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New ECB cash could worsen Spanish repo distortions

Source: Reuters - Mon 13th Aug 2012
New ECB cash could worsen Spanish repo distortions

A fresh injection of long-term ECB loans into the banking system could worsen a shortage of Spanish government bonds in the repo market, further squeezing a source of short-term funds for Spain's banks.

Traders said a distortion of prices in the Spanish repo market that followed a 1 trillion flood of 3-year ECB loans in December and February could be exacerbated if the bank repeated the operation.

Spanish government bonds have been in short supply in the repo market, where banks commonly use them as collateral to raise funds, since domestic banks parked them at the ECB in return for cash - particularly the 3-year loans.

This prompted investors who need the bonds because of their own short positions to pay a premium for the paper.

In a normal repo operation, the party needing the cash would pay the premium but in the distorted Spanish market, it is the other way round.

"In Spain there're a lot of short positions in the market...and we're seeing the repo levels around -3 or -4%," a repo market trader said.

A negative number means the borrower is effectively being paid to take the lender's cash.

"As soon as the repo market gets to be like that, it stops functioning effectively and that has a knock-on effect in the cash market because you can't provide liquidity to clients," the trader said.

ECB President Mario Draghi said earlier this month the ECB would discuss loosening its collateral rules further in September and could repeat other measures such as its long-term cheap loans, known as LTROs.

"Perversely if another LTRO came in and there was a big take-up by Spanish banks and they put Spanish bonds in, the repo market could get worse," another trader said.

"This is contributing to the decline of the cash market because you need the repo to oil the wheels in the cash market."

Banks can repay the ECB's initial three-year loans after 12 months, but as the 3-year-old sovereign debt crisis rumbles on with Spain now on the front line, analysts expected reliance by peripheral banks on the central bank to remain high.

Spanish banks' reliance on ECB loans has increased in recent months as it has for Italian banks. But unlike Spain, the Italian repo market is still functioning normally, supported by the deeper liquidity in the country's debt market.

Uncertainty over how efficient promised ECB intervention in bond markets would be in lowering Spanish and Italian borrowing costs, as well as over final details of a bailout of Spanish banks of up to 100 billion agreed with the EU last month, was also keeping repo investors on edge.

"On the whole the repo market in Spain has deteriorated much faster with the Spanish markets under pressure. You need the sovereign market to be more liquid," said Elaine Lin, a strategist at Morgan Stanley.

"Immediate improvement is unlikely for the Spanish sovereign or the banking sector given their close link and the capital injection (for banks) is not going to start until October."

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