Cash-rich companies could boost repo market liquidity – Insight
EUROPE - Companies sitting on large piles of cash should post those funds into a central repurchase (repo) market to help investors such as pension funds access larger pools of liquidity for margin calls on centrally-cleared derivatives trades, one asset manager has claimed.
Andrew Giles, co-CIO at Insight Investment, told IPE that, due to the restricted liquidity of the current inter-bank repo market - and pension funds' increasing need to access large amounts of cash to cover variation margin requirements under central clearing - a centralised repo facility should be created.
Under the current European Market Infrastructure Regulation (EMIR), most derivatives trades made by pension funds to hedge their liabilities must go into central clearing.
However, the current central clearing system only allows variation margins, posted for derivatives trades, in the form of cash.
Acknowledging that pension funds are not typically large users of cash, the European Parliament and the European Council agreed in February to grant those investors a temporary exemption from the EMIR.
This exemption aims to give central clearinghouses more time to provide a suitable solution to swap pension funds' physical assets such as government bonds for cash.
One possible solution under consideration is the repo market, but banks and pension funds must still overcome a number of hurdles, according to Giles.
"Relying on the repo market to fund your variation margin calls is something we are not comfortable with," he said. "The current term repo market is very limited and cannot necessarily provide long-term solutions to pension funds, looking to fund variation margin calls.
"The reason is that the periods where you are likely to experience the largest margin calls - conditions of market distress - are precisely those periods when the inter-bank repo market is likely to be the least liquid.
"In the worst-case scenario, where a large margin call needs to be met, the current repo market will not have sufficient liquidity or capacity to provide guaranteed funding."
Giles called instead for an expanded centralised repo market, in which big companies sitting on large volumes of cash - such as Apple, Google or Microsoft - would start lending their cash.
At the moment, however, most of those companies are reluctant to post their cash balances in the repo market, as many lack the necessary infrastructure and are unprepared to accept the associated counterparty credit exposure, according to Giles.
"We understand that many such companies currently place their deposits with the central banks," he added. "But those deposits only provide a very low rate of return.
"If those investors had access to a centralised repo facility through which pension funds and other investors collateralised their borrowings with high-quality government bonds, then large companies' credit exposure would be comparable with placing their cash with central banks."
Giles went on to say that a central system could broaden and deepen liquidity in the repo market "way beyond where it currently stands".
He said banks could also play a pivotal role, putting lenders in touch with borrowers and charging agency fees in return.