Rising demand for dollar funding has led to more stress in EUR/USD cross currency basis swaps over the past few weeks, as dollar-hungry European banks have increasingly turned to the market. But senior traders indicated basis swap levels are unlikely to reach those seen following Lehman Brothers’ collapse as most predict the European Central Bank would likely intervene further to ease funding problems if necessary.
“Clearly there are some issues on dollar funding for certain banks, but we do not see this getting out of control like in 2008. Central banks have tools to ease conditions if it starts to get tricky,” said Elie El Hayek, global head of rates at HSBC. “The ECB offers dollar at 100bp above fed funds at the moment, and they can lower that level if need be. You can pledge any collateral to get those dollars, so banks can theoretically access practically unlimited funding in dollars.”
Dollar funding sources for European banks have become increasingly scarce over the past few months as US money market funds have scaled back liquidity provision, leading some banks to ramp up secured borrowing programmes to help meet their dollar obligations.
“The ECB facility sets some kind of floor to prevent things from getting ridiculous. Things could get a bit more stressed, but I’d be surprised if it got as bad as after Lehman because central banks will act before then,” said the head of cross currency swaps trading at a major dealer.
Despite participation being anonymous, banks have so far endeavoured to steer clear of the ECB’s dollar facility. It was tapped for only the second time today, with two bidders taking down a weekly allotment of US$575m at a rate of 1.1%.
Meanwhile, the EUR/USD cross currency swap market remains stressed as European banks continue to use it to get their hands on dollars. The three-month EUR/USD basis swap is currently trading around 103bp below Euribor, compared to around 80bp below in August and 30bp below in mid-July. In contrast, the basis swap hit around 250bp below Euribor in the wake of Lehman Brothers failing.
“European banks are using the FX swap market to switch euros into dollars, so it is creating some stress. You can lend three-month dollars at around 1% in the FX swap market compared to 25bp a couple of months ago. We’ve seen people trying to convert euros into dollars using relatively short-dated FX swaps – three months and six months – but nothing in really big size,” said El Hayek.
Traders indicated some technical factors could also be driving the currency basis to wider levels. Eonia – the overnight lending rate for euros – is being kept artificially depressed as a result of the ECB’s euro liquidity operations. This glut of liquidity at the front-end of the curve has exacerbated the Eonia-Euribor basis, which is around 85bp. In contrast, the basis between fed funds and USD Libor is currently around 25bp.
“Of the EUR/USD cross currency basis swap, about half of it is driven by stress in the cross currency market, and the other half is optical, and reflects the situation in Europe,” said the head of cross-currency swaps trading. “The Eonia-fed funds basis (at around 47bp below 3-month Eonia compared to 20bp below back in July) is a better indication of the stress in the market.”
With the ECB theoretically providing a backstop in the dollar funding market, traders remain sanguine the situation should not become critical. Overall, many characterize the issues faced by European banks as a symptom of the sovereign crisis that continues to engulf Europe.
“We’re not quite at 2008 levels, but we are very close to that. I don’t think it reflects the same unsatisfied demand for dollars that existed in 2008. These banks aren’t submitting higher Libor numbers and they’re not paying huge amounts for dollar funding. So while things are tight, it’s more orderly than 2008 and there isn’t the same sense of panic,” said Simon Wilson, deputy head of delta trading at RBS in London.
“Liquidity is poor, as it is across all markets at the moment. The level of volatility and uncertainty in the markets is the highest I’ve ever seen. This is a consequence of people asking about the existence of the euro. These are big issues, and they may well manifest themselves in looking at how a French bank funds itself in dollars,” he added.
Christopher Whittall