OTC Swaps Regulation: A new wave of bond repo?

With the arrival of EMIR, users of derivatives suddenly need to get their hands on a lot of cash. Cécile Sourbes asks if the biggest collateral-transformation market, repo, is up to the task

On 15 September 2010, the European Securities and Markets Authority (ESMA) was much in demand. On that day the Paris-based authority was releasing its first proposal on the European Market Infrastructure Regulation (EMIR). Market participants knew that the bilateral derivatives landscape would undergo a radical change. But few were thinking about the consequences the EMIR requirements might have for the repurchase (repo) market.

But as months elapsed and the volume of trades going through clearing increased, the realisation dawned that the pressure on the repo market by end-users desperate to gain access to large pools of liquidity for variation margin on derivative transactions - or indeed to generate leverage with which to bypass the increasingly costly derivatives market entirely, could, sooner or later, become unbearable.

According to Laura Brown, head of solutions at Ignis Asset Management, repo is a tool that end-users such as pension schemes should be looking to use even before the arrival of central clearing.

“Pension funds can utilise their strong position, as holders of Gilts, to borrow at low rates by posting these Gilts as security for cash borrowing,” she says. “The cash is typically used to purchase additional Gilt exposure, but could be used to post as collateral under centrally-cleared swap contracts.”

Brown goes even further. She suggests that achieving leverage via repo is already cheaper than leveraging via swaps - reflected in the fact that some schemes have switched from swaps to repo in their liability-driven investment (LDI) portfolios. “Interest on cash borrowed under repo is structurally lower than the swaps pay leg - typically six-month LIBOR - because of the secured nature of this borrowing,” she argues. “This was significantly so during the financial crisis.”

This is precisely what Denmark’s ATP did in 2008. Prior to the financial turmoil, the scheme used to hedge its liabilities with swaps but, ever since, its hedging portfolio has consisted of 50% derivatives and 50% repo. “During the financial crisis, the yields on long-dated government bonds were higher than on interest rate swaps,” says co-CIO Anders Svennesen. “By buying government bonds and repo financing them, we got, say, 20 basis points more than by buying a swap.”

Some issues with repo solutions remain, however. “When you enter into an inflation-rate swap, for instance, if you have the yield move against you, you just need to post collateral and don’t need to come up with cash,” Svennesen explains, “whereas in the repo market, every three or six months you have to roll your repo, which means that if the market has moved against you, you have to come up with new pools of cash.”

Svennesen nonetheless argues that repo requirements will be the same as with central clearing. “The difference will lie in the fact that centrally-cleared derivatives will be done on a daily basis, whereas the repo market [works] on a three to six-month basis.”
Not all market participants are convinced by this option of using repo for liability-matching, however.

“Repo is too short-dated,” argues Ben Gunnee, director of Mercer Sentinel Group. “That is fine if you want to hedge very short-dated liabilities but it is certainly not where your benefits are coming from. The benefits are coming from the long end of the curve.”

One could, nonetheless, argue that the short tenor of the pay leg of a swap mirrors the short-term horizon of repo. The repo market extends out to 12 months but is most liquid at terms of around one to three months. By comparison, the floating leg of an interest-rate swap contract is typically six-month LIBOR. It is the long-term maturity of the Gilts purchased with the cash received under repo contracts - not the repo term itself - that makes this a viable alternative to swaps for hedging pension funds’ liabilities.

Repo solutions could nonetheless present more pressing issues such as liquidity constraints. Many market participants believe the inter-bank repo market will fail to provide long-term solutions to pension funds for variation margins over time.

“Relying on the existing repo market to fund variation margin calls is something we are not comfortable with,” says Andrew Giles, co-CIO at Insight Investments. “The reason is that the periods when you will have the biggest margin calls to meet will directly match the periods when the inter-bank repo market is likely to be less liquid.”

A report published in July 2012 by the rating agency Fitch also warns against the potential lack of liquidity in the repo market. According to Fitch’s analysis, liquidity risks could arise in the near future for both repo borrowers and the underlying asset class if relatively less liquid and volatile assets continue to be exchanged.

The new, evolving supply-and-demand imbalance is already prompting a response from repo providers: whereas some counterparties used to benefit from zero haircuts in the past, banks have now started to apply fees to pension funds willing to swap their physical assets into cash.

In light of the difficulties met by banking institutions to provide liquidity cheaply, new cash providers could come fill in the gap left by the inter-bank model. This, in turn, would lead to a broader central repo market. The system could be extended to the sovereign debt funds, or even to large corporates that are looking for new and better ways to exploit their cash balances in a low-yield environment. By offering cash facilities collateralised against government bonds, the credit risk of cash-rich companies would remain the same but their balance sheet returns could benefit significantly.

“If that was done through a robust clearing platform that minimised credit risk while providing a higher return than comparably secure deposits, companies would be more inclined to lend the necessary amounts of cash,” Giles suggests. He adds that this model could even represent an opportunity for banks to act as repo agents, putting lenders in touch with borrowers for fee.

Not everyone is convinced that cash-rich companies like tech giants want to extend their business models to act like banks. “Would these corporates be comfortable lending cash through the repo market to a pension fund they don’t know?” wonders Ted Leveroni, executive director of derivatives strategy at Omgeo. “I am not so sure.”

Nothing is written in stone. But repo certainly feels like it is at a turning point. “If Brussels is currently working at better regulating the derivatives market - alongside many others - the increasing number of participants within the repo market might also be a crucial argument for the European Commission to develop a new set of rules for this model in the years to come,” Gunnee concludes.

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