The confusion around the Target2 system of the Euro

As the Euro crisis developed there were a wide range of discussions and disagreements. One of the longest lasting and most polarised was and indeed is the one over the Target2 settlement system. There has been a new outbreak of this which has been triggered by a letter published on Friday by ECB (European Central Bank) President Mario Draghi. Let us cut straight to the chase.

If a country were to leave the Eurosystem, its national central bank’s claims on or liabilities to the ECB would need to be settled in full.

Boom! This opens more than one can of worms and one rather large one is opened if we step bank in time to July 2012 and the emphasis is mine.

And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

That speech was also famous for something else which is relevant to the discussion.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

So how can you leave something which is irreversible? Accordingly you will not be settling up partly because Mario will not let it happen. That July 2012 speech was a success for keeping the Euro going forwards although reading it again exposes a fair bit of hot air and boasting about relative economic success of which the clearest critic is the ECB’s 1.5 trillion Euros plus of QE (Quantitative Easing) and -0.4% deposit interest-rate.

But as I read the crucial sentence in the letter to Mr Marco Valli (MEP) and Mr Marco Zanni (MEP) my other thought was that Mario Draghi had just boosted the credibility of those who have argued that Target2 balances matter.

How has this come about?

Ironically this is another side-effect of the QE programme.

the recent increase in TARGET2 balances largely reflects liquidity flows stemming from the ECB’s asset purchase programme (APP).

Oops! Also the change is how can one put it? Geographically concentrated.

Almost 80% of bonds purchased by national central banks under the APP were sold by counterparties that are not resident in the same country as the purchasing national central bank, and roughly half of the purchases were from counterparties located outside the euro area, most of which mainly access the TARGET2 payments system via the Deutsche Bundesbank.

As we note that foreign investors have been selling Euro area bonds to the ECB on a large-scale we see this as a consequence of who they have chosen to sell them too.

This, in turn, resulted in an increase in the Deutsche Bundesbank’s TARGET2 balance vis-à-vis the ECB.

With Germanic accuracy we are told that this amounted to 754,262,914,964.24 Euros as of the end of 2016. It may be hard to believe now but back in the early 2000s there were occasions when the German Bundesbank was a debtor in this system but the amounts back then were far far smaller. You will not be surprised to read it became a creditor as the credit crunch hit and at the end of 2008 that amounted to 115.3 billion Euros. At the time of Mario’s “whatever it takes” speech the balance was 727.2 billion Euros. This of course poses the problem that it we are in so much of a better place now why are we seeing a new record surplus? Here is the official reply.

However, the current increase in TARGET2 balances is not a symptom of increased stress and is therefore inherently different from the previous episodes of rising balances.

Ah, so this time is different!

What is Target2?

It is a settlement system which represents the monetary side of transactions described below by the Bundesbank.

These payment transactions can take a wide variety of forms, such as payment for a goods delivery, the purchase or sale of a security, the granting or repayment of a loan or the depositing of funds at a bank, among many others.

Now this reminds me of the case of the way changes in UK £M3 were represented some 30 years or so ago. This is because back then just because there was an accounting identity we were told there had to be a causal identity as well. Sadly that did not go so well. However the scale of Target2 leads to worries.

An average of around 350,000 payments with a value of just under €2½ trillion are processed using TARGET2 each working day, a figure which is broadly equivalent to the size of Germany’s GDP.

Other central banks have settlement systems but you see where the difference is comes from the fact that the Bank of Japan works in an environment of political and monetary union so nobody worries much about balances between Kobe and Osaka. The problem is created because the Euro is an economic concept which crosses national boundaries. Thus these cash-flows cross national boundaries. But the Target2 balances are not a causal force they are a consequence of financial actions elsewhere. For example back in 2011/12 they built up because of the banking crises seen and now they are building up ironically as part of the ECB’s response to that and the subsequent economic problems.

How could it go wrong?

There are two possibilities. The mildest would be something that cannot be settled under the current structure as described by Beate Resazt here.

in Target2 there is always a danger that one leg of a transaction is paid and the counterparty is not willing or able to fulfil its part of the business. For this eventuality banks have to provide collateral. If collateral turns out to be insufficient to realize the full amount the resulting loss is shared by the euro area NCBs in line with their capital shares.

So a risk but after so many stresses we have avoided that so far meaning it is there as a risk but the ECB has so far kept on top of it. The bigger issue is of course someone leaving the Euro as Mario Draghi stated. This poses all sorts of questions. The current fractious state of Brexit negotiations would presumably be considered to be something of a tea-party compared to this so there are genuine dangers. In such an environment the worst case scenario would be if the departing state refused to settle its deficit as after all it would likely be in deficit. Some argue that there is no deficit only claims and perhaps they have a point when everyone is still in the Euro as you can then argue that in essence this is simply a settlement system run by the ECB. But we return to what if you leave when you are now outside the system and refuse to settle up what would now be a deficit?


As I indicated earlier to my mind rather than being a problem in itself the Target2 issue indicates problems elsewhere. For example the German current account surplus or the way that ECB QE is settled mostly at the German Bundesbank. So when we see headlines like “debt” or “profit and loss” I am not convinced as it is an accounting system telling us about flows of cash. Of course cash flow leads many companies to come a cropper and indeed can do to governments as we are reminded again that this would not be a subject for debate beyond regional policy if there was fiscal and political union.

Somebody leaving seems likely to be an explosive event both politically and economically and in the turmoil lots would happen. For example a new currency for the country concerned and probably an element of default on debts too. This would bounce around the Target2 system but it would be an accounting identity rather than a cause.


20 thoughts on “The confusion around the Target2 system of the Euro

  1. sorry Shaun, but you have wind of some state leaving the Euro ?

    or are you implying the UK leaving is affecting the target 2 ?

    I think I read that the BoE had some support for the Euro even if were not using it as our currency ?


    • The Uk shouldn’t affect Target2 as it a financial accounting system applying to countries using the Euro as their currency or more officially the Eurozone (EZ) and the UK is not a member of the EZ.

    • There are several states where a referendum would have a decent chance of getting a “leave” result, hence the ECB making it clear that trying to escape will, very definitely, result in punishment beatings. Upcoming elections are the closest that anyone outside of the UK will get to such a vote so there’s a lot of chatter in the air. Boris’ comment last week is probably framed within this general landscape since he’s been talking off-record to a lot of MEPs and Eurocrats, and not just the random witterings of an eejit as some of the press (and maybe Boris) would have us believe.

  2. Great blog, Shaun. There seems to be a disease which infects senior Eurocrats, whether politicians or central bankers:
    1. They set up systems which coincide with their world view, which is of ever closer union;
    2. They assume that no one will challenge this orthodoxy;
    3. When people start getting uppity (“populism” takes over), they move into mode 2, which is a combination of “it cannot be done” (Irreversible) and threats (no one can leave without paying back the whole of QE).
    Meanwhile, no one actually thought about the effect of creating the Euro without a central fiscal policy, so we have in the real world the extraordinary unemployment and financial crises formerly known as southern Europe.

    • Hi James and thank you

      In the end we find ourselves discussing a halfway house monetary union. If they had been more honest and gone the full way then cash flow between Italy and Germany would only be a regional policy issue.

  3. Shaun, it seems very complicated to me, is target2 a kind of intraEuropean payment setttlement system? The scale of numbers is mindboggling. What I think I have understood is that ECB QE has been used to pay off Foriegn bond holders who “want out” of the European fiasco. That solution is a kind of hidden slight of hand to make the markets appear healthy but in fact substitute a payment with a promise of future re-payment by each nation. The QE is then not a solution but a massive Ponzi, in this text Mario is reminding all potential leavers that their debt under his policies has become far higher than they might have thought possible or reasonable.

    I propose my Euro currency solution, not to abandon the physical euro but reintroduce the national currency as an electronic form only for tax coĺlection and for meeting payment obligations, state employee wages and pensions.

    Paul C.

    • I agree that it is very complicated, but that is part of its magic for politicians and central bankers. I think that what has gone on is:
      1. The ECB invents money by using a very clever computer, entirely unrelated to the real world;
      2. It uses this “money” to buy bonds, some from Governments and some from companies;
      3. This makes people very happy, because the bonds go up in price and our friends in the financial sector do very well out of what is known as a one-way bet. They also get to swap all of their rubbish bonds for nice ECB paper;
      4. It also makes governments happy, because they can now borrow very cheaply and, in fact, can spend lots of money without going to the trouble of taxing people or borrowing from the markets at real rates;
      5. Gradually, the central banks run out of bonds to buy, so either relax the rules about what to buy or buy equities, with the same wonderful consequences for the financial sector;
      6. No-one even thinks about how to get out of this, or indeed why it is not rigging the markets, or indeed why it won’t end up in tears. That is because they all hope that someone else will be in power when it goes wrong.
      7. When it does go wrong, there will be a wailing and gnashing of teeth as taxpayers realise that they have to pay for something that they knew nothing about, has enriched the bankers and that politicians have lied to them.
      Anyway, that is my best shot at making it simpler!

  4. Good blog Shaun.

    It was intsructive to watch what happened to hapless Prime Minister Alexis Tsipras in Greece in 2015/16. He held a load of good cards (on the basis that if you owe the bank countless brillions then it’s them who have the problem if you default). Yet as soon as Tzippy naively made it clear he would not be prepared to leave the Eurozone under any circumstances, the Troika ground his face in the dirt. He’d blown it big time, the terms of the bailout were tightened and the Greek people are still paying the price for his poor negotiating skills.

    Up to that point the Troika had been terrified of Greece holding the pin on the default/devalue hand grenade. Part of those concerns, I’m assuming, would have been around Target 2. There must have been some very big big sighs of relief at the ECB…

    • default is painful both ways. The creditors lose a hell of a lot. The debtors can no longer borrow. They can print their own currency – but will sellers accept it ? Currency failure means govt salaries unpaid, pensions unpaid, people hungry and decidedly unhappy. The Bulgarian currency collapse of 1997 shows that default can be painful.

    • Hi therrawbuzzin

      The German Bundesbank seems rather content with its lot. From the FT.

      “Following a surge in German inflation to 1.7 per cent in December, on the back of climbing energy prices, the Bundesbank said price growth could hit a “good 2 per cent” in its latest monthly report – a level it has not hit since 2012. The ECB targets average inflation of just under 2 per cent.

      German policymakers said the eurozone’s largest economy picked up a healthy pace at the end of last year, helping push annual German GDP growth to its best level in five years at 1.9 per cent.”

      I am not sure how long it will remain happy as inflation rises though….

  5. Hi Shaun – “roughly half of the purchases were from counterparties located outside the euro area,” – that would be me in March 2016.

    “Almost 80% of bonds purchased by national central banks under the APP were sold by counterparties that are not resident in the same country as the purchasing national central bank” abd that would be me in November 2016, 10% better off! It’s nice to see concrete evidence on an aggregate scale of one’s own individual actions.

    What is the “fractious state of Brexit negotiations”? There haven’t been any with Europe have there?

    • Hi Noo2

      I think that there has been a type of negotiation albeit in public in the equivalent of a phoney war. Nice to see you making money but the way that so many investors front-run central banks these days is not healthy for the financial system.

      • “but the way that so many investors front-run central banks these days is not healthy for the financial system”

        Yes, I completely agree but as they say in the US – don’t blame the player. It is the CB’ers whom decided to make themselves into rock stars making public pronouncements on their next actions creating the opportunity for investors whom understand the system to make money out of their pronouncements.

        Personally, I think CB’ers should be very quiet shadowy figures whose CB’s operate silently in the background which should smooth capital flows.

        I was sitting on 20% profit, but following Trump’s election the hot money almost immediately left EZ bonds and ran off to the US given his re(in)flationery fiscal expenditure rhetoric which may help to explain the 80% of bond sales by foreign investors. If this QE had not been announced so publicly there would probably not have been such stampede into and later on out of EZ bonds with the resultant losses for the ECB.

        In fact I didn’t consider it an investment, it was a pure short term speculative one way bet that I couldn’t lose .

        I tend to hold my “real” investments for years, not months….

  6. years ago, to save a few French banks, Trichet, Juncker & company decided they would ignore treaties and rules. They thought themselves immune to accountability and they are correct -> there is no policing authority that can arrest them, no judicuiary capable of trying them. But they failed to see the damage to their own credibility and the credibility of the EC, ECB and Euro. Once the electorate is convinced you are a charlatan – you won’t be believed even when you aren’t lying.

    These crooks from the EC are destroying the EU, and we’ll all be worse off with out the EU.

    • Hi ExpatInBG

      I agree that it did not have to be this way. For example if the EU had remained more like a body for a single market the UK would not be on its way out. However whilst the technocrats deserve blame it is the politicians above them who deserve the most blame in my view as they sat supinely and watch what was taking place.

  7. “The confusion around the Target2 system of the Euro”

    Hi Shaun,

    – I must say my opinion as well: almost all the comments I read are off topic!
    And they are the cristal clear confirmation of your headline!

    – Target2 is a real-time gross settlement (RTGS) system… so talking of “debt”,
    “borrowers”, “lenders” etc. is nonsense.

    – Better to understand what is behind these flows: who buys, who sells, what is bought..
    and so on.

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