The global financial crisis over a decade ago shook confidence in financial systems and exposed risks lurking beneath the surface.
Since then, policymakers and regulators have undertaken major reforms to strengthen the financial architecture and promote stability.
However, gaps remain, notably in Europe’s Economic and Monetary Union (EMU). The lack of a common euro safe asset – assets perceived as safe from credit risk that can also serve critical functions like collateral – is seen as one such gap.
Why are safe assets important?
They facilitate transactions in financial markets and allow central banks to transmit monetary policy effectively throughout the financial system.
Safe assets also act as a buffer in times of market stress or panic by maintaining their value, unlike riskier assets that may experience sharp drops. This flight to safety gives them a special status.
The euro area currently lacks a single safe asset that can play these roles at the regional level. Instead, markets treat the sovereign debt issued by certain euro area governments, especially Germany’s, as substitutes.
This fragmentation limits the development of euro area financial markets and ties borrowing costs to the fiscal strength of individual countries rather than that of the currency union as a whole. It can also contribute to destabilizing capital flows between countries during crises.
Many solutions have been proposed over the years to fill this euro safe asset gap, but political constraints have prevented their realization. Treaty changes to enable joint debt issuance lack sufficient political backing.
The European Central Bank’s purchases of sovereign bonds have had a homogenizing effect on yields, but purchases are limited in size and scope.
Proposals for synthetic euro safe bonds made up of national sovereign bonds rely on risky assets rather than being risk-free themselves.
More recently, momentum has grown behind market-led initiatives that could support financial integration and stability without requiring direct debt mutualization between euro area sovereigns. French President Emmanuel Macron gave fresh impetus by calling for a discussion around establishing a “European safe asset.” The European Commission and industry associations have also put forward proposals, signaling high-level interest.
Financial engineers are rising to the challenge, exploring innovative ways to extract the safest parts of national sovereign debt markets to manufacture low-risk euro securities. These initiatives promise to introduce safe assets “through the back door” without requiring politically contentious reforms.
The Two Main Approaches
expert groups have put forward detailed blueprints based on two alternative methodologies for carving out the safest slices of individual euro area sovereign bond markets. Each approach has unique strengths and addresses different needs.
The first method is known as sovereign bond-backed securities (SBBS). SBBS would bundle different sovereign bonds from euro area countries into multiple tranches, similar to the structure used to create residential mortgage-backed securities. The senior tranche would capture the lowest risk portion thanks to the protection provided by the more junior tranches. If losses occur, the junior tranches would absorb them first.
SBBS would transform risky euro area sovereign bonds into a security with quasi risk-free senior tranches, given the strong legal protections for senior debtholders. The resulting safe asset could serve as high-quality collateral for financial transactions across Europe. By tying borrowing costs to the wider euro area rather than individual countries, SBBS could also weaken the damaging sovereign-bank “doom loop” plaguing Europe.
The second approach centers on collateral baskets like the European Safe Bonds (ESBies) proposal. Here, euros would be raised by selling bonds backed by a diversified collateral basket made up of euro area sovereign bonds and supranational debt from institutions like the European Investment Bank (EIB). The diversification effect across countries and seniority levels would effectively eliminate credit risk, rendering ESBies virtually risk-free.
Proponents argue ESBies could meet important safe asset needs from the start without extensive financial engineering to repackage bonds, a clear strength. Of the two approaches, ESBies also comes closest to a euro area safe bond – a true common asset class not reliant on national sovereign bonds. The importance of this symbolic shift toward “mutualization” shouldn’t be dismissed.
Navigating the Transition
Despite their promise, neither fully-fledged SBBS nor ESBies yet exist in practice. Transition risks and financial stability concerns have sparked unease among policymakers over letting these markets sprout without supervision. Regulatory clarity also remains lacking. How assets like SBBS would be treated under existing financial rules is unsettled, leaving uncertainty around their regulatory advantage compared to typical sovereign bonds.
But the momentum behind market-based safe assets won’t dissipate even if official sector preferences lean toward a more gradualist rollout. Private solutions are already emerging that navigate this friction. These center on versions of SBBS and ESBies tailored specifically to tap demand from bank treasuries looking to optimize collateral positions. While more limited in scope, targeted issuance to a specialized investor base may enable proof of concept.
For example, a group of banks has developed a SBBS prototype called DIVA (~Diversified European Assets) using simulated bond data that resembles German bunds in risk profile. DIVA and similar pilots by other banks using real bonds help test the SBBS structure. They also showcase willingness by large collateral pools to invest if the securities are structured and priced attractively.
On the ESBies side, the EIB issued notes exchangeable into ESBies earlier this year, providing a tamer version with the EIB rather than euro area sovereigns as underlying collateral for now. Some view these innovations by market participants as stepping stones toward bigger, more liquid official-sector led platforms down the road.
Outlook: Safety in Diversity?
Debate continues around the appropriate sequence – should rulebooks be adjusted to provide space for safe asset initiatives to develop bottom-up, or should regulation await market creation and focus on guarding financial stability? Views differ too on whether SBBS, ESBies, or other proposals offer the best path ahead.
But the basic rationale holds firm across solutions and stakeholders – that safe assets are a missing piece of the euro area financial architecture. There is also shared desire to stray from the dangers of relying solely on fragmented national sovereign bond markets. As French central banker Francois Villeroy de Galhau stated, “In a monetary union, a safe asset for the whole area – rather than one for each member – becomes essential.”
The emergence of SBBS, ESBies and similar innovations highlight the desire among both public and private sector players to find that elusive euro safe asset. This momentum won’t fade even if specific instruments ultimately adopted differ from what’s currently discussed. In euro land’s financial ecosystem, the push toward safety and stability is here to stay through continued evolution. As the old adage goes, “necessity is the mother of invention.” When it comes to safe assets for Europe, steady progress reflects faith in the power of financial creativity – and existential necessity.
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