Hedge funds bet on widening Euribor-ESTR gap

Hedge funds are placing relative-value trades in futures to profit if Euribor moves higher than the euro short-term rate, ESTR, as excess liquidity in the euro-area banking system has declined. European Central Bank data show surplus liquidity has fallen to about €2.13tn from a peak of €4.75tn in 2022. The spread is most visible in short-dated contracts due next week; the December futures were trading near 16.5 basis points versus roughly 13 basis points in June.

Traders buy positions that gain if term unsecured rates, represented by Euribor, rise faster than the overnight unsecured benchmark ESTR. Euribor reflects expected short-term bank borrowing costs over maturities longer than overnight, while ESTR measures actual overnight unsecured transactions. Market participants say the gap between the two rates can widen if banks change how they fund themselves.

The ECB has allowed bonds bought under its asset-purchase programmes to mature without reinvestment, gradually removing cash from the banking system. That quantitative-tightening process has reduced surplus reserves and is expected by some market participants to continue. Falling reserves can alter banks’ use of wholesale money markets and central-bank facilities.

A shift toward greater use of ECB funding operations, rather than interbank term lending, could put downward pressure on ESTR relative to Euribor because ESTR reflects overnight unsecured activity. Banks can access short-term liquidity through the ECB’s main refinancing operations and longer-term liquidity through targeted refinancing facilities. Lenders have generally been cautious about heavy reliance on central-bank funding because it can be interpreted as a sign of funding stress.

People familiar with the trades named Citadel and Schonfeld Strategic Advisors among firms active in the strategy; representatives for both declined to comment. Traders say futures prices are already reflecting tighter conditions, and short-dated contracts are where the effects of shrinking reserves are appearing first.

Banks, traders and investors are monitoring ECB liquidity figures and upcoming bond maturities to gauge how quickly the surplus will fall and how funding patterns might change. The speed of reserve decline and banks’ responses will determine how the Euribor-ESTR relationship evolves.