The ESM’s ability to safeguard financial stability is anchored by the paid-in capital provided by its Members. Preserving this capital is therefore essential to fulfilment of the ESM’s mission.
Initially the firewall was due to receive its capital gradually over five years. However, to show their determination to make the ESM a credible support mechanism for the common currency, the euro area countries accelerated the contribution schedule that had originally been set out in the ESM Treaty and rapidly created a large pool of cash to invest. The capital thus came in over an 18-month period, with the first two instalments paid simultaneously in autumn 2012, and the final three came on a schedule of one every subsequent six months through spring 2014.
By the end of 2018, the ESM had received €80.5 billion of paid-in capital. When the last additional expected instalments from all ESM Members are received in 2027, the paid-in capital will total €80.8 billion. The ESM has a remit to safeguard these funds, maintain the highest possible credit rating, and support the euro area in times of market stress. These investment principles have remained unchanged since the firewall began.
When the permanent ESM was created, there was at first no clear roadmap for specifically how to manage the holdings of this new kind of institution. The overarching goal – to preserve liquid holdings and the long-term value of its capital – needed to be translated into investment guidelines that would spell out the universe of potential investments. The fund also had to find the right people to carry out this strategy and create the right systems for them to use.
While the capital’s main purpose is to ensure the ESM’s highest creditworthiness, it can also be used in emergencies to cover any liquidity needs. Therefore, the ESM’s investment guidelines in part resemble those used by central banks to manage their foreign exchange reserves. This means a focus on investing in high-quality securities and keeping a tight rein on market and credit risk. At the same time, the ESM must also maintain its credit rating, in the manner of those international financial institutions that issue debt.
‘In deciding how to invest its funds, the ESM is somewhere between a central bank and an international financial institution. The investment rules need to be relatively similar to those of central banks, but the ESM must also make sure it has the highest credit rating to raise funds on financial markets,’ said Lévy, the institution’s head of investment and treasury. ‘In practice, this means that we need to define our own approach and we need to make sure proposed solutions are agreeable to all our 19 shareholders.’
The ESM strives for a portfolio of safe, diversified assets that could be easily converted into cash. Transactions are calibrated so they can be absorbed by the market without having adverse effects on asset prices. As part of its long-term strategy, the ESM aims to avoid large-scale purchases or sales that would disrupt market prices.
In the EFSF’s early days, there was no formal investment department. At the start, a team at the Frankfurt-based German Finance Agency handled EFSF debt operations, and this team was initially in charge of investing the short-term liquidity. It also purchased some securities on behalf of the EFSF related to the early Portuguese and Irish programmes, in order to provide investors with additional guarantees. Liquidity management became a bigger part of operations once the EFSF adopted its diversified funding strategy in 2011 and was able to raise money on an independent schedule from its disbursements.
Once the euro area committed to creating the permanent ESM, it was clear that investment activities would grow, in particular when its paid-in capital started to flow in. The firewall began relocating its funding and investment activities in-house.
During the course of 2012, the organisation hired portfolio managers, set up the investment framework, and built the necessary information technology infrastructure. The first head of investment and treasury came from the French central bank, while portfolio managers were recruited from banks, asset managers, public financial institutions, and central banks. The resulting mix of backgrounds reflected the ESM’s effort to bridge worlds and to put together a diverse team – but first the team needed to get organised.
‘It was very surprising at first. We thought we were recruited to manage assets and instead the first thing we had to do was to come up with an investment framework, test the IT system, and establish policies,’ said Carlos Martins, an ESM portfolio manager.
When setting the investment guidelines, the ESM concentrated on debt securities issued by highly rated public entities. At first, the investments were mainly focused on bonds issued in euros by supranational institutions, euro area governments, and public agencies that had a minimum rating equivalent to at least an AA. Over time, as the organisation gained traction, the guidelines have been expanded to allow broader types of investments such as covered bonds and non-euro area issuers, while remaining in line with the original core principles.
The paid-in capital had to be invested in line with these principles and guidelines as it flowed in. For each lump sum, the team developed a ramp-up strategy to place the funds without pushing up asset prices. After all, market participants were generally alert to when the money was due and tried to anticipate the ESM’s operations. ESM Managing Director Regling said: ‘We had to make sure they couldn’t front run us.’
To avoid disrupting markets, the investment team purchased smaller-than-expected amounts and kept its timing flexible, if necessary holding on to the cash until the market was better able to absorb the flows. On average, trade sizes were about €30 million and each instalment was invested over a period of three to four months.
‘It was very important to deploy the paid-in capital in such a way that it did not leave a large footprint in the market,’ recalled Ivan Semerdjiev, a former Bank of Canada staffer who is now an ESM portfolio manager.
‘Everybody knew it was coming and everybody knew that it would be invested, but generally nobody knew over what period it would be deployed. We didn’t want to make any real ripples and overall we achieved this objective.’
From the start, the investment team closely monitored portfolio allocation and performance, keeping the Management Board apprised of all major events affecting the positions. ‘When I joined, I was pleasantly surprised to discover that the ESM had already implemented a detailed performance-monitoring and attribution system. This type of capacity usually comes later,’ said Lévy.
Senior ESM staff meet monthly to review macroeconomic and financial developments and define the investment strategy for the coming months. This structure was present from the beginning and would be refined as the investment strategy evolved and matured. By checking in regularly, they can analyse recent market developments and adjust the portfolios accordingly. These meetings ensure a robust investment decision-making process.
As the range of instruments expanded, the growing investment team reconsidered its internal organisation. The team manages the ESM’s two main investment pools – one for day-to-day liquidity and one for long-term capital holdings – as well as the EFSF portfolios. Over time, the initial everyone-does-everything approach was reaching its limits. The team considered dividing responsibilities between asset classes and maturities, yet eventually settled on a geographical breakdown.
‘We initially couldn’t find a good approach to distribute assets in a way that would be easy to implement operationally and logical financially. We reviewed many possible options and finally, we thought: “Let’s just split euro area issuers by country and create a specific diversification portfolio for non-euro-area issuers and supranationals,”’ Lévy said. ‘The objective was to create a structure where we would collectively be responsible for the whole investment strategy, but implementation would be divided up in a practical way to enable team members to focus on a particular market segment.’
In establishing itself as a professional investor, the ESM built up a network of counterparties to conduct transactions. As early as 2012, the ESM was working with more than 20 international counterparties, ensuring broad access to the European bond market. This network would eventually expand to include more than 35 counterparties, active across different markets.
Portfolio management posed another set of questions for the institution. The ESM had to determine how to apply professional asset management principles, which required regular market operations, but again without interfering with euro area bond market prices.
‘It was not very clear how active the ESM was supposed to be in the market,’ Martins said. ‘A good illustration of this occurred the first time a portfolio manager sold a bond. The sale raised eyebrows. It was even reported to the internal risk committee; people wanted to understand the rationale behind such an operation.’
To help make its case, the ESM consulted established international financial institutions with extensive fund management expertise. Representatives of the World Bank came to Luxembourg to work with the ESM’s team and provided assurances that the firewall was adhering to best practices. The investment team worked hard to convey the importance of active management to the ESM shareholders.
‘We had to explain what it means to be active in the market as a public institution, and not as a market maker or an active fund manager. We had to reassure the shareholders that it was essential for the ESM to be present in the market and to be ready to act if and when a market intervention was required to provide liquidity,’ said Frankel, ESM deputy managing director and CFO.
Active portfolio management brings a number of benefits. By adjusting the ESM’s asset allocation in response to economic and market conditions, the ESM can contain some of the financial risks and enhance returns, building a cushion on top of the paid-in capital to augment the firewall’s financial strength.
For example, when the ECB implemented its quantitative easing programme in January 2015, there was a dramatic change in market conditions. In response, the ESM reconsidered its asset allocation, switching out of some securities deemed to be over-priced and into others with better return prospects. The ESM also lengthened its maturity investment profile when yields turned strongly negative.
The ESM also needed in-depth market knowledge and capacity to ensure it could tackle the challenges that might come from the implementation of a secondary market purchase programme, where the ESM intervenes in financial markets to purchase securities of an eligible country. To be able to act for the euro area when needed, the ESM put together a team able to trade securities not only in normal conditions but also in periods of market stress and low liquidity.
This instrument has never been used. However, all the preparations were carried out so a programme could be put in place quickly when called upon. As early as 2012, the ESM had built a full set-up with the ECB and the French central bank, the Bank of France. This required special procedures, secure communication networks, and close cooperation between the three institutions. Later, this framework was reviewed to include only the ESM and the Bank of France, as the ECB and the ESM needed to ensure a clear separation of duties.
‘It was essential for the success of the ESM to work closely with these well-established institutions, to have our intervention capacity ready. Initially, it was difficult to coordinate well, but, after two test runs, we knew we were ready to take on our responsibilities,’ said Maria Kartcheva, the ESM’s portfolio manager responsible for this project.
The ESM has been reviewing its investment guidelines regularly, leading to changes in strategy as conditions dictated. In 2013, it became clear that the initial investment framework was working but it was excessively conservative and rigid, even given the ESM’s mandate. Broadening the range of investments was becoming necessary to reinforce the ESM’s long-term financial strength in a time of falling yields, without generating significant risk.
‘By then, it had already become increasingly difficult to meet the diversification requirement included in the investment guidelines, which require 30% of the paid-in capital to be invested in supranational or non-euro area issuers, to reduce the overall concentration on the euro,’ Semerdjiev said. ‘At the time, we could only buy euro-denominated securities. So, we approached a number of supranational entities and asked them to issue some private placements, which we purchased. This flexibility was essential to enable us to comply with the requirement set by our shareholders.’
In one instance in 2015, the ESM undertook a short-term private placement with the EU, an eligible supranational entity, which used it to provide a bridge loan to Greece.
For more on the bridge loan, see ‘Focus — An unusual money market transaction’ in Chapter 37.
Lévy, who joined in November 2014, took on responsibility for the further diversification of the fund’s holdings. Yields were falling at the time and, to avoid losses, the ESM had to expand its investment universe. Scenario analysis performed in 2015 showed that more needed to be done because of the negative interest rates on most eligible assets. The risk of losses was looming, to the point of possibly threatening the ESM’s long-term creditworthiness.
All changes had to be reviewed internally and approved by the 19 members of the Board of Directors. The investment team explained for each proposal how the revision would reinforce the institution without generating undue risk. This proved to be a lengthy process.
The first modifications, in 2015, were incremental, broadening the number of issuers eligible for ESM investments.
‘For a very long time, there was no internal agreement. There was a lot of passion about what the ESM could and could not do,’ Lévy said. ‘Ultimately, we went for a shortcut. We just changed a few lines in the annex, but those changes made quite a big impact.’
These changes increased the amount the ESM could invest in certain eligible issuers like AAA covered bonds or public agencies with a minimum rating of AA. More ambitious revisions of the investment guidelines took another year, and these 2016 changes helped to mitigate the impact of negative interest rates, while minimising overall portfolio risk.
The ESM’s investment universe would eventually extend to a wider range of bond issuers, including some with slightly lower ratings than had previously been allowed. In particular, the ESM was allowed in 2016 to invest €75 billion of its capital at a rating equivalent to or above AA- instead of the previous AA rating. The rules also expanded to offer the possibility of investing in covered bonds, sub-sovereign government issuers, and a broader geographical range of issuers, and it enabled the ESM to fully deploy derivative instruments to manage foreign exchange and interest rate risk.
To invest most effectively, the ESM needed to build its investment capacity, so it launched a number of initiatives in parallel. Initially, the only result was a logjam; none of the projects were getting finished. For Lévy, the question was how to prioritise the initiatives the investment team was working on.
‘People were trying to achieve a massive project, called “new instruments”, and were starting to get frustrated at the lack of progress,’ Lévy recalled. ‘We decided to change the approach and target some quick wins. We managed to convince the different teams that it would be more efficient to cut the project into more digestible chunks and focus on short-term non-euro investments traded with public institutions, without collateral. That worked.’
Within six months, the first of the new instruments – foreign exchange swaps and forwards – were coming on board, enabling the ESM to conduct the first non-euro investments. By the end of 2015, the ESM had invested about €2.0 billion in Danish kroner and Japanese yen, hedged into euros to avoid the currency risk, helping to diversify holdings and improve returns. The ESM also laid the groundwork for investing in assets denominated in nine major countries’ currencies: Australia, Canada, Denmark, Japan, Norway, Sweden, Switzerland, the UK, and the US.
By 2016, the ESM could enter into repurchase agreements (repos) to broaden its investment capacity and to raise liquidity in emergencies. This capability was phased in over time. At first, permission was limited to reverse repos, the equivalent of a collateralised deposit. Later on, the ESM added traditional repo operations, lending out securities from the portfolio to receive cash.
‘If we need to introduce a new type of instrument to fulfil our mandate, we will act on it; we have a ‘can-do’ approach,’ ESM Chief Risk Officer Pacciani said. ‘We also have a strong risk culture and a prudent approach. So, we always look at best market practices to build our own standards, our own limits, and methodologies. We aim to be modern and prudent at the same time and we reflect these two dimensions in our risk management framework.’
In 2015 and 2016, one of the principal strategies to enhance the portfolio’s performance was to move into cash. At the time, the ESM’s paid-in capital was fully invested in securities, but plunging interest rates necessitated a re-allocation. Drawing on its eligibility to leave funds at the Bundesbank at 0% interest, even when deposit rates went well below that, the ESM swung heavily into cash – €45 billion at the end of 2015 and €60 billion at the end of 2016. This reduced the ESM’s interest rate sensitivity in a depressed market environment.
‘When yields started to fall into negative territory, we had an incentive to sell our bonds and leave the cash at 0% instead of keeping assets with negative interest rates. We never thought we would end up selling about three quarters of our portfolio’s assets. We looked for alternative investments, but very few eligible assets could offer a positive return,’ Lévy said.
However, these exceptional conditions did not last for the ESM and EFSF. In late 2016, the ECB informed the ESM that it would be treated like many other public institutions and that the cash left in euro area national central banks would be charged the ECB’s deposit facility rate, set at -0.40% at the time. The ESM and EFSF started paying these charges in early 2017.
With these conditions still relatively more favourable than short-term securities, which offered investment returns close to -0.50%, the ESM kept a large part of its assets in cash. It had to count on its accumulated reserves to absorb the expected losses.
Germany and France stepped in to ease the burden. Concerned that these charges might affect the financial strength of the rescue fund, the finance ministers from these countries pledged to reimburse, for a temporary period, the negative interest paid to their national central banks. In 2018, France and Germany made good on that commitment, reimbursing interest paid by the ESM to their national central banks the previous year.
‘Capital preservation in a negative yield environment is arguably the restriction that is the most challenging to comply with,’ Semerdjiev said. ‘We have proposed other solutions to address this issue but, in the end, it will be the responsibility of our shareholders to decide where they would like the balance to be between risk and return.’
In 2017, after three years of preparation, the ESM began to conduct cross-currency swaps, facilitating investments in foreign currency assets without the accompanying currency risk. To do so, the ESM updated the risk framework and the information technology system. This was a difficult task, because the crisis had left regulations in flux and public institutions without a standardised approach. The ESM had to define its own approach. In doing so, the ESM became one of the first public international financial institutions to implement a bilateral collateralisation for its derivative operations, providing the ESM with broad access to market liquidity and competitive pricing. Other public institutions are currently considering this framework.
Overall, the investment strategy has succeeded. However, constant vigilance is essential. In 2017, with the pressure of negative interest rates, the capital recorded a loss of €124 million. The agreement to reimburse the ESM for the negative interest paid to some euro area national central banks is temporary, by nature. In these conditions, the ESM and its shareholders will have to review its investment framework regularly to make sure it remains fit for purpose.
‘The portfolio needs to stand up to stress testing,’ Pacciani said. ‘For example, what if interest rates go back to past historical levels? What if they stay in negative territory for longer than expected? We need to test the resilience of the institution and build capacity to withstand further challenging times.’
From 2012 to 2017, the ESM’s capital recorded an accumulated return of more than €1.2 billion, which has been kept in reserves, to cover the ESM’s future needs and help it achieve its goal of long-term capital preservation. This gain is more than €750 million above the performance of the ESM’s benchmark portfolios over the same period.
‘This shows that, in the end, all the efforts of the ESM to build its investment capacity and enhance return in a prudent manner brought some tangible results, for the whole institution,’ Lévy said.
Hedging against risk
As its operations have grown, the ESM has turned to derivatives to help it manage financial risks. In 2017, for example, the ESM took further steps to expand its investor base, manage the interest rate risk on Greece’s ESM loans, and preserve its capital. Specifically, it conducted the short-term debt relief measures for Greece at the behest of euro area finance ministers, issued its first non-euro bond, and broadened its investment universe geographically.
All these actions could have exposed the rescue fund to detrimental shifts in interest rates or foreign exchange rates. But derivatives, which are financial instruments whose price fluctuates based on an underlying asset, can help protect against such risks. The ESM put in years of preparatory work by its legal, risk, technology, funding, investment, and asset liability management teams to set up a framework for derivatives, and then it expanded their use in 2017.
The ESM uses derivatives such as interest rate swaps, foreign exchange swaps and forwards, and cross-currency swaps. In particular, the ESM deploys interest rate swaps to reduce the risk that Greece would have to pay a higher interest rate on its loans should market rates rise. In addition, for the US dollar bond issuance, the ESM hedged its US dollar cash flows from bond issues back into euros – the currency in which its programme country loans are denominated.
‘Derivatives are an important tool for us to mitigate certain risks related to our activities,’ said ESM Funding Officer Klaus, a former derivatives trader. ‘We are not a bank. We are not here to speculate. The derivatives are not there to be structured in complex financial products. What we’re talking about are plain vanilla derivatives to mitigate risks.’
The ESM applies a prudent framework for its credit exposures to derivative counterparties, which include public sector entities and commercial banks with high credit ratings. For operations with commercial banks, all derivative- related exposures are fully collateralised in cash or highly rated securities, on a daily basis. For lower-rated bank counterparties, the ESM can contractually request additional collateral to reduce credit risks.
Olivier Pujal, currently senior advisor to the ESM secretary general and former deputy head of the asset liability and management (ALM) team, said that, by using derivatives, the ESM reduced interest rate risk for Greece on its ESM loans. ‘Through derivative instruments, we try to limit variability of the ESM cost of funding by locking that cost in as much as possible at current long-term rate levels,’ he said.
Questions that needed to be addressed included contract structure, collateral, and custodian arrangements. For the time being, the ESM has ruled out the use of central clearing facilities for derivatives transactions, as those facilities handle only certain kinds of trades.
The ESM keeps its investing and funding books separate, by barring some data sharing between the departments. The solution was to pull together all derivatives transactions under one International Swaps and Derivatives Association Master Agreement, while the investment and funding teams each have their own credit support annexes with the commercial banks that serve as counterparties. Having two credit support annexes separates the day-to-day collateral needs of each book, while the single Master Agreement guarantees that all positions are netted if a counterparty defaults, keeping the ESM’s overall credit risk exposure at a minimum. Negotiations started in late 2016, and in February 2017 the ESM signed up its first group of banks.
Within the rescue fund, in the context of the Greek measures, the ALM team developed the calculation tools to monitor the volumes, maturities, and pricing of the derivative transactions, while the funding team was responsible for the optimal execution on the market.
‘Thanks to these tools developed in-house, the traders know at all times what operations can be done, and they can search for the best price within those parameters, while ALM checks that everything is done properly,’ Pujal said.
Programme countries aren’t the only potential beneficiaries of these instruments. Foreign exchange and interest rate derivatives have also widened the ESM’s borrowing flexibility and provided more avenues for the investment of the paid-in capital.
Derivatives made it possible for the rescue fund to sell its first dollar bond on 24 October 2017. The 5-year bond raised $3 billion, and the ESM executed cross-currency swaps to lock in a set foreign exchange rate over the life of the transaction. Using derivatives, the ESM can swap all funds back into euros as soon as they are raised, as well as convert euros into US dollars at a pre-set rate so that the ESM can make the coupon and principal payments on the US dollar bonds.
Likewise, foreign exchange derivatives are employed for the purchase of securities outside the euro area. Swaps made their debut in 2015 when the ESM began investing in Japanese yen and Danish krone bonds. For portfolio diversification purposes, the rescue fund can now conduct operations in nine currencies. By 2018, the ESM had invested more than €7 billion across eight non-euro currencies.
‘Everything has to be swapped back into euros to avoid currency risk,’ said ESM Portfolio Manager Semerdjiev. In the beginning, the firewall could buy non-euro-denominated securities only with maturities of two years and shorter. In the interim, the ESM worked up a more comprehensive derivatives strategy and is now capable of all necessary cross-currency trades.
On the investment side, derivatives are included in a set of risk metrics employed to monitor the market risk of the ESM’s portfolios. In particular, they are fully integrated in the standard value-at-risk measures to ensure that the ESM’s overall investment risk remains within the limits defined by the ESM’s shareholders.
 ESM (2018), ESM annual report 2017, p. 46, 21 June 2018, Publications Office, Luxembourg. https://www.esm.europa.eu/sites/default/files/ar2017final.pdf
 ESM (2017), ‘ESM debut in dollar market, raises $3 billion’, Press release, 24 October 2017. https://www.esm.europa.eu/press-releases/esm-debuts-dollar-market-raises-3-billion