The authors argue that part of these developments could have been expected as the consequences of the direct effects of the euro. These direct effects include the shrinking of the foreign exchange market; standardization and transparency in pricing; the elimination of currency risk; the elimination of currency-related investment regulations; and the homogenization of the public bond market and bank refinancing procedures. But these direct effects typically induce additional indirect effects. These are more difficult to assess, and the authors concentrate on them. Danthine et al consider four groups of indirect effects: the cost of cross-country transactions within the EMU area; the liquidity of European financial markets; the diversification opportunities available to European investors; and the institutional changes that are stimulated by EMU. At the centre of the discussion is the observation that arithmetically the euro zone has created a huge financial market with the potential to rival that of the US: in 1995, the combined value of equities, bonds and bank assets outstanding in the 11 EMU countries was $21,084 billion, compared to $22,865 billion in the US. The question is to what extent this arithmetic translates into economic reality.

Transaction Costs

While the euro leads directly to a decrease in explicit and implicit transaction costs, such as the cost of currency conversion and currency risk, this does not automatically signal that the cost of cross-border investment in Europe falls to the level of within country investment. Several important obstacles to intra-European capital flows remain, and these lie at the heart of the uncertainty about the impact of the single European capital market. Within Europe, cross-border payments and securities settlements are riskier, lengthier, more expensive and less standardized than equivalent domestic transactions. What is more, the euro zone has 18 large-value systems (compared to two in the US), 23 securities settlement systems (three in the US) and 13 retail payments systems (again, three in the US). Differences in taxation, legislation and standards create further obstacles.

A recent study by the ECB shows that fees charged to customers for domestic credit transfers rarely exceed €0.1-0.15, while for cross-border transactions these fees vary between €3.5-26 for small amounts and €31-400 for large amounts. The study also shows that, on average, cross-border payments need 4.8 working days to reach their destination and that 15% of the transactions needed more than a week to reach their destinations. By contrast, domestic payments arrive usually in one to three days.

An important indirect effect of the euro has been to expose these problems and put pressure on politicians and market participants to adopt measures that will foster a greater degree of harmonization and efficiency in financial market transactions. And EMU has certainly brought some progress to payment systems: the establishment of TARGET and EURO1 (the settlement systems for large transactions for the European System of Central Banks and the European Banking Association, respectively) and the implementation of the European Commission's Directive on cross-border credit transfers are the most visible steps taken in this direction.

The problem of transaction costs notwithstanding, by eliminating currency risk EMU has put traders in foreign euro-denominated assets on an equal risk base with domestic traders. Together with the increase in transparency resulting from the single currency, this has greatly reduced the barriers to trading such assets. In this sense, EMU has increased the demand side of the market for every asset traded in the euro zone. This effect will be reinforced if the supply of such assets increases or assets that were previously considered different become closer substitutes for investor portfolios.

To the extent that the expanded markets give rise to increased trading, the euro has reduced liquidity risk. An important theoretical feature of markets with transaction costs and liquidity is the possibility of multiple equilibria. In such markets, depth is endogenous and the possibility of 'virtuous circles' of high trading activity and low liquidity risk exist alongside those of 'vicious circles' of low trading and high liquidity risk. When assessing the euro's impact on liquidity, it is therefore important not only to add up the different pre-euro domestic markets, but also to evaluate the relationships between market prices, trading volume, the number and type of participants and transaction costs in the market after EMU.

A preliminary and still incomplete analysis of public and private bond and equity markets reveals that markets have deepened considerably, although there is still scope for further integration of the public bond market. Private bond and primary equity markets have expanded at a speed and to a point where it is possible to speak of a dramatic 'equilibrium switch', although the change in secondary equity markets has been less dramatic.

Market Breadth: Diversification

A second benefit of increased market size is the opportunity for greater diversification. In theory, the reduction in the costs and risks of cross-border transactions allows investors to improve the spread of risk of their holdings and to rebalance portfolios towards assets that were previously too costly in terms of the risk-return trade-off of standard portfolio theory. The only problem with this theoretical argument is that it is inconsistent with the evidence. As documented repeatedly in the 1980s and early 1990s, the share of international equity in total equity holdings by domestic investors has been much too small to be consistent with the standard portfolio model (the home-bias puzzle). Hence reasons other than currency risk must have kept investors away from foreign equity; if this is correct, the unification of currencies will not necessarily change investors' behaviour. Instead, the authors argue that the home bias in equities may be better explained by information problems that domestic investors face when valuing foreign securities.

According to this view, both the weakly developed equity culture of European investors and the lack of transparency and trading opportunities in European firms explain the sparseness of equity flows in and out of Europe prior to 1990. And the change in both these features during the 1990s explains the observed increases in equity flows. Thus EMU fosters market integration not by eliminating foreign exchange risk, but by improving information flows and by reorienting traditional international asset allocation methods from a country basis to a pan-European industry basis. If international transaction costs are high, only a few firms will find it profitable to change their portfolio strategies; but if these costs fall, a major shift in intra-European portfolio allocation is possible. Whether and to what extent the record turnover on European equity markets in 1999 can be attributed to this effect is, however, still unclear.

Institutional Change

In assessing how EMU has affected financial market institutions, the authors note some surprising success stories, such as the rise of Eurex and the increased competition between stock exchanges. But the banks, the main players in the European capital markets, have been affected by the euro in different ways. In particular, while the changes in capital market activity tend to hurt the traditional deposit and lending business of commercial banks (by producing a 'shift from banks to markets') they benefit the more market-based asset management and investment activities.

European commercial banks became more profitable and cost efficient during the 1990s. Some of this progress can be attributed to the competitive pressures of the Single Market, yet the existence of different currencies had been an important factor in maintaining a segmented market. The introduction of the euro seems to have provided an important, perhaps decisive, push towards the emergence of a more competitive and ultimately more integrated European banking market. The authors conclude that banks, especially in Europe, continue to be important in an environment of deepening and broadening capital markets. But they have had to adjust significantly in the past few years, and the evidence suggests that this adjustment has not always been successful. Several indicators, such as the evolution of M&A activity, suggest that EMU has had a major effect on bank restructuring in Europe.

Discussion Paper No. 2413: 'European Financial Markets After EMU: A First Assessment' by Jean-Pierre Danthine (Université de Lausanne and CEPR), Francesco Giavazzi (IGIER, Università Bocconi, Milano, and CEPR) and Ernest-Ludwig von Thadden (Université de Lausanne and CEPR).