Repo market showing increasing signs of liquidity risk – Fitch
GLOBAL - The tri-party repo market is showing increasing signs of "inherent" liquidity risks for both borrowers and the underlying asset class due to less liquid funding and the acceptance of more volatile assets as collateral, according to a new report.
In a study entitled "Repos: A deep dive in the collateral pool", ratings agency Fitch said repo agreements - which constitute a core part of the 'shadow banking' system - were increasingly in the spotlight, given their importance as a funding mechanism and their role in past episodes of market distress.
The tri-party repo market - which involves a custodian bank or clearing house acting as an intermediary between the two parties in the repo - will be of even greater importance for pension funds looking to swap physical assets into cash to meet variation margin calls for centrally cleared derivatives trades under the new regulations both in the US and Europe.
But Fitch warned of the potential liquidity risk borrowers could face.
According to the agency, structured finance repos are typically collateralised by pools of securities that are of lower credit quality, deeply discounted and small in size.
"Additionally," it said, "while Treasuries and agencies represent a significant majority of collateral, repos are also used to finance corporate debt, gold and equity securities.
"Funding relatively less liquid, more volatile assets through repos - which are effectively short-term loans - creates potential liquidity risks for both repo borrowers and the underlying assets."
Fitch - which analysed daily trading volumes for non-agency residential mortgage-backed securities (RMBS) and asset-backed securities (ABS) - noted that the liquidity risk stems from both the small size of many of these securities - whose median value is about $800,000 (€646,000) - and their distressed nature.
The issue lies in the fact that half of the securities analysed consist of legacy CDOs and subprime and Alt-A RMBS, which were for the major part originated by financial institutions that experienced severe distress related to their securitisation and mortgage-related exposures during the US credit crisis.
Even though structured finance repo agreements provide a potentially attractive return opportunity, according to Fitch, US prime money market funds, which act as repo lenders within the tri-party repo market, are short-term and highly risk-averse investors.
"Therefore," Fitch said, "any disruption in repo funding for structured finance could impair the liquidity and valuation of these assets, affecting not only repo market participants but also cash investors that take long positions without the use of leverage.
"Such disruptions might also affect financial institution counterparties that use repo markets to fund inventory of structured finance and other riskier securities."