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Hopes flicker of a fix for eurozone funding market

Hopes of a fix to the collateral squeeze facing the eurozone’s €5tn short-term funding markets were boosted this week after reports emerged the European Central Bank will consider ways to ease rules on how it lends its stockpile of sovereign debt.

A lack of good quality collateral, which market participants use to secure loans, has crippled the single currency area’s short-term funding (“repo”) markets.

One big reason for the shortage is that the eurozone’s central bankers have spent the past year-and-a-half buying €1.1tn in government bonds — some of the best collateral available — as part of their quantitative easing programme to boost growth.

While the ECB set up securities lending soon after launching QE in March 2015, to loan the bonds it buys back to investors, markets have remained stressed. National central banks are responsible in setting most of the terms for securities lending and market conditions are particularly difficult in Germany.

On Wednesday a Reuters report that the ECB would consider making it easier for banks to borrow the government debt central banks in the region have bought was seen as a positive step for the market.

“If it happens it will definitely be good news,” said one trader of potential changes. He added that it is currently seen as “very dangerous” to borrow from national central bank because of the risk of failing to return the bond at the end of the transaction.

It comes ahead of the December 8 meeting of the ECB. A spokesperson for the bank said: “The ECB securities lending is proving valuable for smooth market functioning and it is being reviewed on an ongoing basis.”

Discussion at governing council level would signal there may be a move to harmonise practices across national central banks, which are responsible for most of the bond buying that takes place under QE.

Benoît Cœuré, a member of the ECB’s executive board, said earlier this month securities lending could be “scaled up” and that it was “well within central banks’ operational capacity to play a more structural role in supplying safe assets to the financial system”.

A driving principle behind QE is that the ECB adds liquidity to the system by buying government bonds in exchange for cash. Because of this, national central banks tend only to accept collateral other than cash for securities lending.

While this principle on so-called “cash neutrality” is set by the ECB, national central banks have a say in which collateral they accept in exchange for their holdings of government bonds, as well as the haircuts applied on the collateral and the duration of the swap.

The Bundesbank loans out its stockpile of German bonds, but only for limited periods and in exchange for other forms of high-grade German debt.

Some in the market point to technical aspects of the way the Bundesbank securities lending works for failing to relieve the collateral problems.

“The fact you have to give German government bonds to get German government bonds means you aren’t alleviating market stress,” said Anton Heese, fixed-income strategist for Morgan Stanley.

He also pointed to other problems, including a punitive fee charged if the borrower does not return the bonds in time. “If there is a general squeeze in the market for a Bund, you will struggle to get the Bund back to the Bundesbank,” said Mr Heese.

A relaxation on some constraints of the German programme, for instance by extending the loan period from a limit of a week, would be one way to ease difficulties for banks and investors.

Another route is the relaxation of collateral rules. Market participants hope investment-grade corporate bonds, loans or even cash might be accepted, which would help increase the supply of German government bonds in circulation. Centralised control over collateral rules would, however, be controversial — it is the national central bank that is exposed to losses on its government bond purchases.

The European Repo and Collateral Council, an industry representative, has recently engaged in “dialogue” with the ECB on a range of issues, including the challenge of collateral shortages.

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