Hedge funds target Euribor-ESTR spread as euro liquidity tightens

Hedge funds are betting on growing differences between two crucial euro money-market interest rates as the European banking system experiences a decrease in excess liquidity, according to a Bloomberg report. These investors are utilizing futures contracts to speculate that Euribor, which represents anticipated short-term bank borrowing costs, will increase at a faster rate than the Euro Short-Term Rate (ESTR), the euro zone's overnight rate benchmark.

This trading strategy is gaining traction as tighter financial conditions heighten the likelihood of divergence between the two rates. Sources familiar with the situation reveal that prominent hedge funds like Citadel and Schonfeld Strategic Advisors are actively participating in this trade, although their representatives have declined to provide comment.

The spread between Euribor and ESTR is particularly evident in upcoming futures contracts, with the December contract currently trading at around 16.5 basis points, compared to 13 basis points in June. This trend is being driven by a continuous decline in excess liquidity within the euro-area banking system. European Central Bank data indicates that surplus liquidity has plummeted to approximately €2.13 trillion, a significant drop from its 2022 peak of €4.75 trillion.

This decline is primarily attributed to the European Central Bank's quantitative tightening measures, which involve allowing bonds acquired through asset-purchase programs to mature without reinvesting the proceeds. This process gradually eliminates excess cash from the financial system.

While there isn't yet an acute liquidity shortage, investors anticipate that reserves will continue to diminish, resulting in mounting funding pressures on banks. Consequently, institutions may increasingly rely on ECB funding facilities, potentially decreasing their dependence on wholesale money markets and causing further downward pressure on ESTR relative to Euribor. Banks have traditionally been cautious about over-relying on central-bank funding due to concerns that it could signal financial distress.