It's a bad start to 2017 for the European Central Bank. The collateral freeze that plagued the 5 trillion-euro ($5.2 trillion) securities lending market at the end of last year is still very much with us, and in fact has got worse.
It's not as if it didn't try. At their Dec. 8 meeting policy makers took steps to unblock the piping of Europe's financial system by tackling an extreme shortage of the short-dated bonds that firms can use as collateral in repurchase agreements. These deals operate like high-quality loans, whose proceeds are used for activities such as financing the purchase of other securities. Without a properly functioning repo market a range of other everyday activities, such as bidding at bond auctions and hedging underwriting risk, will grind to a halt.
Normally firms borrow the securities they need for their repo agreements and quickly return them, but the ECB's been buying up a lot of debt through its quantitative easing program. This has created a big shortage of bonds that Gadfly has argued needs to be fixed -- and quickly.
The ECB's made available an extra 50 billion euros of bonds it holds through its quantitative easing program to firms to borrow for use in repo agreements. It will also accept cash as collateral from borrowers of its bonds rather than, as the Bundesbank had previously insisted on, replacing one German government bond with another.
Unfortunately, this was about the same as giving a sick patient who needs five doses of medicine just one. The ECB will need to do much more when policy makers meet on Jan. 19.
This was always going to be a very tight year-end for funding. This is in part because the ECB also now allows national central banks to buy their own government bonds at yields lower than the deposit floor of minus 40 basis points, a move that paves the way for them to purchase more short-dated securities. While this will placate core central banks that have been pushing for better access to such bonds, the result is a worsening shortage of the securities needed by everyone else in the repo market.
Toward the end of December it became all but impossible to find offers to lend out core European government paper. Cash-rich foreign investors shifting into securities with higher yields and longer maturities, and investment funds' usual year-end rotation out of equities and into fixed income, sapped supply for repo participants -- neither of these buyers tend to lend their holdings.
These swamped the ECB's measures, and German two-year yields are now hovering around a record low. Dealers are still asking for much greater access to borrowing highly sought-after bonds from the bank's 1.3 trillion-euro QE holdings, whose vast size has created this shortage.
Before the Dec. 8 ECB meeting the repo market was already in worrying territory. But now it's bordering on dysfunctional. Rates for bonds eligible for use as general collateral went “super special” for Germany, trading as rich as minus 5 percent (per day on an annualized basis), and up to minus 12 percent for particularly highly sought-after issues.
Fixing this collateral shortfall is going to require the ECB to introduce systemic changes. The bank needs to offer far more than just an extra 50 billion euros of additional access -- multiple times that amount is needed.
It might get there, after much delay. At least the ECB's seen the problem, and is addressing it. But true to form, it creates new obstacles in the process. While it's most welcome that it accepts cash instead of securities as collateral, it's charging market participants a fortune (minus 70 basis points, when the ECB's main rate is zero) to participate in its solution to a problem it created.
Other regions, such as the U.K., have none of these issues, and their markets function smoothly. But they don't have a clutch of bickering nations to contend with, and for euro-area money markets, that's never going to change.
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