Excess liquidity in the euro area has declined measurably over the past two years. It has fallen by more than a third relative to its peak in 2022, and it dropped below €3 trillion about a month ago.
This decline in excess liquidity predominantly resulted from banks repaying the loans they had taken under the third series of targeted longer-term refinancing operations (TLTROs). More recently, the phasing-out of reinvestments of bonds maturing under the Eurosystem’s monetary policy portfolios has increasingly contributed to the decline.
As of January 2025, the Eurosystem will no longer reinvest any of its monetary policy bond holdings, leading to a run-off in our portfolios of around €40 billion per month. In a recent speech, Isabel Schnabel, member of the Executive Board of the European Central Bank, discussed the impacts across numerous dimensions such on money markets, market-based funding, sensitivity of €STR, and repo.
Easing of collateral scarcity has led to normalization in repo markets
There is a steady and measurable rise in secured money market rates in the euro area and beyond. While in some parts of the world repo rates are already trading above the main policy rate, or have temporarily drifted outside of the target range, in the euro area the repo funds rate is now trading broadly at the level of the deposit facility rate (DFR).
Within the euro area, repo rates have also converged across collateral classes. Over the past years, transactions secured by German government collateral, in particular, were trading at a significant premium over others. This premium has declined considerably.
The increase in repo rates could result from two factors: higher collateral availability and lower excess liquidity. Depending on which factor dominates, the implications for monetary policy would differ. One of the main conclusions of our monitoring work is that it was primarily the reversal of collateral scarcity that was driving repo rates higher.
Between 2021 and 2023, the ECB’s large bond holdings and the significant take-up in our TLTROs resulted in a sharp decline in the collateral available for secured lending. Collateral scarcity, in turn, caused repo rates to drop sharply. At the peak, more than 70% of repos were trading at least 30 basis points below the DFR. Repos against German collateral temporarily traded more than 100 basis points below the DFR.
Collateral availability has improved significantly over the past 18 months
Large issuance by euro area sovereigns, the Eurosystem’s reduced market footprint from the gradual run-down of the monetary policy bond portfolio and the return of collateral mobilized with the Eurosystem all contributed to easing the strains in repo markets and thus to the gradual normalization of repo rates from extreme conditions. The question is whether the rise in repo rates will continue.
Any answer to this question is inherently speculative. But for as long as there is ample excess liquidity, it is likely that repo rates will stay in the vicinity of the DFR, as banks would be expected to lend reserves in the repo market if there were persistent gains to be made there as opposed to depositing these reserves with the ECB.
And, for now, the DFR is anchoring one-day repo rates, even for collateral of lower-rated sovereign bonds. This is because most Eurosystem counterparties still have excess liquidity several times larger than their minimum reserve requirements, especially the larger ones.
The extent to which markets can mitigate upward pressure on repo rates critically depends on market participants taking advantage of arbitrage opportunities arising from the spread between money market rates and the DFR. This includes banks’ willingness to lend reserves across borders, as the distribution of excess liquidity holdings is highly uneven across countries and institutions.
So, on reporting dates, or at lower levels of excess liquidity, repo rates could rise above the DFR. This may happen, for example, if banks start to refrain from lending reserves in money markets, for instance to keep their regulatory liquidity ratios above a certain threshold.
Such intermediation constraints may help explain the premium that we are seeing today for repo transactions covering the year-end, even for the most liquid collateral. High price mark-ups often reflect trades with non-banks that have no access to our lending facilities.
Upward press on rates
Recent upward pressure on rates in some segments of the money market reflects, by and large, a reduction in collateral scarcity, due to the increased bond issuance by governments and the reduced Eurosystem market footprint. The improved availability of collateral has helped to significantly improve market functioning in the euro area.
In addition, increasing market-based funding activity and growing signs of redistribution of reserves across banks and borders suggest that banks have started adapting to an environment with less ample reserves.
“We expect this process to continue as excess liquidity declines further, with banks increasingly sourcing liquidity through our standard refinancing operations, as these constitute an integral part of a smooth implementation of monetary policy in our operational framework,” she said.