The arrival of the euro marks a profound and almost certainly irrevocable change to the financial landscape – perhaps the most important event in the international monetary system since Bretton Woods in 1944. Instantly, a major new reserve currency has appeared; indeed the euro is already being used in international transactions more extensively than any currency other than the dollar. As the most international financial centre anywhere in the world, London’s business has already been profoundly affected by the euro. This is because, although the UK is ‘out’, London is ‘in’. The conversion weekend – the changeover from participating national currencies to the euro in wholesale  BIS Review 43/1999  2  markets at the beginning of this year – was one of the biggest logistical operations that the London market has ever undertaken. It was also arguably more complex in London than in some countries in the euro area, because London traded in all the euro area national markets, and they all changed over to the euro in slightly different ways. And, though hard numbers are difficult to come by, we are confident that London is maintaining its market share. In exchange traded short-term interest rate derivatives – one of the few areas where we have precise figures – LIFFE has around 80% of euro business. On the London Stock Exchange, over 40% of turnover in the first two months of this year was in stocks of firms in the euro area.
This has led to the built-up of imbalances which increase the risk of a substantial price corrections and of loan losses (charts 13 and 14).6 A second, related, danger is that low rates may induce excessive risk-taking in financial markets – as opposed to reviving productive risk-taking, which is one of the objectives of low policy rates. Here, the economic literature stresses two channels: investors who are unable or unwilling to accept low returns are liable to take higher risks and increase leverage to reach their return objective, a phenomenon known as “search for yield” (chart 15).7 In addition, by pushing up asset prices and dampening price volatility, low interest rates reduce  5  This view is also reflected in market expectations. For instance, 10 year inflation expectations for the US, derived from the yield differential of inflation-linked government bonds and nominal government bonds, stood slightly below 2.25% in August 2013. 6  Empirical evidence suggest that a simultaneous built-up of imbalances in real estate and credit markets is a key leading indicator of subsequent financial instability. Cf., for instance, Schularick and Taylor (2012) and Borio (2012). 7  Cf. Borio and Zhu (2008) and Gambacorta (2009). 4  BIS central bankers’ speeches  measured risk and may lead investors to misjudge the true risk of a given investment.8 A long period of low rates, for example, may lead borrowers and lenders to overestimate debt affordability and underestimate the risk of higher debt servicing costs in the future.