Since early September the ECB’s balance sheet has expanded by 589 billion euros (about 750 billion USD) and the Fed USD swap lines are currently sitting at around 100 billion USD. The second LTRO to be conducted towards the end of February is then very likely to take this number well past 1 trillion USD of liquidity to the European banking system.

This aggressive balance sheet expansion puts the ECB at the forefront of global central bank QE alongside the BOE.

While the ECB has persisted ever since the first full allotment LTRO tender in 2008 that its preferred measures of unconventional easing are temporary (and therefore not QE) we know now that this is not the case. Not only is the ECB now offering liquidity for up to 3 years, the central bank has also lowered the eligible collateral that banks may pledge in order to gain access to the liquidity operations. In this sense, the balance sheet expansion at the ECB appears much more permanent to us.

In relation to the notion of banks using ECB liquidity to fund sovereigns and essentially engage in a carry trade fund manager John Hempton from Bronte Capital provides a useful perspective.

Future Joseph Jett traders get a Christmas card from Mario Draghi

Well the Euro fix is in. Whether it works – that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.

The Government debt has – at least for the moment – a very low (mostly zero) risk weighting for capital adequacy purposes so the return on regulatory equity is more than adequate.

Now of all the things you want to be – top of the list these days has got to be a trader at a dumb bank paid a percentage of income earned at bonus time. Massive return on equity. Unlimited funds to employ. Christmas. Indeed a lifetime of silly-seasons all at once courtesy Super Mario.

Of course your bank is not just going to sign over the 20 million check. You are going to have to bamboozle them for that. After all, the European Government Bond carry trade patently risks capital and the risk management department should charge you mega-bucks for that capital. Indeed the risk management department probably should do more than that and stop you.

At Goldman Sachs (where they are quite tight) the risk management department would stop it dead. Contra: at MF Global certain senior Goldies employees demonstrated how Goldies traders without Goldies risk management behave.

But even at MF Global the risk management department knew what was going on.

So dear traders seeking large bonuses: how do you complicate it beyond the feeble minds of your local back-office? You can do complex things with government bonds – strips, interest rate swaps and all sorts of high-fallutin maths that comes from them.

You might not believe me: remember Joseph Jett who misstated profits and risks at Kidder Peabody (then part of General Electric, now buried in UBS). He reported enormous profits and took home an $8.2 million bonus. Jett operated entirely in Government bonds and their derivatives.

So what are you waiting for? The complexity of the stuff you can trade – all dependent on the above ECB provided carry – is enormous. And surely you are smart enough to run rings around the kids in the risk management department.

Wall Street has proven that complexity and cheap money are the road to riches. Now, dear European traders, is your time.

Hop to it boys. You got a Christmas card to collect.

Our view is not clear cut on this issue. European banks need to roll over a large quantity of short term funding in 2012 and the liquidity taken at the ECB auctions will first and foremost be for that purpose. But the incentives are certainly there for the banks to start investing in high yielding government bonds which qualify as zero risk weigthed assets on their balance sheet.

Recent price action in Spanish government bonds coupled with the very strong take-up by Spanish banks in the first LTRO certainly suggest that, in this case at least, banks are using ECB funds to invest in government bonds. However, it is important to recognize that many European banks have been spending the best part of the past 18 months getting rid of impaired euro zone government bonds due to compliance with Basel III.

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