Hedge funds are positioning for a widening gap between two key euro money-market interest rates as shrinking excess liquidity in the European banking system creates opportunities for relative-value trades, according to a report by Bloomberg.

Investors are using futures to bet that Euribor, which reflects expected short-term bank borrowing costs, will rise faster than the Euro Short-Term Rate (ESTR), the euro area's overnight benchmark. The strategy is gaining momentum as tighter financial conditions increase the potential for divergence between the two rates.

The report cites unnamed people familiar with the matter as saying that Citadel and Schonfeld Strategic Advisors are among the hedge funds active in the trade. Representatives for both firms reportedly declined to comment.

The spread is particularly visible in futures contracts due to expire next week, while the December contract was trading at around 16.5 basis points, compared with approximately 13 basis points in June.

The trade is being supported by a steady reduction in excess liquidity across the euro-area banking system. European Central Bank data shows that surplus liquidity has fallen to about €2.13tn, down sharply from a peak of €4.75tn in 2022.

The decline is partly a consequence of the ECB's quantitative-tightening programme, under which bonds acquired through its asset-purchase programmes are allowed to mature without the proceeds being reinvested. That process is gradually removing excess cash from the financial system.

There is not yet an acute shortage of liquidity, but investors expect reserves to continue declining and funding pressures on banks to build. That could encourage lenders to make greater use of ECB funding facilities, potentially reducing their reliance on wholesale money markets and putting further downward pressure on ESTR relative to Euribor.

Banks can obtain short-term funding through the ECB's main refinancing operations and longer-term liquidity through its refinancing facilities. However, lenders have historically been cautious about relying heavily on central-bank funding because of concerns that doing so could signal financial stress.