• In this note we describe the ECB operations and their relation to the daily fixing of the effective overnight reference rate for the euro (EONIA).
    • In recent weeks short-dated money market rates have fixed above ECB’s refi-rate despite the ECB providing unlimited supply of liquidity – what’s going on?
    • We find that the key factor behind higher rates is related to falling demand for liquidity at tender operations rather than the ECB explicitly changing its exit policy.
    • The ECB might, however, have scared off some bidders at its tender operations, when Trichet recently said that the ECB aims to discourage persistent bidders.
    • At its meeting in March we expect the ECB to announce a shift to fixed allotment for all refinancing operations from April.
    • Normalisation during H1 should gradually put the ECB back in the driver’s seat in terms of more effective management of the liquidity balance and hence EONIA.

    EONIA, ECB operations and excess liquidity

    In the following we describe EONIA, the central ECB operations and the main drivers of developments in the banks excess liquidity (surplus of liquidity supply over demand).

    EONIA

    The Overnight Index Average Eonia (EONIA) is the underlying rate of the Eonia money market curve and of various derivatives contracts. It is calculated on a daily basis as a weighted average of all overnight (O/N) unsecured lending in the interbank market, initiated within the euro area by the 44 contributing banks. Under normal circumstances the ECB provides liquidity such that EONIA fixes close to the refinancing rate. Hence the ECB uses EONIA as the instrument for its monetary policy stance. However, this changed in October 2008, when credit markets froze and the ECB decided to flood money markets with unlimited amounts of liquidity. In turn this pushed down EONIA and brought relief to European money markets. The ECB deposit facility rate has effectively set a floor since then for EONIA. The overnight rate has become increasingly volatile
    over a maintenance period as liquidity has become more difficult to control. During the current maintenance period a tight liquidity position pushed EONIA up to 1.31% (refi at 1.00%), while banks still place cash via ECB’s O/N deposit facility at 25bp. This is not likely to be satisfactory for the ECB and is a sign that money markets are not working properly.

    Liquidity supply
    The ECB’s open market operations (OMO) mainly consist of the main refinancing operations (MRO) and long-term refinancing operations (LTRO). MROs are carried out weekly and have a maturity of normally one week. LTROs are carried out on a monthly basis and have a maturity of normally three months. Prior to the financial crisis OMOs were variable rate fixed allotment tenders – i.e. the ECB decided the amount to be allotted and the interest rate was set through competitive bidding with ECB acting as rate taker.

    The allotment was estimated to be consistent with EONIA reflecting ECB’s monetary  stance – the so called benchmark allotment– implying that EONIA would fluctuate closely around the ECB refinancing rate. Since October 2008 there has been full allotment at all auctions – i.e. the banks decide how much liquidity they want and the interest rate equals the ECB refinancing rate (currently 1.00%). In addition, more longterm tenders were introduced to avoid a massive contraction in money supply – (1, 6, and 12 month tenders). By mid-2010, a whopping EUR700bn was supplied to the system through LTROs.

    Other operations (OT) including the euro liquidity effect of the foreign exchange swap operations also affect total liquidity supply and are included in total OMO. The ECB also displays the liquidity effect of the covered bond portfolio (EUR60.7bn) under open market operations. The Securities Markets Programme (SMP), which covers ECB’s purchase of certain Euro member states’ government debt, does not affect the liquidity supply as they are sterilised each week via 7-days term deposits.

    If banks have acute liquidity deficit they can lend through the marginal lending facility (currently at Refi +75bp). The use of the marginal lending facility has been very modest and with no clear pattern over the maintenance period,

    Liquidity demand

    The liquidity need arises from two subcomponents, namely reserve requirements and autonomous factors.

    The reserve requirement that banks are obliged to hold need to be fulfilled for each maintenance period. Banks’ current account holdings can deviate from the average reserve requirements on a daily basis. Indeed there is a tendency for banks, on aggregate, to frontload their fulfilment of the reserve requirements. In the current maintenance period there has been much less front loading than usual due to tighter supply of liquidity. This, in turn, implies expectations of larger demand for current account holdings towards the end of the maintenance period and has been a key driver behind increased volatility in EONIA. Seasonal patterns in EONIA have overall become more significant as liquidity has tightened.

    The autonomous factors are largely out of the ECB’s control. These are: 1) Banknotes in circulation; 2) Governments’ deposits at some Eurosystem central banks; and 3) The investment portfolio of euro area central banks.

    In addition, the emergency liquidity assistance (ELA) for Irish banks, which effectively enables troubled Irish banks to get liquidity by putting up collateral, is not included in the autonomous factors. The ELA amounts to EUR49bn (24% of the Irish central bank’s total assets) and is thus non-negligible. The ELA is another factor outside ECB’s direct control with an unpredictable nature.

    The ECB publishes its forecast for the average autonomous factors up to the day preceding the settlement of the subsequent MRO each time an MRO is announced. The ECB is able to forecast around 70-75% of the variation in the autonomous factors. However with an increasing number of unknowns it seems likely that it becomes more cumbersome for the ECB to estimate these autonomous factors going forward . If banks have a liquidity surplus, which they do not want to place in money markets, they can deposit these funds in the deposit facility. The use of the deposit facility normally increases during the maintenance period mirroring the frontloading of reserve requirement fulfilment.

    As liquidity supply has tightened, the use of the deposit facility has declined in nominal terms. However, relative to liquidity supply, another picture emerges. Currently around EUR25bn is placed at deposit which, given the combination of the low deposit rate (0.25%) and the relatively tight liquidity position, is puzzling. Unfortunately we cannot provide a precise explanation for the significant use of deposits at the ECB. However it seems likely that some banks use the deposit facility as part of managing liquidity risks. Further due to expectations about changes in the future regulatory landscape some banks might it attractive to “pay a cost” for having funds placed O/N with the ECB. In sum, the amounts placed at deposit are not circulating in the money markets - another risk factor for higher EONIA outside direct control of the central bank. The ECB would probably prefer a more stable and predictable development in the use of the deposit facility.

    Excess liquidity has declined since mid-2010

    The liquidity supply over liquidity demand is denoted as excess liquidity. We use this as a way to address tightness in money markets. Since mid-2010 demand for liquidity at LTROs has fallen sharply as the duration of the longest LTROs has fallen from one year to three months as part of the ECB’s exit strategy for non-standard measures. The trend accelerated going into Q4, as the final 6-month LTRO expired on 11 November 2010 and the final 12-month LTRO matured on 23 December 2010. Declining excess liquidity has resulted in higher money market rates – see chart below.

    Around New Year banks increased demand at the 3M LTRO. This gave some temporary relief and consequently pushed down rates. However, since the start of 2011 banks have gradually lowered demand at the ECB tenders and excess liquidity has almost vanished– although a little relief was seen at this week’s MRO.

    ECB to take back driver's seat in Q2 2011

    Excess liquidity is gone, and we have recently seen how this affects money markets. EONIA volatility increased significantly and money markets have become much less predictable. Further, there are some signs that daily volumes in EONIA are declining. Clearly this is problematic for the ECB, but it is currently very difficult for the European Central Bank to do much about.

    It is our long held view that the ECB wishes to take back the driver’s seat sooner rather than later. In fact, it is our view that, had it not been for the escalation of the Irish debt crisis during Q4 2010, the ECB would have speeded up normalisation of non-standard measures at the December meeting, for instance by regaining control over the amounts taken at the refinancing operations.

    For details on the normalisation we will have to wait for the rendezvous at the 3 March meeting. We expect the announcement of a shift to fixed allotment for all refinancing operations from April. There was no one-month LTRO prior to the crisis, but it seems likely that the ECB will not phase out this tender when it shifts to fixed allotment as it seems practical to operate with a tender  running over the maintenance periods.

    A return to fixed allotment would imply that ECB’s calculations of the benchmark allotment will again form the basis for the amount offered at the weekly auctions. Usually the ECB allotted roughly 75% through MROs and the remainder through LTROs.

    Due to an increasing number of unpredictable factors it becomes more difficult for the ECB to estimate the benchmark allotment compared to before the financial crisis. In an alternative scenario the ECB might not reveal its benchmark allotment before auctions are held, and then decide the allotment discretionary when it collects bids from banks and hence sees the aggregate demand curve.

    Overall it will not be easy for the ECB to continue its exit strategy without experiencing large volatility in EONIA.

    Key events

    • ECB meeting today at 14.30 CET – watch out for hints or comments regarding normalisation. We expect no news before the March meeting.
    • Allotments at weekly MROs are important to follow, as we expect them to be rather volatile in the coming weeks. Hence EONIA should remain volatile for some time.
    • Reserve maintenance period 3 begins next week – watch out for allotment at 1M LTRO.
    • We expect the ECB to announce a shift to fixed allotment at its March meeting

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