Liquidity is the Word

The Bank of England introduced a new contingency liquidity facility--Extended Collateral Term Repo (ECTR) Facility. The purpose is to have a facility in place in case there is a market wide shortage of sterling liquidity. This is currently not a problem, so the facility is preemptive in nature.

Should the euro, for example, disintegrate/devolve, sterling would be one of the likely recipients of capital. There would be a shortage of sterling relative to demand. This new facility gives the BOE existing capability to provide sterling liquidity in an auction setting with a liberal collateral. As a central bank the BOE wants to promote financial stability in what seems to be an increasingly tumultuous world.

There is talk the ECB could engage in a similar move later this week, especially in terms of widening the acceptable collateral. Although it has quite a liberal policy already, there is further that it can go down that path. For example, there is some talk it could accept bank loans as collateral. Another option would be to make current collateral more effective. This would reduce the haircuts on the current universe of acceptable collateral.

In some ways, the reduction in the punitive rate for dollar swaps was also a step toward addressing the existing crunch. The press and many observers played it up as a sign of international coordination and cooperation. This seems like a gross exaggeration. Cooperation and coordination implies more than one side doing something. In this case the Federal Reserve did something, cut in half the premium it charges over 7-day OIS to swap dollars to 50 bp. The other central banks simply agreed to pass on those savings to member banks.

There are all sorts of conspiracy theories about why the Fed moved when it did. Some suggest knowledge of some budding funding problem at a single entity. However, that does not ring true. Not that there is no funding problem, but that policy is rarely aimed at one institution. Instead, we suspect that Fed officials were increasingly concerned about systemic risks posed by the highly lucrative liquidity swaps. Some financial institutions were reportedly making money hand over fist, lending dollars for euros.

The 3-month cross currency swap was, about 165 bp below 3-month euribor. The banks involved seemed to just want a safe place to hold the euros. This leads to the large overnight deposits at the ECB and the German repo market. This generated negative rates in the German repo market. Even now the German 3 and 6 month bill yields are negative and last week for two days the Germany 1-year note had a negative yield. This in turn began disrupting other markets.

As the FT noted, the result of the Fed's action was to reduce the arbitrage opportunity and make it easier to secure dollar funding from the central banks than the private sector banks. Euros in central bank hands are less disruptive than in the banks.

Tomorrow the central banks will for the first time under the lower rates auction dollars. There was some talk that the lower take down at this week's regular refi operation (about 13 bln less euros than were maturing from last week's operation) was due to the fact that participants are anticipating taking up dollars tomorrow.

It may seem counter-intuitive, but the larger the participation tomorrow the more risk-on (in whatever limited way ahead of Thursday ECB meeting and Friday's summit) insofar as banks would secure their dollar funding in a less disruptive way. The smaller the take down, the more dysfunctional the system may appear.