Since its creation in 1999, the Euro has grown rapidly to become the world’s second most widely used currency after the US dollar. Now, the Euro is used not only as the domestic currency of its nineteen member states, but as an international reserve and settlement currency. Every day, hundreds of thousands of Euro-denominated domestic and international payments, totalling nearly 2 trillion Euros in value, flow through Target2, the Euro area’s real time gross settlement (RTGS) system.1
The Single European Payment Area (SEPA)
A complication of the Euro is what exactly constitutes an “international payment.” Generally, it is correct to describe payments across borders within the European Union, as well as payments beyond it, as international payments, since the EU is made up of 28 independent countries. But the Euro countries share a currency, a central bank and a payments network. The Euro area became a Single European Payments Area (SEPA) in August 2014 – this means that wire transfers and direct debits across the whole Euro area are now effectively domestic payments.2
Currently, payments between Euro and non-Euro countries within the European Economic Area (which comprises the EU plus Norway, Iceland and Liechtenstein) would be regarded as international payments. But in October 2016, the non-Euro EU countries, plus the other EEA members, will also join SEPA. At that point, all Euro-denominated payments within the EEA will be treated as domestic payments, even if the originating or receiving country is not a Euro member. Of course, payments between Euro and non-Euro countries in the EEA will still be subject to currency exchange rate fluctuations. But there should be no other impediments to the movement of funds within the SEPA.3
Target2: the heart of SEPA
Target2 is run by the Eurosystem, the Euro area’s system of central banks – nineteen National Central Banks (NCBs) around a central “hub”, the European Central Bank (ECB). Target2 is one of a global “family” of RTGS systems run by central banks, including Fedwire for the US dollar and CHAPS for sterling.
Target2 settles all Euro-denominated international payments, both within the EU and beyond it. It also directly processes large value domestic payments. Euro area businesses making large value payments can route them directly to Target2 or send them via the Euro1 system.
Euro1 is a privately-owned large value payment system not unlike the US’s Clearing House International Payments System (CHIPS). It collects payments during the day, and at the end of the day sends the netted payments to Target2 for final processing.4 For this reason, Target2 is often preferred for urgent payments, because it processes the transaction instantaneously when it arrives, meaning that funds can reach the payee within minutes. However, payments by either route should reach their destination on the day they are sent.
All banks in the Euro area that have clearing accounts at their respective national central banks are members of Target2. Banks headquartered in non-Euro EU and EEA countries also have direct access to Target2. Other banks access Target2 for international payments either through a branch in an EEA country, or via a correspondent bank network.5 Most Euro area large banks are also members of Euro1: smaller banks access Euro1 via arrangements with Euro1 member banks.6
Smaller and less time-critical domestic payments, including high-volume retail transactions, are processed through various systems, all of which are (or soon will be) compliant with SEPA requirements. Most of these are “clearing house” systems running at intervals during the day and/or overnight, which send aggregated payments to Target2 for final settlement.7 We can safely say, therefore, that all Euro-denominated non-cash payments – wire transfers, direct debits, cards and checks - end up going through Target2 by one route or another.
Target2: issues and uncertainties
Target2 is not without its problems. An international payment system that has no frictions is wonderful for trade – but it can also be used to move large quantities of money for other reasons. Prior to the 2007-8 financial crisis, Target2 helped foreign banks to lend large amounts of money to businesses, households and banks in the Euro area periphery. Equally, when the financial crisis hit, Target2 enabled those same banks to pull their funds out of the periphery countries, causing what is known as a “sudden stop” in several countries.8
During the Euro crisis of 2012, Target2 enabled people to move money from countries in crisis to those considered “safer.” Mostly, this was done by wire transfer: people wired money from bank accounts in, say, Spain to bank accounts in Germany. As a result, large imbalances built up in the Target2 system which made it look as if central banks in the sending countries owed money to central banks in the receiving countries. These so-called “Target2 balances” have been the subject of fierce debate, with some arguing that sending countries should be forced to settle these “debts”, and others saying that they simply reflect private sector capital flows and no policy action is required to correct them. To date, this argument remains unresolved.9
Perhaps the most serious problem with the Target2 system occurred in the 2015 Greek crisis. To prevent bank collapse due to capital flight, the Greek authorities imposed capital controls, effectively preventing cross-border and international payments via Target2.10 This set a precedent. After all, no state in the U.S. could unilaterally suspend access to Fedwire for its residents. To what extent is the Euro area really a Single Payment Area if its national governments can limit access to Target2?
As the Euro international payments architecture becomes more streamlined, strains are showing. The EU authorities are grappling with a conundrum: should there be deeper integration, which would mean less authority for national governments, or is national autonomy too important to dilute? It remains to be seen how this will be resolved – and hence what the future holds for Euro international payments.