* Funds pay record fees for German, French bonds
* Scarcity undoes ECB stimulus, threatens stability
* Chart on collateral squeeze since QE:
By Francesco Canepa
FRANKFURT, Jan 5 The European Central Bank's
bond-buying programme was intended to rescue the euro zone's
economy by flooding it with cash, but it is also siphoning off
one of its most valuable assets: high-quality government debt.
The worst drought of German and French bonds on record is
undoing some of the ECB's own stimulus and raising questions
about the functioning of the financial system, bankers and
Aggressive ECB bond buying have deprived investment funds of
collateral they need to raise money and guarantee their trading
positions: high-rated and liquid debt such as that issued by
For a chart: reut.rs/2hymSHD
The cost of borrowing German and other high-rated bonds has
risen to record highs over the past week, despite ECB efforts to
make more of the bonds it owns available to borrowers
The bonds have historically been used to raise cash against
collateral in so-called repurchase agreements, or repos. But the
ECB's negative interest rates has turned the system on its head:
companies are now paying to swap their cash for German debt.
Last Friday, they were paying some 4.9 percent to borrow
German debt, more than on any day on ICAP records going back to
2006. The rate had since eased to 1.5 percent, but that was
still twice as high as before Christmas.
Consequently, investors have no incentive to sell those
relatively safe bonds and invest in riskier assets -
contradicting one of the objectives that the ECB's quantitative
easing programme (QE) aims to achieve.
"QE is about the quantitative aspect but also getting
investors to take on more risk, and that simply doesn't have to
happen if the repo market gets more expensive," Peter Chatwell,
head of euro rates strategy.
Worse, the scarcity of bonds to borrow could leave banks and
investment funds struggling to meet sudden obligations to post
collateral - in a market sell-off, for example. In extreme
cases, that could lead to the firm's being put into default by
its clearing house, the middle man between parties in a trade.
"The bond scarcity increases systemic risk," one senior
banker said. "If one bank fails to deliver to a central clearing
counterparty, this could put it into default."
The rise in the cost of borrowing bonds was probably
exacerbated by thin supply over New Year, when banks that lend
the paper are reluctant to deploy resources before their
But the record rates, far higher than at any point thus far,
suggested the problem was more fundamental and likely to occur
again at crunch times, such as the end of quarters.
That raises questions about the effectiveness of the ECB's
bond-for-cash scheme, begun in December to allow banks to borrow
ECB holdings of government bonds in return for cash.
Market participants said one of the faults of the scheme was
that euro zone central banks were only allowed to lend bonds at
existing market rates, meaning their power to influence them was
The problem was exacerbated by tougher post-crisis
regulation, which had limited banks' ability to make the market
while increasing funds' need for high-quality bonds to use as
"Maybe the ECB will take more action, the door is not shut
for them never to change the rules again," David Schnatz, rates
strategist at Commerzbank, said.
"But the whole repo problem is likely to stay with us for
some time and it is likely to get worse before it gets better."
The ECB declined to comment.
(Additional reporting By Dhara Ranasinghe, editing by Larry