(Bloomberg) -- The repo market’s capacity to provide liquidity in the euro area has yet to be properly tested, as the region still counts on trillions of euros in excess cash, according to the European Central Bank.
The central bank staff wrote in a blog post on Tuesday that there are signs a “transformation” is underway in Europe’s cash management system, but excess liquidity above €3 trillion ($3.3 trillion) still limits the need for alternative sources of funding.
The extra cash washing around the Eurosystem has dropped by a third since a peak in 2022 as policymakers roll back years of easy money. This has increased the importance of repo markets — where one market participant sells a security to another one with an agreement to repurchase it later — in providing liquidity.
“Going forward, repo markets will have to prove their ability to efficiently redistribute liquidity to all corners of the financial system,” the ECB blog’s authors including Pamina Karl wrote.
During the years of quantitative easing, when the ECB pumped cash into financial markets via cheap bank loans known as TLTROs and vast bond buying, investors used the repo market to source collateral that became difficult to find.
But with the repayments of more than €2 trillion of outstanding TLTROs, almost 60% of the collateral previously pledged in exchange for these funds has returned to the market, according to the ECB. Elevated government bond issuance has also helped ease the shortage.
Similarly in the UK, policymakers have urged market participants to prepare for a new cash regime as excess liquidity wanes. The shift has already begun, with usage of the Bank of England’s short-term repo facility hitting records week after week.
The ECB sees “tentative signs” that market participants are making greater use of repo as a source of funding in the euro area, citing a notable increase in activity of liquidity-motivated transactions on major European trading platforms. Still, it said it’s early days.
“As the Eurosystem dials down its footprint, markets need to rise up to the challenge of providing viable and effective alternatives,” they wrote. “For banks, this means preparing to tap multiple and alternative sources of liquidity, including some that have not been used for a long time.”
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