Trading directions and the pricing of Euro interbank deposits in the long run

Abstract

We investigate the relation between aggregate trading imbalances and interest rates in the Euro money market. We use data for OTC contracts as well as information from the major electronic trading platform in Europe to study the presence of cointegration between trading pressures and money market rates. We report strong evidence of a long-term linear relation between trading imbalances and liquidity prices for Euro interbank deposits.

Keywords:

• Euro money market
• order flow
• interest rates

JEL Classification:

• G14
• E52

Notes

¹ The reason is that the pricing of funds in the overnight market is largely determined by the interplay between demand and supply of liquidity, with the supply by the European Central Bank playing a key role. In the jargon used in the official statements of the ECB, the liquidity supply should be ‘neutral’ (e.g. see ECB, 2005). This means that the the monetary-policy stance should be affected only by the decision on the key interest rates. The management of the daily liquidity conditions should not impair the signals conveyed by the ECB about the policy stance.

² A nonexhaustive list includes Angelini et al. (2009), Baglioni and Monticini (2008), Beaupain and Durré (2008), Durré and Pilegaard (2003), Heider and Hoerova (2009) and Heider et al. (2009).

³ Evans and Lyons (2001) suggest that, in the foreign exchange market, order flows explain a substantial fractions of exchange rate fluctuations.

⁴ Bjonnes and Rime (2005) measure order flow as the ‘cumulative flow of directions’.

⁵ The 2009 Euro Money Market Study suggests that around 35% of the overall trading activity takes place through bilateral deals, 20% through voice brokers and 45% through electronic platforms.

⁶ The unsecured market involves trading uncollateralized lending and borrowing contracts. The secured segment, instead, consists of trades where collateral is posted against interbank lending. The 2009 Euro Money Market Survey reports that around 60% of trades in both the unsecured and the secured segments have a maturity longer than 1 month.

⁷ Idier and Nardelli (2008) report that approximately 2000 financial institutions are eligible for the MROs, out of the 6500 located in the Euro area. However, only between 340 and 400 institutions take part, while only 148 participate on average to the LTROs.

⁸ See Baglioni and Monticini (2008), Beaupain and Durré (2008) and Angelini et al. (2009).

⁹ The tests with models with unrestricted constants only produce the same results and are not reported here for brevity.

¹⁰ These matrices consist of weighted means of the system variables in levels and first differences and are constructed such that their generalized eigenvalues share similar properties to those in the Johansen (1988) approach.