The ECB’s upcoming repo market headache

The dark and opaque world of repo — where institutions can borrow cash against collateral — is making itself heard. Again.

Some might call it a run on safe assets. Others, a collateral squeeze. Either way, as Renuka Fernandez from Nomura’s European Rates team notes on Wednesday, the market is still processing the true impact of the “unprecedented” distortions experienced at the turn of the year.

To illustrate the scale of the shock, here (by way of Nomura) is the historic spread between German general collateral and Italian general collateral repo rates:

And here we see the distortions compared to ECB excess liquidity — the thing everyone thinks is to blame:

In that context, the question on everyone’s mind is: will those quarterly blips get less severe? The answer sadly, is probably not.

According to Fernandez, the only probable reason for a quieter quarter-end in March was the considerable tightening of cross-currency basis spreads on a global level. Had this not been the case who knows how the repo market would have responded.

It’s worth remembering the market freaked out only after the ECB announced changes to its Securities Lending Facility (SLF). The assumption being, notes Fernandez, that the changes fell short of what the market had been hoping for in terms of accommodation. Since nothing more has changed since then, there’s no basis to assume the market is feeling happier now.

But before going on, a little background for those who may not be too familiar with the world of repo markets leading up to and after the 2008 global financial crisis.

European repo markets (at least compared to the US) have always been fragmented, disjointed, opaque and mysterious. For the longest time countries boasted idiosyncratic settlement system and market processes. And most national Debt Management Offices followed different procedures when it came to securities lending or secondary market intervention, especially with regard to dealing with repo squeezes or settlement fails. Some countries held back bonds at issuance in the style of reserves deploying them only if and when market rates got out of whack with official rates. Others had the capacity to synthesise bonds. Others still had no real policy at all. Either way, the structural idiosyncrasies made borrowing from state institutions confusing and expensive.

The start of ECB asset purchases in 2015, however, paved the way for the centralisation of securities lending. To its credit, the central bank pre-emptively realised some sort of formal facility would be needed to ensure purchases didn’t trigger repo market distortions. The more bonds the ECB buys, the more the supply of collateral for the repo market shrinks. That disproportionately hits the non-bank sector, which is even more dependent on repo markets than the banks.

The ECB’s Benoît Cœuré flagged the issue quite prominently in a speech on March 10, 2015:

In the case of the PSPP, securities purchased by the Eurosystem may be valued by market participants not only for their coupons but also for collateral services they provide. For instance, one of the papers presented today at the conference shows how purchases of government bonds under the Securities Market Programme increased the scarcity of certain Italian government bonds in 2011 and 2012, with the impact being more pronounced for securities that were already in high demand. [15] Demand for collateral securities may be further amplified by incoming regulation, for example by the moving of over-the-counter derivatives trading towards central counterparties.
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Securities lending will not only be important to ensure collateral availability but also for market liquidity in general. The ability to borrow securities from the Eurosystem will allow intermediaries to continue quoting competitive prices, as it gives them more time to subsequently cover their open positions in the market. By supporting market liquidity, securities lending will be an essential element for the success of our asset purchase programmes.

Nevertheless, by 2016, it became evident the lending facilities developed by the ECB were not enough to keep repo markets in check.

Something more was needed. Hence the revisions to the terms of the lending facility in December 2016. These included an allowance for cash to be used as collateral, without the need to re-invest it in a cash neutral manner.

But even then, analysts were worried the measures would not be enough to calm repo markets. As Giles Moec and team at Bank of America Merrill Lynch noted in December:

While the ECB acknowledging repo stresses is positive, the overall limit for securities lent against cash is set at €50bn, a relatively small number considering total Eurozone excess liquidity now exceeds €1.1trn.

Which highlights the absurdity of the situation we currently find ourselves in. As Fernandez notes, the market wants more. But the options the ECB has are limited.

The one thing the ECB really can’t be seen doing is extinguishing the liquidity it creates through asset purchases in any meaningful way — because that would be deemed sterilisation, negating the whole point of QE. It might also expose the ECB’s ultimate monetary limitation (the fact that nobody wants the ECB’s liquidity, just its bonds — which unlike liquidity are entirely limited).

The ECB’s only remaining options, according to Fernandez, are:

Increase the size of the facility (with the tightening consequences)
Harmonise the rate at which securities are lent with policy rates (to ensure it’s not more expensive than depositing liquidity in other ways).
Allow non-banks to have access to ECB operations as well as its deposit facility.
To increase the amount of safe assets by issuing an ECB bond.

None of these are optimal, and almost all of them move the ECB closer to a snookered situation.

Hence, as Fernandez notes, in the short term the ECB is likely to go down a more benign path:

For now the ECB is likely to opt for a more benign solution, which could be to adapt the existing features of the SLF. While expanding its scope to include non-banks and allowing them to also deposit their funds at the deposit facility is likely to be the optimal response in terms of easing repo market dysfunction, the ECB will probably be reluctant to announce such a measure at the April meeting, when it is currently going to great lengths to unwind the tightening story currently building in markets. However, as ECB President Draghi clearly stated at the March meeting that repo market dysfunction had more to do with non-financial institutions not having access to the deposit facility than to the APP per se, we would not discount the introduction of such measures from the ECB in the medium term.

Nevertheless, it’s important not to kid ourselves. The consequence of the ECB allowing access to non-banks is potentially seismic. It could be comparable to the Federal Reserve’s creation of its Overnight Reverse Repurchase Facility, interpreted by the market as a tightening manuevre. Meanwhile, it’s not just that the move would send a signal that banking licenses don’t matter (with all the related moral hazard consequences associated with that), it’s that it could in the worst case scenario be perceived as equivalent to the time the Fed widened access to its lender of last resort facility.

Suppose that, to stabilise the repo market, excess liquidity from bond-buying must immediately be re-absorbed into ECB coffers through the securities lending facility and/or by giving non-bank institutions access to the deposit facility. It would render the entire QE exercise a potential farce, unless the goal were just to flatten the yield curve.

Either way, what’s becoming apparent is that what the market really wants is access to liquid bond collateral, not central bank liquidity. And for the market to be truly pacified, the ECB must now become the depositor of last resort. In that sense ECB liquidity may have become (in a nod to Gresham’s law) the bad stuff nobody wants to hold on to, while bond collateral is now the good stuff everyone wants.