ECB Deposit Rates and the Two Tiered System

The EURO introduction in 1999 meant a complete revamp of not only the European system but a complete overhaul of the banking system. Prior to 1999, Europe had `16 separate and sovereign countries, 16 separate Libor Rates, 16 separate overnight and interest rates, 16 separate currencies. Each bank in each nation functioned according to their own money and money supplies. To align the European system as one under the Euro, three main interest rates were introduced to govern the Euro money supply system inside Europe and align bank operations: Eonia, Main Refinance Operations and the Marginal lending Facility. The two most important interest rates are Eonia and the Main Refinance Rate. The three rates as a whole would later be termed in academic literature a corridor system of interest rates and would mirror the same corridor system as most other nations.
The purpose of a corridor system of interest rates is to steer, to direct, to channel the money supply inside a small corridor of interest rates and its directed by either the ECB in Europe or respective central bank because central banks have ability by law to set interest rates at pertinent levels. The ECB is only in charge to change the Main Refinance Rate. The corridor system is a protection to ensure the central bank doesn’t lose control over the supply of money. EURO Libor would govern London Money markets.

When the EURO was introduced, Dutch Gilders, Austrian Schillings, German Marks, Italian Lira’s, Greek Drachmas and other currencies were placed on deposit at the ECB and exchanged for Euros. To ensure the new mad rush of money supplies would not wack out the system, the ECB set Eonia at 2.75, MRO at 3.00 and the Marginal Lending Facility at 3.25. The entire spread was 50 basis points and quite narrow yet channeled purposefully into the small corridor. From 2000 to 2008, ECB policy was spreads from Eonia to the Marginal Lending Facility would be 200 basis points wide. The system would look like this Eonia 2.75 Refinance Rate 3.75, Marginal Lending Facility 4.75. As the ECB adjusted the Main Refinance rate up or down, Eonia and the Marginal Lending Facility would soon follow and adjust as the market determines since both are complete market instruments.

From 2008 to present day, the ECB adjusted the Corridor to 100 basis points but since 2009, the ECB cut the Refinance Rate from 2.50 December 2009 to current 0.05. The corridor on Main Refinance Rate cuts were actually found from 75 basis points to as high as 250 basis points. Since September 2014 and negative Eonia rates, the Corridor has been 50 basis points wide.

The purpose for the ECB to go negative was to force money into the open market to settle rather than place money on deposit at the ECB. The ECB went negative on Eonia to create a penalty rate to force Europe’s 5,000 banks to deal with each other in the open market and force competitiveness rather than settle accounts at the ECB. The idea for the ECB was to eliminate its cost to handle money. An example. End of day Bank A has a deficit of 10 million Euros but Bank B has a surplus of 10 million Euros. Eonia Friday was 0.86 in the open market yet the ECB offered Euros at 0.80 while Libor offered Euros at 0.81. Not one location along the yield or interest rate curve Friday could Euros be purchased at 0.80 Eonia. So the channel to buy and sell Euros Friday was 0.80 – 0.86, 6 basis points wide. My view is this 6 basis point channel compresses further, targets a lower for longer EUR/USD yet kills volatility in the future.

The 2 tiered system would add another penalty interest rate between Eonia and the Main Refinance Rate. The penalty rate however is not for retail customers but rather steered to banks so to not park excess money at the ECB. The ECB is trying to be the lender of last resort not the first. The corridor would yet again compress. I quote Danske Bank to offer Eonia trades about EUR 10 billion daily, 2% of the 530 billion EUR excess liquidity in the banking system daily. The SNB to offer a counter example has a spread of 10 basis points from Saron and CHF Libor and within an overall range from 0.25 – 1.25 or 100 basis points. Denmark has about 50 basis point wide differentiation between CITA and the CD rate but 75 basis points overall inside the channel. Friday the spread was 29 basis points.

I offer the basics overall in this writing but the EUR system looks like this currently

Libor Eonia Main Refinance Rate Marginal Lending Facility, the new possible proposal

Libor Eonia New Interest Rate Main Refinance Rate Marginal Lending

Dansk Bank outlines a scenario how the ECB can easily offer further QE as well as a further 20 basis point Eonia cut. The two tiered system is yet again another Keynesian approach to allow central banks full market control, its a defensive move and far from the basic premise of central banks since its 1913 founding to add or subtract money to the system and guide that addition and subtraction based on interest rates. Note money first and interest rate secondary not interest rates first. Money creation or subtraction guides interest rates. Today and the shift to Keynes is interest rates first, money secondary.

Why now for the Two Tiered System is possibly because the US introduces another interest rate in Q 1 2016. Our markets will change and enter a new period as all central banks will match the traditional fire and ice relationship between the US and Europe. Its not good nor healthy economically but