Refreshing the repo market

Refreshing the repo market

Godfried De Vidts, chairman of the International Capital Market Association’s European repo Repo Council, says the repo market is ready to quench the buy-side’s thirst for collateral

Is the glass half-full or half-empty? To Godfried De Vidts, chairman of the International Capital Market Association’s European Repo Council (ERC), it’s definitely the former. When he surveys the impact of post-crisis regulatory reform on the financial markets, De Vidts sees potential risks almost everywhere. Portfolios may go unhedged, markets may be drained of liquidity, and risks may be transferred to less regulated entities – all resulting in an increase in systemic risk rather than the higher levels of transparency and safety intended by regulators. But there are plenty of reasons for optimism too, if you look closely enough.

And De Vidts looks at the markets very closely. As chair of the ERC since 1999, he is focused in particular on the inner workings, processes and dynamics of the repo market. Traditionally used by banks to meet short-term funding needs through repurchase agreements, the repo market is currently undergoing radical change in a post-crisis world that places a premium on the ability of financial institutions to exchange assets to meet increasing collateral requirements. As the representative body of banks involved in repo activity for the last 20 years, the ERC is responsible for maintaining an orderly and efficient market (for example through the standardization of documentation under the Global Market Repurchase Agreement), the promotion of best practice (through the recently updated ‘Guide to Best Practice in the European Repo Market’) and various educational activities, such as its April conference, ‘New Regulation and Collateral Fluidity’.

Losing liquidity

To find potential threats to the repo market, De Vidts need look no further than Basel III’s leverage ratio. Introduced in stages, the leverage ratio effectively sets a minimum level of capital that banks must hold as a percentage of assets. Banks are already reporting leverage ratios to national regulators and these filings will be made public from January 2015, with the ratio – currently 3% – scheduled to be fixed at the beginning of January 2018.

Banks have responded in a number of ways: by retrenching from non-domestic markets, by reducing their liquidity provision in the fixed income markets, and by withdrawing from repo activity. The Basel-inspired shift in the risk / reward profile of the repo market is already having an effect. The ERC’s latest semi-annual survey of the European repo market, which calculated the amount of repo business outstanding on 11 December 2013, found the market had shrunk by 8.2% to €5,499 billion in the previous six months.

This has a number of worrying implications. Due to its role in bank funding, the repo market is a core transmission mechanism in the overall economic system. Effectively it stands between central banks, as lenders and liquidity providers of last resort, and the banks that distribute to the real economy, both retail and institutional. A thinner repo market is a less effective distribution mechanism to the real economy and less reliable source of collateral pricing, says De Vidts.

“All the new regulations, and not just the ones that impose capital costs, add up. Banks are less profitable. Regulation is decreasing the presence of the banks at a time when there should be increased repo market activity. This means liquidity will become more opaque. It will be harder to find prices,” he says.

Reduced repo activity may also slow Europe’s post-crisis reorientation from bank funding to raising debt in the capital markets. De Vidts observes, “Issuance of corporate and government bonds has been increasing. But this move of the real economy toward European capital markets has to be financed. If you reduce the activity of banks in the repo market, this financing has to come from somewhere and that means shadow banking.”

 

 

 

“Collateral is the new cash. We have to become more efficient in how we execute trades.”

Godfried De Vidts
European Repo Council

Replenishing the market

Is that glass looking half-empty yet? While Basel is encouraging banks to pull back from the repo markets, other elements of the post-crisis regulatory settlement – namely the migration of major classes of OTC derivatives to central clearing – are encouraging non-traditional participants to step up their presence. Institutional investors that need to lay their hands on eligible collateral to supply margin to clearing houses in support of centrally cleared swaps are looking to the repo markets as an effective channel for exchanging the assets they have for the assets they need. Moreover, corporates sitting on large piles of cash are looking for an alternative to unsecured lending for short-term use of their otherwise idle assets.

“It’s inevitable that the sell- and buy-side have to work together more closely in the repo market,” says De Vidts. Indeed, he predicts a “fundamental” change to the repo markets in which bank-dominated structures and processes will accommodate a wider range of participants. 

Tri-party repo agreements – used by institutional investors to switch between cash and other longer-dated assets for collateral management purposes – are already a growing element of the overall repo market. “Triparty repo is effectively a form of collateral management outsourcing for the buy-side. If you talk to tri-party agents, there is evidence of enormous growth in the participation of the buy-side. These are early signs that I expect to continue,” he says. “As the market for bilateral repo declines – particularly for corporate bonds – tri-party will grow more.”

The ERC’s European repo market reported a relatively modest increase in the market share of tri-party repo to 9.9% from 9.6%, against the backdrop of a sharp fall in the size of the overall repo market. The outstanding value of tri-party repo reported directly by the major triparty agents in Europe leapt 22% to a record €1,344 billion, suggesting a lot of new buyside firms are entering the market as traditional sell-side participants moderate their activity.

De Vidts believes that progress on market infrastructure reform will facilitate further growth. But there is no scope for complacency, nor trace of it in De Vidts’ analysis of the challenges ahead. A key risk is that post-crisis reforms make use of OTC derivatives for hedging and other forms of portfolio management too expensive for many buyside firms, thereby increasing systemic risk.

A high proportion of big insurance firms and large asset management groups have repo desks already, but the future is more of a challenge for less frequent users of OTC derivatives. De Vidts was alarmed a couple of years ago when he heard a buy-side executive tell a London audience he would not employ hedging strategies that required his firm to post margin as collateral transformation was not the job of the buy-side.

This would be possibly the most negative outcome of the whole regulatory framework. It might look acceptable today not to hedge, but when rates go up firms will need to be hedged properly for future investment purposes.

Bilateral transactions

With so many regulatory developments unfolding in multiple jurisdictions as G-20 reforms are implemented, one should not be distracted from major changes to the rules for the derivatives transactions that remain bilateral. Phased in from December 2015, the new rules – drafted by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions – impose initial and variation margin at levels that explicitly incentivise use of cleared derivatives and impose strict conditions on re-hypothecation of initial margin collateral.

“The big risk that will not go away is the non-CCP cleared positions. New regulation on bilateral clearing is very important because that accommodates the tailor-made hedging that the buy-side needs, says De Vidts, who implies the post-crisis landscape will undergo further structural shifts before the dust finally settles.

The appropriate response to the challenges ahead is to continue to break down the barriers to the movement and exchange of assets that can be used to collateralise trading and funding, in the process making the repo market more user-friendly to the buy-side. “We need to arrive at a point where it doesn’t matter where your collateral is located, its currency or rating. If I need cash, I should be able to use that collateral,” he says. • 

A longer version of this article appeared in The Trade Derivatives, Q2 2014.