We’ve discussed why the ECB’s policy of applying different haircuts to eurozone government debt collateral may be adding to dysfunctions in the repo market.
It’s one reason why broadening the ECB’s list of accepted collateral to include lower-quality assets won’t make much of a difference on a policy scale.
Now Nomura’s Fixed Income strategist Guy Mandy makes a similar argument.
As he noted earlier this week:
The ECB’s outstanding pool of eligible collateral stood at €14trn at the end of 2010, indicating that insufficient collateral is not a problem and somewhat dismissing calls for broadening collateral allowances. In our view the greater problem may be the gradations of haircuts, rules which have recently been tightened over the past year to include greater haircuts on lower-quality sovereigns.
This may have had adverse consequences in terms of cheapening the belly and back end of curves and increasing the perception of differentiated sovereign risk in Europe.
Haircuts tend to define the relative attractiveness of funding facilities with the corollary that they define the collateral used for greater funding efficiency. The ECB’s graduated haircut policy could potentially be causing a greater differentiation of euro sovereign curves. The graduated structure was first introduced in April 2010 when the debt crisis was set in motion as Greece lost market access.
Mandy’s point is that while the ECB’s haircut policy might have been seen as prudent at the time, in a single monetary union — where markets are already reflecting preferences for certain types of Eurozone debt — having the ECB treat government collateral differently only intensifes the phenomenon.
The ECB should, by all definitions, treat all government debt the same.
As Mandy notes, the graduated regime has instead encouraged banks to trade some bonds in private funding markets and others only at the ECB :
To make matters worse, as far as increasing credit risk on the ECB’s balance sheet is concerned, the significant haircut differential between private repo and ECB repo leads to generally poor quality assets being posted to the ECB and quality assets being held for use in private repo or simply sold given the higher cash generating ability of the last two options. As an example a 10y Bund through the ECB is subject to a 5.5% haircut versus ~2% in the private market. We think increasing the cost of using lower quality sovereigns was a mistake. This is because it immediately creates reduced demand in the use of these assets for repo purposes and may have added to the decreasing liquidity in those curves. As such the further graduation in the haircut structure has confirmed sovereign curve segregation.
And there are important consequences on private repo markets too, especially at the repo dealing desks of major broker dealers:
As the crisis grows, the risk is that counterparty credit risk and increased volatility of underlying bonds leads to a greater desire to hold high quality collateral, which increases repo financing costs appreciably. As general liquidity dries up in the market the amount of eligible collateral available also decreases as anyone holding the quality collateral is increasingly likely to hold onto it in the case of further decline in conditions.
This includes repo desks, which may not on lend any securities taken in through other operations. The problem is compounded by regularity factors such as Basel 3 tying up collateral. Moreover, while the Basel 3 liquidity framework if requirement banks to accumulate a liquidity buffer of government bonds, the deepening European debt crisis has limited the ability of many banking systems to accumulate their own countries sovereign debt.
This has aggregated the squeeze on AAA rated collateral. It is worth noting that despite the slight pullback in the front-end of the German curve Schatz yields are negative out to June 2012.
Ironically, it’s also these dysfunctions which may be forcing markets into shorter funding arrangements — something which is incorrectly being interpreted as a liquidity crunch:
The increasing market tightness and elevated demand pushes investors into shorter maturities as demonstrated by the strong rally in the German front end. Given the lower haircuts and duration risk, especially on already rich curves, shorter-term securities are more likely to be pledged for short-term funding operations. At the same time money market funds tend to invest heavily in short-term repo or bills to hold down weighted maturities, sapping supply to the market. In stressed markets there is generally a lower amount of repo activities from these accounts further draining eligible collateral, stopping the provision of term funding to the markets. Demand for short-term securities may have been increased further following the suggestion by policymakers that shorter-term credit would in effect take preferential treatment over longer obligations in the event of a restructuring.
So what’s the ECB to do?
According to Mandy, the first step is to recognise that current policy is encouraging excess reserves to increase beyond productive levels. This is impairing the efficient use of funds, and driving them into unproductive stores of value, like German bunds — a fact which is creating negative yields.
To combat this, the ECB could consider doing what the Fed did when it was faced with a similar problem. Initiate a supplementary financing programme, or Special Liquidity Scheme, to distribute more quality collateral (in the form of ECB bills) back into the system.
If Mario Draghi is of the same opinion, and comments to date suggest he is, you could expect any of the following in the near future:
1) A reduction of ECB haircuts and shallower graduation on sovereign bonds.
2) The announcement of some sort of Supplementary Financing Programme or ECB bill distribution mechanism.
3) The announcement of a Special Liquidity type scheme to inject bills directly onto the balance sheet of banks, a la a liquidity swap.
So stop thinking Eurobonds, and start thinking ECB Bills.
Mandy’s whole report is available in the usual place. We classify it as a *must read*.
One Eurobond to rule them all – FT Alphaville
Draghi: “We are aware of the scarcity of eligible collateral” – FT Alphaville
The bund that broke the Bundesbank – FT Alphaville
On the perils of plunging repo rates – FT Alphaville
Eurobills, not Eurobonds – VoxEU.org