ECB as Pawnbroker of Last Resort (POLR) | FT Alphaville

ECB as Pawnbroker of Last Resort (POLR)

First we had the ‘credit crunch’. Now some warn what Europe might in fact be experiencing is better described as a ‘collateral crunch’.

Ever since banks turned to the secured collateral markets known as ‘repo’ for their funding needs, especially over longer durations, quality collateral has become the most sought over security in town. So much so, in fact, that some quality collateral is hardly circulating. Getting your hands on it, meanwhile, can make the difference between being able to fund in the public market or having to turn to the ECB.

The ECB’s less fussy nature when it comes to the type of collateral it accepts makes it, de facto, the dumping ground for all collateral that the public market has deemed unacceptable and is no longer prepared to fund against.

In many ways, therefore, if you are going to fund at the ECB, it does make sense to get your hands on the cheaper stuff. It’s one possible explanation why Italian bond auctions (and other distressed bond markets) have always been well covered despite notching up record-high bond yields.  You might call it ‘The Distressed Funder’s Dilemma‘, albeit with a cooperation twist:

– We all want cheap bonds to use at the ECB.
– We only want them if they are cheap, because otherwise it’s not cost effective to use them at the ECB.
– We had all better bid at a rate which makes accessing ECB liquidity worthwhile.

But it also means the ECB’s ‘pawnbroker of last resort’ monopoly is now ‘cornering‘ markets which nobody really cares about unless they are cheap from a funding perspective. The central bank’s attempts to strengthen those markets will thus be futile.

Tracking the collateral crunch

While soaring Libor rates were a key indicator of market stress during the credit crunch, the best indicator of collateral crunch intensity is instead the repo rate. The lower the rate, the greater the crunch.

The wider the spread between Libor and the secured (repo) rate, the greater the general distress in the market. The following chart reveals just how good an indicator of general market stress it is:

Upon which point we’d like to refer back to ICAP’s European repo report from Monday, because it makes some excellent points about the prospect of negative repo rates in core European bond markets.

Negative repo is in a way the ultimate indicator of collateral tightness.

As discussed here and here, negative repo markets, while unusual, are not unprecedented. Simply put, they indicate when a particular type of collateral (usually a government bond) is so sought after that would-be borrowers are willing to pay beyond the face value of the bond just to have access to its financing potential. Alternatively, you could say, those holding the bonds now need to be compensated for lending them out.

In a nutshell, the repo market turns from a financing market into a securities lending market.

The reason it’s risky in bond markets, however, is because it’s the first symptom of capital erosion. Whatever happens, you the security borrower (or in another world, you the cash lender) will have to pay more than the value of the bond to acquire it, meaning you’re giving away financing in part for free, or even more extreme — you’re paying someone just to hold onto your cash.

So whereas money used to have a time-related value, because of its ability to be invested in bonds, it now has a time-related depreciation.

That depreciation of money effect can cascade into the psychology of markets. Some suggest that it’s actually a useful policy, because it might be the encouragement the market needs to start investing in alternative, more risky, investments which don’t yet generate a negative yield. But if the market is not ready to get riskier, because they feel they might lose all instead of just a little, that translates to general time-related wealth erosion.

Which brings us back to ICAP, and what they had to say about the prospect of negative repo rates (our emphasis):

The subject of negative yields is hardly taboo for euro money markets these days. Last week we saw Dutch T-bills changing hands at negative yields and with the Dutch Treasury Bill due 29th June 2012 still being quoted above par this morning. Elsewhere, the plunging 3-month EURUSD basis swap rate on Friday briefly pushed to a level that more than offset Euribor – in effect implying that a counterparty would have to pay to lend 3 month euros for the privilege of borrowing against US dollars at the prevailing US$ libor rate.

So what’s to stop core AAA GC curves also moving into negative territory? Not much, at least on the face of things – the market is well used to the idea of deeply negative rates being applied to specific govt. bonds. Albeit the US Treasury repo curve has flirted with the big zero level on a number of occassions over the past few years without ever moving through it.

With 3 month German GC trading as low as 0.12% and overnight French GC hitting a low of 0.09% last week, we certainly seem to be within touching distance. Worth noting here that, if GC rates continue to fall, French overnight GC may well prove the first to print negative. With rather elevated demand seen to push into shorter and shorter maturities seen throughout euro money markets, overnight provides the surest haven for investors and the French GC market has particular appeal over its German equivalent. The German overnight market closes at 09:30 London time (in LCH) each morning to make sure that all trade has time to settle before market close whereas the French overnight market remains open till 12:45 London time (in Clearnet) meaning that there is a significant period of each trading day when France offers the deepest and most sought after overnight collateral market. In practice, most German short dated trade goes through in the tom-next market.

By way of a running score, tom-next German GC has been marked this morning around 0.16% with equivalent French GC trading at 0.22%. In the overnights, Dutch GC is at 0.15%, France at 0.20%, Belgium at 0.25% and Spain up at 1.05%. The charts below give an impression of the state of play out in the term markets.

One might argue that general collateral should not trade at such a premium to EONIA, normally the preserve of severely illiquid or overwhelmingly sought after bonds. But this is a taboo that has already been well and truly broken. German GC is already trading at unprecedented spreads to the EONIA OIS curve, including the post-Lehmans-collapse period. Just by way of example, we’ve seen the German GC curve trading around these levels before, as the chart below illustrates, but back then we had policy rates 25bps lower than they are now. If the ECB were to cut again in December, as seems entirely likely, the German GC curve may well take the plunge.

And here’s a chart of that amazing flattening in the German repo curve:

How can German bunds trade so much lower than EONIA and periphery bonds trade so much higher than EONIA? We presume , overall, that’s a function of ECB graduated haircut policy. As well as the fact that EONIA only reflects the rate for the strongest banks in the market.

Related links:
Of bonds and automobiles
– FT Alphaville
When a government bond becomes a Giffen good
– FT Alphaville
One Eurobond to rule them all – FT Alphaville
Bund auction reaction, the liquidity case
– FT Alphaville
ECB decision could be critical in Greek debt crisis – Risk