In an effort to ameliorate some of the distortions its €60 billion in monthly asset purchases are creating in euro money markets, the ECB has rolled out its securities lending program. As we’ve documented since PSPP’s inception in early March, it will be critical for the central bank to make its holdings available to borrow lest it should end up impairing repo market function. Falling GC rates and the suggestion by one trader last month that every PSPP-eligible bund was trading special illustrate the degree to which the central bank has made high quality collateral scarce to the point where holders are essentially adopting a “you’ll have to pry it out of my cold dead hand” approach to the market.
If the ECB hopes to alleviate this, JPM has argued that the central bank’s securities lending program needs to: 1) promote decentralization by allowing NCBs to work with the largest securities lenders (i.e. make the collateral available across the board through widely used channels as opposed to adopting an approach where central banks only lend their holdings to a narrow list of counterparties), 2) ease the standards on what counts as acceptable collateral, and 3) allow the posting of cash as collateral. The latter point there may seem counterintuitive. That is, why would you not accept cash? Here's why:
“Cash neutrality” means that there will be no exchange of cash for collateral but only an exchange of collateral for collateral. As expected, the ECB seems unwilling to appear to be altering the overall amount of liquidity by “draining” reserves in cash for collateral exchanges.
There’s a certain level at which this borders on the absurd. That is, the ECB’s liquidity injections (QE) have created a liquidity crunch in repo markets which could be relieved by effectively reversing QE, but that would send a weird signal (i.e. “now they’re draining the money they just injected?”), and so it isn’t seen as the best option.
Nevertheless, it would help the market because as discussed previously, cash is not “efficient” compared to other types of collateral which can be re-pledged down the line and so the point of accepting cash in lending ops would be to effectively reverse the effect of QE. More simply, in QE, inefficient collateral (cash) is exchanged for efficient collateral (bonds); point number 3 above seeks to do the opposite and in the process “grease” the system’s proverbial wheels and in essence, overnight repos would be no different from overnight deposits:
While we recognize that a reserve draining facility would be perceived contradictory to the ECB’s objective of injecting liquidity, we believe that a facility similar to the Fed’s reverse repo facility, perhaps limited in size, would have helped to alleviate collateral shortage without practically changing the overall amount of liquidity in the banking system as such a facility would merely replace reserves which are overnight deposits with overnight repos, an equally liquid instrument.
Here’s the Cliff’s Notes version of the above courtesy of Janet Yellen: “...cash is not a very convenient store of value.”
In any event, JPM says the ECB’s lending program hasn’t really met the other two necessary conditions either as the process is, so far at least, highly decentralized and prone to being unnecessarily punitive:
The ECB made their holdings available from Thursday, 2nd April allowing eligible counterparties to borrow for example Bunds from the ECB in exchange of other collateral such as French bonds or Italian bonds. However, the 40bp fixed fee being the difference between the repo rates on the collateral pledged and collateral borrowed and the 1-week term seem very punitive… As a result, this makes the ECB’s facility more like a lender of very last resort also given the ECB will only hold 8% of PSPP holdings.
The bulk of securities lending will rather be channeled via national central banks. This means that the securities lending programme will be largely decentralized and confined to bilateral or other arrangements between national central banks and eligible counterparties. In other words condition A above is not met, i.e. at least initially it will likely be more like the Bundesbank lending Bunds and the Bank of Italy lending BTPs to mostly existing counterparties with whom they already have bilateral or other arrangements.
So, if you want to borrow from the ECB you’re going to pay up and they aren’t holding that much in the first place and although borrowings from NCBs may have some limited effect on the number of and degree to which some issues trade special vis-a-vis GC, it’s not clear how effective the program will be on a more general level as it relates to relieving the collateral drought:
Market impact will likely be confined to redistributing any temporary security tightness within a jurisdiction or across jurisdictions, by making for example specials cheaper to borrow versus the respective GC repo curve especially for core, or to be reducing the spread between core and non-core GC repo curves.
Speaking of making specials cheaper versus GC repo curves, JPM goes on to note that given supply constraints (i.e. issuance) and the fear trade (i.e. flight to quality) which began during the eurozone debt crisis, the German repo market really can’t afford (in terms of liquidity) large scale asset purchases by the central bank and as a result, it’s “likely that the German repo market contraction will continue if not intensify this year, hampering market trading liquidity.”
Here’s what a shrinking repo market looks like:
Summing up: these are your euro money markets on central planning. Get used to it, because the bizzaro world of NIRP-inspired distortions isn't going anywhere anytime soon.
* * *
Here's the official word from the ECB:
Lending of holdings purchased under the public sector purchase programme (PSPP)
As of 2 April 2015, the securities purchased under the public sector purchase programme (PSPP) are made available for securities lending in a decentralised manner by a number of Eurosystem central banks. Further national central banks will follow soon. The aim of securities lending is to support bond and repo market liquidity without unduly curtailing normal repo market activity. The Eurosystem is primarily targeting market participants with market making obligations.
The Eurosystem central banks will use various channels taking into account not only the diversity of the existing securities lending arrangements and market characteristics across jurisdictions, but also the goal of starting securities lending without undue delay. The Eurosystem will endeavour to attain a further convergence of lending arrangements over time. Each Eurosystem central bank provides more detailed information on its own securities lending arrangements.
General PSPP securities lending framework
PSPP securities lending arrangements of Eurosystem members
General PSPP securities lending framework
Eurosystem central banks will make their PSPP holdings available via effective lending channels, depending on their current practices. These channels may include bilateral securities lending and lending relying on specialised securities lending agents or on the lending infrastructure of international central securities depositories (ICSDs).
Furthermore, Eurosystem central banks will, in principle, also make their PSPP holdings available for so-called fails mitigation lending programmes of international or domestic central securities depositories or ensure that comparable arrangements are in place in their jurisdiction.
Lending of PSPP-securities holdings is to take place on a cash neutral basis. This means that repo transactions against cash collateral shall be accompanied by a fully offsetting reverse repo transaction for the same value date, and typically with the same counterparty.
Operational and risk parameters
The individual Eurosystem central banks determine the securities lending modalities of their respective PSPP holdings, including collateral eligibility, pricing, haircut, term and counterparty eligibility, so as to achieve the objective of supporting market liquidity. This allows Eurosystem central banks to reflect domestic infrastructures and market practices.
Effectiveness of operations
The Eurosystem PSPP securities lending activities will be monitored closely so as to ensure the ongoing effectiveness of the arrangements.
PSPP holdings of securities issued by supranational institutions
Securities issued by supranational institutions and purchased under the PSPP by Eurosystem central banks will be made available for securities lending under the coordination of Banque de France and Banco de España.