It is too early to ring the death knell for the repo market but the pressure is on thanks to stricter regulations and the ECB’s latest round of QE. Market participants are not only undergoing soul searching but also looking at new ways to reinvigorate the industry. Lynn Strongin Dodds explores.
The well has not yet run dry but the combination of tougher regulation with the European Central Bank’s current round of quantitative easing is taking its toll on the repo markets. Structural change is on the horizon with sell-side firms re-evaluating their financing propositions while other participants are exploring alternative ways to boost liquidity.
Even before the ECB’s latest monthly €60 bn bond buying programme took effect in March, the market was showing signs of stress. The latest half year survey of 67 firms, undertaken by Richard Comotto, senior visiting fellow at the ICMA Centre at the University of Reading, on behalf of the International Capital Markets Association (ICMA) revealed a 4.8% dip of the total value of repo contracts outstanding to around €5.bn on 10 December 2014 from the roughly €5.8bn in June. 2014. This was mainly attributed to subdued market conditions as well as tighter leverage and liquidity constraints under Basel III.
“There wasn’t a marked fall in volumes or significant pressure in our last repo survey but the next one (published in early August) could reveal a different picture,” says David Hiscock, an ICMA senior director, market practice and regulatory policy. “We are concerned because the ECB programme is taking securities out of the collateral market and the impact will grow as QE continues.”
The US market, which is farther ahead than Europe in the implementation of the stringent banking legislation, is feeling the repo squeeze more. According to a report by money market strategist Joseph Abate at Barclays, banks and broker-dealers have cut their repo borrowings back by $650 bn, or 24%, in the past three years alone. Data from the Federal Reserve also reveals the impact on the tri-party route, where banks lend the securities used as collateral and clearing banks serve as middlemen. Financing is down 17% to $1.62 trn as of 11 May 2015 from $1.96 trn in December 2012 and Abate predicts that this market segment may contract a further 20% in the next year or two.
“Banks have always had to juggle revenues with capital and liquidity but now they have to do this with one arm tied behind their back,” says Nick Nicholls as a principal consultant at consultancy GFT.
“Banks have always had to juggle revenues with capital and liquidity but now they have to do this with one arm tied behind their back,” says Nick Nicholls as a principal consultant at consultancy GFT. “One of the main reasons is the leverage capital ratio which seeks to limit the ratio of Tier 1 capital to total exposure. It is limiting the ability of banks to take on as much risk weighted assets as they would like to. The result is sell-side firms are becoming more discerning in their repo and securities lending activities in terms of the customers, the balance sheet needed to support the trades and the pricing.”
Hiscock adds, “The leverage ratio is creating a balance sheet cost but there are also other regulations that will make it more expensive to conduct repo transactions. These include the mandatory buy-ins being proposed as part of the Central Securities Depository Regulation (CSDR) as well as the proposed liquidity definitions under MiFID II, which are currently being hotly debated. There is a significant problem with false positives (inaccurate classification of instruments as liquid, when in fact they are illiquid) tied-in to the requirements to provide pre and post trade transparency.”
Although the CSDR technical standards are out for consultation until September, ICMA issued a statement in February strongly criticising the mandatory buy-in proposals, which are designed to act as an additional buffer for the buyers in any securities trade. They allow them to find an alternative seller of those securities if the original vendor doesn’t deliver within a set time frame. The purchasers would acquire the securities for the initial price, but the original sellers would have to make up any difference. The main issue is that they could deter banks from offering a wide range of securities for sale, which could force market-makers to charge a premium, widening bid-ask spreads and leading to a deterioration in liquidity.
ICMA is not alone in its concerns. Earlier in the year the International Swaps and Derivatives Association commented that the transparency requirements for illiquid instruments would make it hard to hedge derivative trades or exit a position because the market would be able to move against a firm faster than it could react. The potential result is that dealer banks would be unwilling to take on the risk of executing some client orders, which would also impact the depth of the market.
Given the backdrop, it is not surprising that market participants are mulling over their options. “We are facing a crossroads in the industry as the challenges and workload is huge,” says Cedric Gillerot, Director, Product Management and Collateral Management at Euroclear. “It is ironic in many ways in that the buy-side are looking for secured financing such as repo and securities lending– at the same time that the sell-side is facing regulatory reforms. One of the big questions firms are raising is whether repo can remain a business line in its own right?”
“Banks are being incentivised to allocate away from high volume, low margin government repo business at exactly the same time that buy-side firms want to open it up because of central clearing of derivatives. Repo is the primary tool to convert securities into cash for margin purposes…” – Mick Chadwick, head of trading for the securities finance business of Aviva Investors.
Mick Chadwick, head of trading for the securities finance business of Aviva Investors, echoes these sentiments. “Banks are being incentivised to allocate away from high volume, low margin government repo business at exactly the same time that buy-side firms want to open it up because of central clearing of derivatives. Repo is the primary tool to convert securities into cash for margin purposes. Banks will become more stringent in the way they ration their balance sheets. It will be based on price, availability and the breadth of the relationship. The price may change sufficiently to have an impact on the underlying trading strategy.”
The general consensus is that small to medium sized buy-side players could be squeezed out because they may not have the wider broker relationship. This is leading firms to look at other alternatives such as total return swaps and securities lending although as Chadwick notes, “Total return swaps, repo and securities lending are all correlated activities, and all are likely to be subject to similar regulatory pressures. At the end of the day, the economic objectives are the same- party A has cash and needs securities, party B has securities and needs cash- regardless of the legal construction. For most parties, repo is the simplest way to make this exchange.”
A better solution may be found in the different electronic platforms being proposed. “Traditionally buy-side firms connect with their broker dealers but we are seeing more interest in buy-side to buy-side connecting to each other not just with repo and securities lending but also when they need particular assets for collateral,” says Brian Staunton, managing director, BNY Mellon Markets Group. “It is an interesting opportunity but there needs to be more work done in terms of the types of platforms and infrastructure that can be used.”
Gillerot says, “We are facing a huge transformation although it is premature to say that the repo market is completely drying up. However, securities financing will become more commoditised due to the new regulations. We are looking at the different initiatives in the market but also providing as well as enhancing infrastructure at utility costs to meet the changing underlying environment.”
For example, Euroclear will be the tri-party agent in Europe for DBX-V, a multilateral trading platform for repo trades to be launched by Swiss interdealer broker, Tradition in the fourth quarter. Open to corporates, asset managers, pension funds, insurance companies, hedge funds, brokers, dealers and banks, the focus will be on “general collateral” baskets, consisting of assets such as government and high-grade corporate bonds. The trades, which will be conducted as repo trades, with the assets returned via a repurchase agreement,, can be in several currencies over standard maturity dates, akin to the futures market.
“The short end is almost structurally broken due to LCR, leverage ratio, as well as the bank levy that has made the role of intermediaries more challenging,” says John Wilson, CEO at DBV-X, part of Tradition. “We are offering a peer-to-peer model, trading standardised collateral baskets from independent sources, and participants also do not have to sign a smorgasbord of legal agreements with counterparties, but just one multiparty standardised GMRA in order to trade on DBV-X. We provide price transparency but with pre-trade anonymity because our platform has embedded counterparty risk limits. Orders only match if both parties have sufficient limit to trade with each other within triparty or the trade is being cleared.”
While the interest is definitely piqued, peer to peer lending has its own set of challenges. As Chadwick puts it, there are “a number of operational and risk issues to deal with but most importantly a cultural shift would need to take place. The platforms imply that the buy-side will become the price makers, but for most long only fund managers, best execution is implicit in the rules of engagement and language of MiFID. The assumption in MiFID is that an orderly and liquid market exists and that we are the price takers looking for the best price.”
There are also issues over the buy-side’s direct involvement in repo clearing without a clearing member intermediary. The benefits are well documented. It would allow more positions to offset each other, thereby reducing their overall exposure and alleviating banks’ capital constraints. In addition, matching trades in a clearing house, with a confirmed counterparty, would also improve pricing for their trades.
However, fund managers point to the costs of investing in the right infrastructure as well as contributing to the default fund as major stumbling blocks. Many are not allowed to have exposure to mutualised losses, so they would not be allowed to pay in. “How to tackle the default fund contribution is one of the thornier issues,” says Bruce Kellaway, Global Head of Fixed Income at LCH.Clearnet. “An alternative is could be that a bank or futures commission merchant can provides it on their behalf, but being an agent for a swap is different than for repo. It is a high balance sheet commitment and they would probably have to charge a fee for the service.”
