FT Alphaville " The dollar-euro repo arb?... Not yet Well, here's one answer to a question we'd been wondering about since last week, when the ECB lowered the deposit rate from 0.25 per cent to zero. We were curious to know whether some EUR-denominated investors would switch into USD short-term markets in a search for yield. The reduction on the deposit rate to zero, after all, is essentially the same as the removal of a safe asset for banks, thereby also reducing "supply" for money market funds. Banks could previously arbitrage the yield they pay to MMFs (which is still more than what these funds would get for simply parking their cash as deposits) and the 0.25 per cent they get from the ECB. This, at least, was the rationale given by by JPMorgan, BlackRock, and Goldman Sachs when they shut down new subscriptions to some of their MMFs. But in the US, the Fed still pays 25bps interest on excess reserves. Primary dealers have increased their holdings of Treasuries across all maturities this year - not just of the front-end stuff which they've been buying from the Fed through Operation Twist and haven't yet offloaded to final holders, but also of the longer-end Treasuries that some dealers will be selling to the Fed as part of Twist (more on which later). This has pushed up repo rates as more collateral has come to the market. But Joseph Abate of Barclays has a short note today arguing that a switch is unlikely because, among other reasons, the lower deposit rate has also been accompanied by a cheaper EUR (costlier USD). He adds that some of these investors have liabilities in EUR and are unlikely to want exposure to currency swings: We do not expect this repo arbitrage to occur. Converting euros into dollars in order to purchase higher yielding assets is still expensive. The 3m cross currency basis remains more than 50bp. Moreover, the European institutions may prefer to stay in euros because their obligations and liquidity needs are in that currency. Swapping back and forth into dollars exposes a community primarily concerned with principal protection to exchange rate movements. At the same time, there are significant frictions in these markets that impair any rate arbitrage. Credit exposure limits and balance sheet capacity, which, for instance, have enabled overnight repo to trade over unsecured fed funds also limit the ability of global banks to fully arb the spread between regional collateral rates. It is not clear how willing banks long euros at the ECB would be to take on additional credit risk with their liquidity pool by purchasing dollar repo. Questions remaining, then: What will replace MMFs for those investors on the margin? Will investors park more of their money as deposits? Good luck finding much more yield there, and we reckon this would simply lead to further flows to and concentration in the banks of the safer countries. How will the banks that traditionally tapped MMFs as short-term funding sources replace them? This will all take a while longer to play out - especially if more EUR-denominated funds shut down new subscriptions - but in the meantime this makes a certain amount of sense. Doesn't mean there won't be capital flight, only that it will be limited. For now. This entry was posted by Cardiff Garcia on Monday, July 9th, 2012 at 20:35 and is filed under Capital markets. Tagged with EUR, Money market funds, repo, usd.