Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

Down in the depths of Europe's financial system, a nasty blockage is building. The plumbers at the European Central Bank meet next week to try and fix it.

They may be four days too late. Italy's referendum could just stretch the system to breaking point before then.

At stake is the health of the 5 trillion-euro ($5.3 trillion) securities lending market, which greases the wheels of all manner of derivative, short-selling and structured transactions. A crunch point has arrived in Europe. The last few days have seen an extreme spike in demand in particular for short-dated German government bonds. 

Collateral Crunch
Bunds are getting more expensive relative to overnight money, or Eonia
Source: Bloomberg

These are among the few securities of high enough quality to be accepted as collateral in repurchase agreements. Cash is no good (well, not for the Bundesbank anyway). These agreements operate like high-quality loans whose proceeds are normally used for activities like financing the purchase of other securities. Without them, a lot of other everyday activities -- such as bidding at bond auctions and hedging underwriting risk -- could seize up. 

The demand spike is from the usual year-end surge in demand for collateral getting pulled forward, and has exacerbated a shortage of securities that count as collateral.

In normal times, firms borrow the securities they need and quickly return them -- there's usually a flood of lending and borrowing going on, and the repo market operates silently in the background of Europe's financial system.

But the ECB's drive to jump start the economy has led it to buy up about 20 percent of the market for German bunds and other top-quality securities. Schatz -- German government bonds of a two-year maturity -- had become notably harder to come by. Firms can borrow them from the ECB, but only on the strictest of conditions. The Bundesbank has been even more resistant: it's long been reluctant to accept any kind of collateral of lesser quality than German government bonds.

Parking Deposits
In theory, banks should put less money with the ECB when rates turn negative. The reverse has happened
Source: Bloomberg

If all that wasn't difficult enough, it's getting more expensive, too. Schatz and other short-dated core European government bonds have repriced from being accepted as "general collateral" to being increasingly "special." In order to borrow them in the repo market, firms have to pay up -- despite them offering no interest or coupon.

The schatz yield now is so negative that the ECB is ineligible to purchase these two-year securities under its own criteria for bond purchases. The central bank's floor is minus 40 basis points, and schatz now yield minus 70 basis points.

That means the ECB can't meet its objective of buying those securities, allowing the cash to be funneled back into the wider economy. Its own program has become self-defeating.

Relaxing the rules would, ironically, benefit Germany the most: it would allow more of its shorter-dated paper to reappear back on the bond-buying radar.

A Reuters report last week that the ECB is looking for ways to make it easier to lend out its stockpile of bonds drove the schatz yield up from a record low. But it's not quite as simple as that, and the two-year yield is now as negative as it was before.

The shortage of securities eligible for general collateral is severe. Failure to return said collateral on time to a national central bank is a serious problem. If you did the same thing with the Bank of Japan, that would almost certainly get you fired or your firm fined.

This severely restricts the system's flexibility. It only takes one unreliable counterparty in what can be a long chain for a firm to fail to deliver to a central bank. Everyone wants to avoid being fined, or potentially shunned in the future. And that's how the market can slowly grind to a halt.

Unless it happens quickly. A "no" vote on the Italian referendum on constitutional reform could see Prime Minister Matteo Renzi leave office and the ascendancy of the opposition Five Star Movement, which is committed to hold a referendum on leaving the euro zone. It's conceivable that could push Europe to the precipice (again) and investors to the safe haven of German government debt.

If we learned one thing from Lehman Brothers, it is how important it is to keep money markets functioning in times of tumult. Draghi may already be planning to relax current procedures -- the simple solution would be to accept cash -- but he's at risk of being too late.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Marcus Ashworth in London at

To contact the editor responsible for this story:
Jennifer Ryan at