Despite very strong demand, the rate of allocation has remained low. The issue isn't dire given the current liquid market. But should liquidity drop, smaller banks wanting to secure ECB funds below market rates could be squeezed, analysts say.

The ECB allocates funds at a fixed main refinancing rate of 2.5%, in 14-day reserve transactions. Traders say employing a variable rate is the only viable option to discourage overbidding, solve the oversubscription problem and make fund allotments fairer.

However, with the euro hitting lows, the move to auction-style refinancing could send the wrong signal to markets about ECB monetary policy, analysts and traders caution.

`Wrong Signal' "A variable rate will be tied to the euro weakness and the ECB would be sending a wrong signal -- that it's trying tomove interest rates to protect the currency," says a money-market trader at Barclays in London. A variable-rate refinancing system should allow for market rate movements in either direction, but, "when the market tone is bearish, any change by the central bank would be taken as confirmation of market sentiment at that particular point," he says.

A move to a variable rate now would push market rates higher, especially when expectations are rising for monetary tightening in the U.S. That in turn has raised fears that the next euro-zone rate move will be higher, despite weak economic fundamentals, he says.

Speculation about the variable-rate system pushed euro-zone deposit rates up Wednesday, when the euro fell to a low below $1.0350.

Widespread Uncertainty

Market sentiment is weighed down by uncertainty in the larger euro-zone economies and by political discussions on structural and budget reforms and the euro's future. Against this backdrop, there is too much at stake to make any changes now,says Conrad Mattern, treasury analyst at Deutsche Genossenshaftsbank in Frankfurt.

"The ECB doesn't intend to say it wants to raise interest rates, but if the ECB changes to a variable rate, it can't be sure which direction interest rates would go," Mr. Mattern says. "At this moment, they don't want to signal anything, so they won't change [refinancing]."

Last week, ECB President Wim Duisenberg said the central bank will continue to monitor oversubscription developments, noting that "there may be a day" when the bank could switch to a variable rate.

Analysts and market players say only the variable rate can completely solve the oversubscription problem, but there are other options the ECB could take till then.

More Reasonable Bids

With a variable refinancing rate, banks will be forced to come up with more reasonable bidding rates in accordance with their financing capacity and funding needs, traders say, thus reucing the incentive to overbid. "Under the controlled or fixed rate, players don'thave a chance to be competitive. Only the size of bidding determines the allocation level," the Barclays trader says. "But under a variable rate, the market will find a natural level."

The Barclays trader says the ECB could flood the money markets more aggressively to bring cash-market rates below its main refinancing rate. Overbidding during ECB refinancing operations means banks can raise money for a two-week period at a cheaper rate than from the market.

Euro interbank offered rates for a two-week period have generally been confined to a 2.54 per cent to 2.55 per cent range.