The imbalances within the ECB’s TARGET2 payment system have risen to same levels as they were in the midst of the last Euro debt crisis. These are the amounts that the different Eurozone National Central Banks lend to one another overnight, in order to settle mutual payment obligations. In other words the Bundesbank – and a very few others – fund the overdrafts of the GIPSI National Central Banks.

In a normal payment system the participants have to zero-balance their settlement accounts at end-of-day by either borrowing/lending the balance in the open market, or, as a last resort, dealing it away to the central bank via a repurchase agreement: a borrower sells collateral to the lender for cash to cover their overdraft, and buys the collateral back as the first transaction of the following day.

In this case the available collateral is government bonds issued by the owner of the National Central Bank needing the money – a major correlation risk.

In TARGET2 a repurchase agreement would raise a further and very uncomfortable question: what strike price should be used? The face value or the market value? It should be the lower of the two, because otherwise the lender is taking a ‘clean’ credit risk for the difference between face and market. But the market price of the securities involved is in many instances well below par.

In that case a repurchase agreement struck at ‘market’ would cause a global, downwards mark-to-market adjustment, with disastrous consequences: market participants continue to hold these securities at full face value because they fall into the definition of ‘sovereign risk’, which should mean risk-free. Not only that, there might not be sufficient market value of bonds to pay off the overdraft.

The alternative would be to use a strike price of par – but that is off-market and would imply the existence of a parallel trading market with a disconnection between intra-TARGET pricing and open market pricing.

When between a rock and a hard place… do nothing.

The mantra that participants have to zero-balance their settlement accounts at end-of-day has been abandoned. Positions are left to sit, secured by bonds that contain 100% correlation risk and which have a face value equivalent to the overdraft but a market value that is much lower.

The credit risk being taken by the Bundesbank – and a very few others – in TARGET alone exceeds its aggregate exposure in the three formal bailout funds (EFSM, EFSF and ESM). The result is a major excess of Germany’s aggregate value-at-risk over the supposed limit of EUR500 billion, agreed through the organs of the German parliament (Bundestag) and the constitutional court (Bundesgerichtshof) after heated debate.