With an average volume of 2.7 billion euros ($3 billion) a minute over the course of each business day, the euro area's TARGET2 settlement system is one of the world's most important bits of financial plumbing.
Like most bits of plumbing it is generally out of sight and — except for extreme monetary fetishists — out of mind. This does not mean, however, that people should dismiss TARGET2 as nothing more than a piece of infrastructure, as it throws up insights into stresses within the euro system.
So what is it, exactly?
TARGET2 is a payments system for banks. If a bank needs to move money to another bank, it electronically transfers the funds using TARGET2. The transaction is very simple.
Every bank in the euro area has an account with its own national central bank. If an Irish bank, for example, wants to move money to a German bank, it informs the Irish central bank of its transaction. The Central Bank of Ireland contacts the Bundesbank, where the German destination bank has an account, and the transaction is completed. The Central Bank of Ireland debits the Irish bank's account, and the Bundesbank credits the German bank's account.
All very simple really. And very quick too, with 99.9 percent of all transactions completed within five minutes. Basically, TARGET2 is just a phone line.
So, why am I still reading this?
Well, things get interesting when the European Central Bank adds new money into the mix.
Let's return to our example of a transaction between an Irish and a German bank. Also, let's set the calendar to some time in mid 2009.
The Irish bank had borrowed €100 million over three years from a German bank back in 2006, when Irish banks seemed like a good bet. By mid-2009, things were looking different and the Irish bank had a €100 million bill coming due, with nobody in the market willing to lend to it.
Luckily, the European Central Bank had recently moved to full-allocation liquidity operations,1 so the Irish bank is able to borrow the money from the Irish central bank, and the payment gets made.
However, when we look at the transaction through the prism of TARGET2, something odd has occurred.
The money that was credited into the Irish bank's account to allow it to pay the German bank did not come from anywhere. It just kind of appeared into the system.
This money started appearing across the periphery of the euro area as the crisis continued leading to imbalances in the TARGET2 system, like a credit created without a matching debit. It is important to note that the transnational imbalances only existed as the funding crisis was concentrated in particular countries.
As the bank funding crisis eased in the aftermath of ECB president Mario Draghi's famous "whatever it takes" speech, peripheral banks' reliance on central-bank liquidity started to lessen. As banks repay this money to their national central bank, the imbalance is extinguished.
Why should I care about this today?
As you can see from the chart above, TARGET2 balances have started increasing again. This, again, is due to the ECB creating money and adding it to the banking system in the middle of a normal TARGET2 transaction, but at a slightly different point — and in a more direct way.
In the run up to mid-2012, peripheral central banks were lending to banks in their own countries and those banks were then using that money to repay debts to banks in the core.
Since the ECB started its asset-purchase program in early 2015 national central banks are once again creating money, but this time they are not crediting banks' own accounts, they are crediting the bank accounts of the holders of the bonds they are purchasing.
This time, it is where those bank accounts are located that is causing the imbalance.
As Peter Praet, chief economist of the European Central Bank, explained in a speech last week, most of the accounts of those asset holders are in Germany. So, if the Bank of Spain, for example, wishes to purchase some Spanish debt in the market the seller is likely to hold an account in Germany. To TARGET2, the transaction looks like this.
As the money is created at the Bank of Spain and then moved to the Bundesbank, the liability does not arise in Germany, but rather in Spain.
In the run up to the 2012 crisis, TARGET2 balances were useful in giving an indication of where reliance on ECB liquidity was highest. Since the ECB's Asset Purchase Program began, all they are telling us is where bondholders prefer to bank.
But at least you now know how the whole thing works.
Finally, the ECB could get rid of much of the TARGET2 confusion by removing the national central banks from the system and put itself alone in the center of all transactions — having every bank in the euro area hold their accounts with it, rather than their national bank — but that may be a reform too far for now.