Ahead of the Curve: Repo faces paralysis
As the repo market faces an uncertain future, Andy Hill looks at the ramifications of increased regulation and liquidity demands
The European repo market is in transformation. A combination of Basel III capital and liquidity requirements, monetary policy, and regulatory initiatives is driving this shift.
The leverage and supplementary leverage ratios have increased the cost of holding repos to the point where netting (or matched-book trading) is necessary to remain profitable. Accordingly, banks’ provision of repo pricing and liquidity has become a value-added service for clients, subsidised by profitable businesses.
The concern is that the reduced effectiveness of the European repo market will have repercussions for capital markets and the real economy. This is the subject of a study* based on interviews with market participants and stakeholders, including bank repo desks, fund managers, inter-dealer brokers, electronic trading platform providers, agency lenders and tri-party agents.
As well as reevaluating the liquidity banks are prepared to provide to clients, the eventual transactions that they are prepared (or able) to do are driven more by the banks’ liquidity and capital requirements than client financing needs. Whereas clients could once rely on their banks, they are now forced to be more flexible. The terms of transactions are becoming a negotiated process involving matching interests with a view to netting and liquidity optimisation.
This is forcing banks to change their business models. Traditionally, repo desks have been stand-alone profit centres within the fixed income division. They are now overlapping with treasury, securities lending and equity finance, as well as bringing margin management out of the back office. Effectively, the repo desk is a centralised collateral and liquidity management hub rather than a trading unit.
There are growing concerns that the Public Sector Purchase Programme of the European Central Bank could lead to scarcity in government bonds, particularly Bunds. It could also reduce the availability of High Quality Liquid Assets in the repo market. Meanwhile, excess liquidity is making it harder to invest short-term cash on a secured basis, particularly around reporting dates. This phenomenon is being reflected in increased repo rate volatility and thinning liquidity at month ends.
While the market adjusts to the new leverage ratio and liquidity coverage ratio requirements, there is concern over the net stable funding ratio, which will make short-term repo activity even more onerous for balance-sheets. Meanwhile, other regulatory initiatives such as Central Securities Depositories Regulation, mandatory buy-ins and Bank Recovery and Resolution Directive stay provisions will add to the risks of trading repo. Various reporting requirements, such as the Securities Financing Transaction Regulation, will also increase the overall cost.
There are mixed views on the future of the market, with some identifying opportunities, as they recalibrate their business models as many retrench. Some suggest that excess liquidity is papering over the cracks in the market, which are set to widen. However, the consensus view is that repo will still exist, not least since the demand for secured funding and the need for collateral will continue. Several banks will cease providing repo liquidity to clients, while new entrants, both sell-side and buy-side, are expected to fill any gap.
Meanwhile, overall volumes and liquidity should decrease, and bid-ask spreads should begin to widen to reflect better the true cost of capital. Balance sheet efficiency will remain the primary concern, and so central clearing for repo is likely to expand, with more buy-side firms exploring central counterparty solutions.
A significant concern is that much needed collateral sits with real money investors, many outside of Europe, most of whom do not need to lend securities and do so only as a marginal ancillary business. As regulation makes it more onerous and expensive for these investors to provide collateral to the market, so the possibility of a much feared ‘collateral crunch’ increases.
Andy Hill is director, market practice and regulatory policy, at the International Capital Market Association (ICMA).
* The current state and future evolution of the European repo market, available at www.icmagroup.org