Wednesday’s three-year LTRO funding allotment is unsurprisingly the big focus in the market this week.
And while many suspect that some banks are gratuitously loading up on cheap-to-deliver bonds just to exploit the operation for carry trades, those with actual funding needs are potentially facing a very different situation.
To be clear, as with the ECB’s very first LTRO, there will be two main uses of the facility.
The primary (and intended) use will be by banks holding assets which are no-longer repo-able in private markets — at least not at a price that is cost efficient.
The secondary (unintended) use will be by banks wishing to lock-in the above-mentioned carry trade.
To analyse tomorrow’s LTRO effectively analysts will be mindful of extrapolating the carry-trades from the actual funding bids.
Overall there is something in the region of €432bn expiring ahead of Wednesday’s LTRO, according to RBC Capital markets. The analysts see three different possible allotment scenarios based on that information:
RBC is sceptical that this time around there will be as much of an incentive to use the facility for carry-trades:
Given the particularly low cost of this term money we believe that the temptation of entering new longer term carry trades may well exist for bank CFOs and treasurers. However this would be limited to banks in bailed out Europe as well as Spain and Italy. The extent of increased appetite for carry trades is very difficult to assess. There still is a significant negative stigma related to this in our mind and the large banks in Spain, Italy and France may well be reluctant to be associated to that.
The domestic banks in these countries may well take a more liberal approach to this given that the negative stigma is probably less relevant to them (given that all market funding avenues are virtually closed to them anyway), versus the Net Interest Margin benefit they could derive from these carry trades. Nevertheless, this is a risky trade as this would leave them exposed to further volatility in the sovereign prices and even potentially a new EBA stress test along the same lines as the one carried out after the summer. Finally, the more a bank uses up ECB liquidity and other forms of collateralised funding, the more the senior unsecured becomes subordinated in the liabilities structure. Something that would make any recovery to a more ’normal’ funding pattern even more difficult to achieve.
In other words there are plenty of disincentives, the greatest one of all being potential volatility of the underlying and exposure to margin calls as a result, as well as the stigma that is associated with using the facility in the first place.
Though, regarding stigma, we’re not exactly sure how it would become common knowledge which banks tapped the facility and which didn’t, since the ECB would never name individual banks. In the past, assumptions have been based purely on the type of collateral that has been pledged. Lots of Greek bonds imply large use by Greek banks, and so on.
Whether that assumption is still fair in the land of carry-trade tapping, who knows?
Meanwhile, the fact that Tuesday’s Spanish bill auction was well received could actually imply there will be more carry-trade use (by non Spanish banks) than expected — despite the hugely increased nature of the riskiness of the trade. The use of short-dated paper, in a way, helps the banks curb their volatility exposure, since expiring paper is open to substitution at better rates.
*Update - As it turns out ECB rules state banks can’t use collateral which matures before the funding operation does, so you can rule out the duration mismatch incentive too.
As for banks wishing to conduct bona fide funding trades… they are currently limited by the amount of usable collateral they hold and the fact that they may not have had enough time to package bank loans in a way that makes them suitable for central bank operations.
Which brings us to the following chart from Fidentiis, a small institutional Italian brokerage, which has tried to estimate how much traditional collateral Italian banks have left. We stress, however, that these are estimates only:
In that context, Italian banks are already pretty stigmatised.
The LTRO’s wider collateral requirments, though, have hopefully offered them a stigmata miracle — but only if they’ve prayed packaged hard enough in the last two weeks.
Related links:
Prepare for the 3-year LTRO – FT Alphaville
The Sarko and Corzine trade – FT Alphaville
The carry trade and the goldilocks LTRO – FT Alphaville