By far the most interesting story anywhere yesterday was the report written by Francesco Canepa of Reuters about the grave concerns of the European Central Bank over the state of the 5.5trillion euro short-term funding market. As Canepa put it, that market underpins Europe’s financial system. The ECB fears a “market-freeze” and is preparing measures aimed at trying to avert it.

It looks like a canary in the coalmine story, similar to those early reports of problems in the sub-prime housing market before the last crisis. We’ll see.

It sounds dull. Really, it isn’t. In essence, banks and other financial firms use high-rated bonds (such as German debt) as collateral when lending and trading with each other. This is known as repo, for repurchase agreements. It is the oil in the financial engine that makes the giant debate machine go round smoothly. If it stalls, then the severe problems of banks in countries such as Germany and Italy may get worse rapidly.

The problem is that the ECB bought more than 1 trillion euros of eurozone government debt, to prop up eurozone growth. The ECB holds most of that stuff, which reduces the bonds available for the struggling banks to use as collateral in the repo process. Reuters reports that in response the ECB will make it easier for banks to borrow the bonds the ECB holds, to facilitate trading and lending and avoid a potential freeze that would spread panic throughout Europe’s financial system.

The ECB meets to discuss all this and more on December 8th, four days after Austria votes in its Presidential election and Italy holds its constitutional referendum. A solution is not straightforward. The ECB bought and holds those bonds (a quarter of it is German), but the national central banks ultimately own it and will all have to agree to any measures undertaken to prevent a market freeze. The scope for miscommunication and the assertion of national self-interests is obvious.

As Canepa reports:

“Germany, the only large euro zone country with a top-notch credit rating, is where the problem is at its most severe. With the ECB now owning more than a quarter of all outstanding German bonds, funds pay up to 1.5 percent to borrow a 10-year Bund, up from some 0.40 percent a year ago, according to Icap data. This is putting a strain on investors as they face increasingly frequent demands to put up cash or liquid collateral against their derivative positions due to new regulation.”

Meanwhile, the FT’s Big Read today is on the meltdown of banks in the hitherto prosperous Veneto region. Well worth a read.

Today, the ECB also issued a warning that financial stability is at risk, even when markets seem on the surface to be fine. Equities are strong and volatility, prompted by recent political upheaval, is in the short-term good for trade and profits in the business of making money from money. The ECB warns against complacency:

“Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas… This, in turn, could delay much-needed fiscal and structural reforms and could in a worst-case scenario reignite pressures on more vulnerable sovereigns… In particular, concerns about debt sustainability might re-emerge despite relatively benign financial market conditions.”

Forewarned is forearmed and all that.