LONDON, Nov 18 (IFR) - It’s looking increasingly likely more European banks will be forced to tap the European Central Bank’s US dollar facility, as stress in the cross currency basis swap market has once again become acute this week.
Few banks have opted to tap the ECB’s dollar facility so far, but a combination of foreign investors continuing to shun European banks and swaps markets fast becoming prohibitively expensive may soon spur a larger drawdown at the ECB’s weekly unlimited dollar auction.
“We are more or less at levels where banks are indifferent about going to the ECB or the FX market for dollar funding. Over the last few days spreads have widened dramatically in the FX market, making dollar funding more expensive. As a result, banks may well want to start tapping the ECB dollar facility more,” said Pavan Wadhwa, global head of rates strategy at JP Morgan.
The dollar funding issues for European banks have been well publicised over the past few months. Fearful of the worsening Eurozone crisis, vital sources of dollar liquidity like US money market funds reduced their exposure to European banks in the third quarter.
Many European banks reacted by selling dollar assets and entering into secured funding transactions to alleviate their funding stress. At the same time, coordinated central bank action announcing the introduction of new dollar swap lines in mid-September helped to significantly ease markets.
However, signs of dollar funding stress have returned over the past fortnight, as the Eurozone crisis once again stepped up a gear. The three-month EUR/USD basis swap is currently trading at 129bp below Euribor, compared to around 103bp below three weeks ago.
According Wadhwa, the cost for European banks of getting dollars in the open market has traditionally been in the region of five to 20bp lower than going to the ECB (which charges 100bp over the Federal Funds rate). Now, the increased stress in the market is starting to make it economically unviable for European banks with dollar funding shortfalls to rely on the open market.
“The way that the market is going, pressure is increasing for people to start tapping the ECB dollar line, both because the FX forward markets and the cross currency markets are drifting in the wrong direction making it more expensive to roll funding in the open market through the FX forwards, and because the banks themselves in Europe are under increased funding pressure as time goes by,” said Nick Hallett, head of cross currency swaps at Barclays Capital.
There is a stigma attached to tapping the ECB’s facility, and so banks try to avoid doing so if possible, despite the auction process being anonymous. Use so far has been limited: this week two bidders took down USD552m at the auction, compared to four bidders taking USD395m the week before. Participants believe the basis swap market may have to get even more stressed before there are significantly more bids.
“Banks will only go to the ECB if they are forced to. I think the basis swap market will have to get around 25bp more stressed before people abandon the market completely and start going to the ECB,” said Wadhwa.
Meanwhile, central banks will likely continue to monitor the situation. Some market participants have suggested the ECB may look to lower the rate it charges for tapping the facility, with some observers estimating a 50bp cut would attract far more banks and alleviate the stress in the market.
Participants believe central banks have already shown their willingness to act, following the unprecedented announcement from the Bank of England, European Central Bank, Bank of Japan, Swiss National Bank and Federal Reserve in September of offering three three-month unlimited dollar auctions.