The co-ordinated liquidity operation announced by central banks yesterday is promising but questions remain about its implementation. The market response has been muted: three-month dollar LIBOR was fixed just 7 bp lower this morning, while the corresponding euro rate was unchanged.

The Fed’s new “term auction facility” is modelled on the ECB’s three-month repo operations, although the first two auctions will be of shorter maturity (28 and 35 days). The key features are 1) a non-penal, market-determined interest rate, 2) acceptance of a broad range of collateral and 3) borrower anonymity.

However, the ECB’s auctions have not been reflected in greater success in reducing Eurozone LIBOR premiums compared with those in the US and UK. The reason is simple: the ECB has offset its additional three-month lending by cutting back funds supplied in shorter-term operations. Banks' reserves at the ECB have shown little change since the onset of the liquidity crisis.

The success of the new operations therefore depends on them being used to increase aggregate central bank lending to the banking system, not just extend the maturity of existing support. The outcome will be unclear until after the auctions take place, partly explaining the market’s muted response.

One curious feature of the operation is that the ECB will offer dollars to European banks but is not planning additional euro lending. This explains the failure of euro LIBOR rates to match the modest declines in dollar and sterling rates.