but still low
• Outstanding stock increased by around 3.6 times since 2002 (next
slide)
• Six countries (France, the UK, the Netherlands, Germany, Italy, and
Luxembourg) accounts or about 80 percent
• During 2009-2016, the European corporate bond market
compensated for the decrease in corporate bank loans
• SMEs still mostly rely on bank loans, due to bond market barriers
related to size, reporting requirements and ratings
▪ Corporate bond yields compared to government bond yields
• Yields are generally higher (with same ratings) → higher credit risk
• In particular, yields on lower rated issuers are higher (also related to
business cycle)
• Trade-off between liquidity and transparency (quote-driven
market)

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Spreads of AAA-rated corporate bonds over German
government bonds (percentage points), 1999-2018

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Special types

▪ Leverage finance. Leveraged loans and high yield bonds for non-
investment grade firms that are highly indebted
▪ Market has roughly doubled in size since the global financial crisis and
leverage has gone up. Imbalances have grown

▪ Covered bonds. Debt securities issued by banks and collateralized against

a pool of assets. Banks retain the assets on their balance sheet or provide
guarantees on dedicated structures to which the assets are transferred
▪ Most important segment of privately issued bonds on Europe’s capital market

▪ Contingent convertible bonds (CoCos). Hybrid capital securities that

absorb losses or are converted into equity when the capital of the issuing
bank falls below a certain level
▪ Issuance of CRR/CRD IV compliant CoCos picked up strongly in 2013 and
2014

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Special types

▪ Leverage finance. Leveraged loans and high yield bonds for non-
investment grade firms that are highly indebted
▪ Market has roughly doubled in size since the global financial crisis and
leverage has gone up. Imbalances have grown

▪ Covered bonds. Debt securities issued by banks and collateralized against

a pool of assets. Banks retain the assets on their balance sheet or provide
guarantees on dedicated structures to which the assets are transferred
▪ Most important segment of privately issued bonds on Europe’s capital market

▪ Contingent convertible bonds (CoCos). Hybrid capital securities that

absorb losses or are converted into equity when the capital of the issuing
bank falls below a certain level
▪ Issuance of capital requirements directive (CRR/CRD IV) compliant CoCos
picked up strongly in 2013 and 2014

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Conclusions

▪ Financial markets release information (price discovery),

provide platform for trade, and infrastructure to settle
trades

▪ Euro money market for liquidity management of ECB and banks

(unsecured segment collapsed during crisis)

▪ EU bond market has experienced spectacular growth after introduction

euro

44
Chapter 7 DSW
Financial Infrastructures
Learning objectives - chapter 7

◼ Define what a payment system is

◼ Explain the difference between wholesale and retail payment
systems
◼ Describe the various steps of the post-trading process
◼ Understand the economic characteristics of the payment and
securities market infrastructures, and explain how these
characteristics influence the EU market structure
◼ Assess the extent to which the different elements of the EU
financial infrastructure are integrated
◼ Understand the growing importance of central counterparties
(CCPs) and the related concentration risk.

46
Payment systems and post-trading

47
Payments and payment systems

▪ Payment = transfer of money between economic actors (e.g.,

consumer/merchant)

▪ Payment system = a combination of technical, legal, and

commercial instruments, rules, and procedures that ensure the
transfer of money between banks

1. Retail payments = low-value and non-time-critical payments,

typically related the purchase of goods and services

2. Wholesale payments = large-value and/or time-critical funds

transfers are made between financial institutions

48
Push transactions (initiated by payer)
Pull transactions (initiated by payee)

49
Efficiency of retail payments
▪ Private and social costs of providing retail payment services are on
average nearly 1 per cent of GDP

▪ Efficiency has been enhanced by transition from:

❑ the distribution of cash via ATMs instead of bank branches

❑ the use of electronic payment systems instead of bank branches

❑ Automated end-to-end processing instead of manually processed

payments

▪ Usage of retail payment instruments differs across the EU

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Use of cards and cash in selected countries

• Since 2000 cash demand roughly doubled in the euro area

• But in China it decreased substantially

51
Use of cards and cash in selected countries

• Since 2000 cash demand roughly doubled in the euro area

• But in China it decreased substantially
• Sweden may become a cashless society. The Riksbank (2018) is there
fore considering the introduction of a “central bank digital currency” as
an alternative to cash.

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Number of card payments per inhabitant

53
Use of payment instruments in the EU
Billions of transactions per year

54
Card payments: four-party payment scheme

55
Card payments: three-party payment
scheme

56
Wholesale payment systems
▪ Correspondent banking
• Payment between 2 banks through intermediary (correspondent
bank)
• Has declined since introduction euro

▪ Real-time gross settlement (RTGS) systems

❑ Each payment immediately settled on a gross basis
❑ TARGET2 run by central banks; TARGET Instant Payment
Settlement (TIPS) offers instant settlement in central bank
money since November 2018

▪ Net settlement systems

❑ Net balances are settled at close of business at the ECB
❑ EURO1 run by over 60 major European banks

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Large-value payment systems
(daily turnover in € bn)

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Post-trading process
▪ Post-trading process provides for the transfer of ownership and payment
between buyers and sellers of securities.

▪ Divided into four main activities:

1) confirmation of terms of the trade as agreed by buyer and seller
2) clearance: establish the respective obligations of the buyer and seller
3) delivery: transfer the securities from seller to buyer
4) payment: transfer the funds from the buyer to the seller

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Economic features of financial
infrastructures

60
Economic features

▪ Economies of scale: arise when the cost per unit falls as

output increases

▪ Economies of scope: reduction of the per-unit costs

resulting from the production of a wider variety of goods
and services

▪ Network externalities: value of the services and products

offered to the participants depends on the number of other
participants purchasing the same services and products

▪ Switching costs: customers face substantial costs when

they want to switch from one network provider to another

61
Economies of scale in payment market

62
Network externalities
Simple network with 4 side branches

63
Network externalities
Simple network with 4 side branches (e.g., railways)

64
Two-sided market
Generally, payment and security settlement systems are two-sided markets

A market is two sided if the platform or system can affect the volume of
transactions by charging one side of the market more and reducing the price
paid by the other side by an equal amount.

Aggregate price
level: 𝑎 = 𝑎𝐵 + 𝑎 𝑠

65
Conclusions

▪ Transfer of money: retail versus wholesale payment

systems

▪ Post-trading process provides for the transfer of

ownership and payment between buyers and sellers of
securities

▪ Economies of scale and scope + network externalities →

impacts the functioning of markets

66
 Tutorial
Exercises and mini-case
Exercises Chapter 5

1. Explain the three main functions of financial markets.

68
Exercises Chapter 5

2. What is the difference between quote driven and

order driven markets?

69
Exercises Chapter 5

3. The most important money market segments are the

unsecured deposit markets (with various maturity,
ranging from overnight to 1 year), and the secured repo
markets (often called repos) with maturities also ranging
from overnight to 1 year.

a.Explain the main differences between both segments

in terms of risk and return.

b.Which segment declined during the financial crisis

and the euro crisis? And why?

70
Exercises Chapter 5

4. Interest rates on bonds are affected by the term

premium, credit risk, and liquidity risk. Explain how.

71
Swapping Debt for Climate or Nature: A Case Study

▪ Innovative debt swaps can

help governments that have
limited access to traditional
grants or debt relief

▪ Countries that are most

vulnerable to climate change—
and the associated loss of
natural biodiversity—are often
those least able to afford
investment to strengthen
resilience because their
budgets are burdened by debt.

▪ Such countries face a high risk

of fiscal crisis

Zihao LIU Money, Credit and Banking - Lecture 4 72

Swapping Debt for Climate or Nature: A Case Study

▪ Innovative debt swaps can

help governments that have
limited access to traditional
grants or debt relief

▪ Countries that are most

vulnerable to climate change—
and the associated loss of
natural biodiversity—are often
those least able to afford
investment to strengthen
resilience because their
budgets are burdened by debt.

▪ Such countries face a high risk

of fiscal crisis

Zihao LIU Money, Credit and Banking - Lecture 4 73

Swapping Debt for Climate or Nature: A Case Study

74
Swapping Debt for Climate or Nature: A Case Study

▪ Debt-for-climate swaps and

debt-for-nature swaps seek to
free up fiscal resources so that
governments can improve
resilience without triggering a
fiscal crisis or sacrificing
spending on other
development priorities.

▪ Creditors provide debt relief in

return for a government
commitment to, say,
decarbonize the economy,
invest in climate-resilient
infrastructure, or protect
biodiverse forests or reefs.

Zihao LIU Money, Credit and Banking - Lecture 4 75

Swapping Debt for Climate or Nature: A Case Study

▪ Debt-for-climate swaps and

debt-for-nature swaps seek to
free up fiscal resources so that
governments can improve
resilience without triggering a
fiscal crisis or sacrificing
spending on other
development priorities.

▪ Creditors provide debt relief in

return for a government
commitment to, say,
decarbonize the economy,
invest in climate-resilient
infrastructure, or protect
biodiverse forests or reefs.

Zihao LIU Money, Credit and Banking - Lecture 4 76

Swapping Debt for Climate or Nature: A Case Study

▪ Why would we address debt and climate or nature

jointly?

▪ What about climate-conditional grant and debt

restructuring?

77
Swapping Debt for Climate or Nature: A Case Study

▪ Why would we address debt and climate or nature

jointly?

▪ What about climate-conditional grant and debt

restructuring?

78
Exercises Chapter 7

1. What are the key elements of retail payment

systems?

79
Exercises Chapter 7

2. What is a two-sided market?

80
Exercises Chapter 7

3. Payment and securities market infrastructures are

characterised by economics of scale and scope and
network externalities. What does this mean and how do
these characteristics affect the internal market?

81
Good Luck with your mid-term!