While much has been said about the vagaries in the European repo market elsewhere, the truth is that the intraday variations of assorted daily metrics thereof indicate three simple things: a scarcity of quality assets that can be pledged at various monetary institutions in exchange for cash or synthetic cash equivalents, a resulting lock up in interbank liquidity, and above all, a gradual freeze of the shadow banking system. As we have been demonstrating on a daily basis, we have experienced all three over the past several months, as the liquidity situation in Europe has gotten worse, morphing to lock ups in both repo and money markets. As a reminder, both repo and money markets (for a full list see here), are among the swing variables in shadow banking. And shadow banking is nothing more than a way to expand credit money while undergoing the three traditional banking "transformations" - those of maturity, liquidity and credit risk, although unlike traditional liabilities, these occur in the "shadow" or unregulated area of finance, interlocked between various institutions, which is why the Fed has historically expressed so much caution when it comes to discussing the latent threats in it.
Indicatively, of the $15.5 trillion in shadow US liabilities (by far the biggest such system in the world), $2.6 trillion are liabilities with money market mutual funds and just $1.2 trillion are repos. Indicatively, traditional plain vanilla bank liabilities amounted to $13.4 trillion as of Q2 (an updated for Q3 is imminent). As such, the focus on repo while useful, misses the forest for the trees, which is that not the repo market, but the entire shadow banking system in Europe is becoming unglued.
What explains this? Two simple words, which form the foundation of modern finance - "risk" and "confidence", and in Europe both are virtually nil. Seen in this light, the unwind of the shadow system explains much: the inability of Germany to place bunds, the parking of cash with the ECB, the freezing of repo, the plunge in the currency basis swaps, the withdrawal of money markets, the blow out of various secured-unsecured lending indicators, etc. All of these fundamentally say the same thing: there is too much risk and not enough confidence, to rely on the abstraction that is shadow risk/maturity/and liquidity transformation. All this is easily comprehended. What is slightly more nuanced, is the activity of the ECB and especially the Bundesbank in the last few weeks, whereby as Perry Mehrling of Ineteconomics demonstrates, we may be experiencing the attempt by the last safe European central bank - Buba - to disintermediate itself from the slow motion trainwreck that is the European shadow banking (first) and then traditional banking collapse (second and last). Because as Lehman showed, it took the lock up of money markets - that stalwart of shadow liabilities - to push the system over the edge, and require a multi-trillion bailout from the true lender of last resort. The same thing is happening now in Europe. And the Bundesbank increasingly appears to want none of it.
So just what is happening? Mehrling first explains the European funding status quo:
Apparently everybody, borrowers and lenders, public and private, wants the ECB as their counterparty. Reluctant though the ECB may be to step into that role, and vocal as the ECB has been about that reluctance, what we are seeing in practice is that it has no choice, literally.
Clearing imbalances within the Eurozone that cannot be resolved in the interbank market show up mechanically as imbalances between national central banks on the books of the ECB (see here for details). The ECB lends to the central bank of the deficit country and borrows from the central bank of the surplus country, so expanding its own balance sheet on both sides. (Think Greece on the asset side, and Germany on the liability side.)
Something quite similar happens when private banks settle private clearing imbalances not by shifting reserves from deficit to surplus but rather by the deficit bank borrowing from the ECB and the surplus bank lending. Again, the ECB balance sheet expands on both sides.
Why is this happening?
The underlying problem is that deficit central banks and deficit private banks increasingly have nothing to sell (or to pledge) that surplus central banks and surplus private banks want to buy (or accept as collateral for a loan). The ECB is also reluctant to buy--it is serving as pawnbroker of last resort , not dealer of last resort.
The consequence is that the ECB is more or less forced to lend, against more or less whatever collateral is offered; even bad collateral is better than no collateral. (The famous Bagehot Principle offers an out, since it urges valuation of collateral at non-stress prices.)
So far so good: this is the system that as noted above is slowly crumbling. So what is happening next? One read is the following:
Now comes the latest deal over eurozone fiscal rules , presumably the deal that ECB President Draghi asked for last week . It is a deal about sovereign budget discipline. But if I read Draghi's speech right, we should not expect him to be buying sovereign debt. (That will be the IMF's job, if anyone's, and with strict conditionality; details to be sorted later.)
Instead, he'll be buying bank debt, specifically the debt of the banks that hold the sovereign debt. Banks currently borrowing from their own national central banks will therefore be able to repay, and consequently the national central banks will be able to repay the ECB. This takes national central banks out of the picture on the asset side.
What about the liability side? Here, perhaps in a longer time frame, I think the logical move is again to take the national central bank out of the equation, by replacing liabilities to the Bundesbank with deposits to the credit of private banks. Freed from the responsibility to fund ECB loans to other central banks, the Bundesbank will be able to return to its preferred asset holding, German sovereign bonds.
One conclusion that is possible is that one proposed by Mehrling: "we're not going to be using the payment system to hide imbalances any more. The ECB is going to serve as a proper lender of last resort to the banking system, affirmatively and up front rather than mechanically and through the back door. But it will be doing so only to the banking system, not to sovereign debtors." It would be expected that some combination of EFSF/IMF funding would sourced the balance. In effect the ECB would intermediate itself directly in the national bank bailout scheme, allowing it to be more like the Fed, which has been the primary complaint against the ECB all along.
There is also one other explanation: the Bundesbank wants slowly and quietly out.
As a reminder, while the Fed is the one central bank in the world which supposedly has the biggest amount of gold in possession with 8.1 thousand tonnes, Buba is #2 with 3,401 tonnes. In other words, it has a solid backing to its fiat asset representation. However, unlike the Fed, the Bundesbank is part of a nation that has a natural trade surplus and thus is cash flow positive from a current account perspective. One may say that Germany, far more than the US and the UK, is the world's truly AAA-rated nation. All this means that the Bundesbank, if disambiguated from the ECB, where it currently is accountable for funding a major portion of deficit nations' funding deficiency, would regain its status as the world highest quality monetary institution. And going back to the beginning, it is the Bundesbank which is effectively depleting "good money" in exchange for "bad" either in the form of undervalued collateral through the repo markets, or soon to be devalued fiat.
Here one has to keep in mind the primary prerogative of the Buba - keep inflation low. If that means detaching from a failing currency, or halting asset-liability matching in which it hands out good money in exchange for worthless assets, so be it.
Which is why another interpretation of the ECB's proposal is not to bring the ECB as a lender of only resort closer to the peripheral, deficit nations, but to commence proceedings for severing the umbilical cord of the Bundesbank with a Eurozone which is doomed in all but the most optimistic eyes. Bringing us to our question: for anyone wondering what the future of the Eurozone is, should they merely observe what steps the German central bank is stealthily starting to take. Because if indeed the Buba wants to have as little as possible with Europe, what does that mean for the EUR, and for Europe itself?
Full video explanation below: