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ICMA warns of eurozone repo “dysfunction”

UK omnishambles; the BoJ’s “broken” monetary policy; a creaking Treasury market; China’s economic woes; EM debt crises. It was about time that we had an ominous European headline to collect the full set.

The International Capital Markets Association has today sent this open letter to the European Central Bank to express finance industry fears over “rising dysfunction” in the eurozone repo and money markets.

. . . The conditions can largely be attributed to a disequilibrium situation of excess liquidity in the Euro banking system and a scarcity of high-quality, liquid collateral. The resulting risks are accentuated by constraints on bank intermediation.

While the environment of excess reserves and collateral scarcity has been the norm for a number of years, it has led to major market dislocations only on a limited number of occasions, notably certain year-end reporting periods and the COVID-induced turmoil of March-April 2020. However, as we enter a new phase of the monetary policy cycle, with the normalization of interest rates and associated market volatility, the potential for both the scale and frequency of such dislocations is likely to increase.

The market focus and associated pricing for 2022 year-end is already indicating such concerns, as is the persistent widening of asset swap spreads of short-dated high-quality euro securities. For example, we have observed the 3-month Bubill-EURIBOR spread invert to around 60bp (reaching 100bp in early September), while the swap spread for the on-the-run Shatz has become ever more deeply inverted to around 110bp (having reached 120bp last month). Meanwhile, German General Collateral over year-end is implying a rate for the “turn” of between -10% and 12%, while the USDEUR FX Basis Swap is also implying a rate of around -14%. The recent September 2022 quarter-end, which saw the widest quarter-end dislocation between collateralized and uncollateralized rates since the introduction of the euro, has only added to these concerns.

These pressures on short-term markets and collateral scarcity could be further accentuated by less favourable rates for the Targeted Long-Term Refinancing Operations or the introduction of reverse tiering to the ECB deposit facility. This extreme sensitivity to any changes in the liquidity-collateral equilibrium was highlighted at the start of the September 14 maintenance period when despite the ECB deposit rate being 75bp higher, repo rates actually tightened, with euro General Collateral trading around -0.30%.

Basically, if we’ve got this right, the ECB’s QE programme created reserves to buy eurozone bonds, but banks are now swimming in reserves while the European financial system is struggling with a shortage of high-grade eurozone bonds to use as collateral.

This is now gumming up financial plumbing in a worrying way — actually impeding the ECB’s attempts at tightening monetary policy in a firm but careful way — and the year-end could become a crunch point.

ICMA wants the ECB to consider two measures introduced by the Federal Reserve and the Swiss National Bank as a way to ameliorate the “disequilibrium of excess liquidity and collateral scarcity”. These are:

1) The Fed’s Overnight Reserve Repurchase Facility, through which the New York Fed repos some of its Treasury holdings (selling them and agreeing to repurchase soon afterwards) to provide the system with extra collateral, soak up excess reserves and set a floor under short-term interest rates.

2) The SNB’s recent announcement that it would issue tradable Treasury bills. Of course, starting a eurozone bill issuance programme could be politically touchy, but ICMA reckons it would be less complex than a reverse repo programme and would also not further clog up bank balance sheets in the same way.

Since ICMA is a finance industry lobbying body, the letter also includes some more general lobbying on behalf of banks to loosen their regulatory straitjacket — even though this is beyond the purview of the ECB.

A further, and possibly complementary, consideration relates to the capacity for banks to intermediate in the euro repo and money markets (and potentially the bond and derivatives markets more broadly). While the euro repo and money markets function relatively well on the whole, there are clearly identifiable pressure points around bank reporting dates (primarily quarter-ends and year-ends), as well as during times of heightened volatility, both of which have direct impacts on bank balance sheets and available risk capital to support market intermediation. A targeted recalibration of the Leverage Ratio (such as for certain transactions counterparty types) or the ability to re-allocate capital buffers to supporting liquidity provision, particularly at such times, could contribute to both market stability and resilience. While such refinements to the regulatory capital framework are beyond the gift of the ECB, it may be something where its support and guidance could be helpful.

FTAV has to admit that we hadn’t cottoned on to some of the issues raised by the letter, but we’re unsurprised that is causing problems.

It’s actually been surprising how little breakage there has been from the abrupt shift in monetary policy, and the year-end is a traditional time for mulled wine, family and financial plumbing issues.

But what do our readers think? Is this just industry moaning, or a new thing we should start to freak out about?

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