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Repo: uncertainty casts a shadow

07 June 2012

While some progress has been made on improving elements of the repo market, concerns surrounding the future direction of clearing and regulation persist. Paul Golden reports

Read more: repo tri-party

A paper published by the International Capital Markets Associations’s European Repo Council (ERC) in March sought to place repo in its proper context. A key aspect of the politically disparaged 'shadow banking’ sector, its chairman observed, is that repo is a legitimate funding tool used by regulated banks and financial institutions and an instrument of financial policy for central banks.

Similarly, a Fitch briefing note produced earlier this year pointed out that money market funds rely heavily on the repo market as a means to invest short-term and meet daily liquidity requirements. One of the problems in any discussion of repo, according to ERC paper author Richard Comotto, is that it is treated as a homogenous international market, but this is not the case. For instance, he describes the US and European tri-party markets as different as "fish and fowl", principally because there is no intra-day credit risk in Europe.

The regulatory approach to repo also differs on either side of the Atlantic, with Europe taking a more data-intensive approach as it builds up understanding of how the market functions. In a speech at a European Commission conference in late April, ECB vice president Vítor Constâncio suggested that a database was required to provide basic information about the functioning of the European repo market. However, Comotto is concerned that regulators are too focused on using data to monitor the market.

"Flow and trends are elements that someone monitoring the market closely can keep track of, but there is a danger that we are getting into the realms of algorithmic regulation. You need to be able to interpret figures to make sense of them and regulators have become wary of listening to those operating in the repo market, which has created a distance between the market and those regulating it."

The US is further down the path of regulatory reform. Anshuman Jaswal, Celent analyst and author of a recent report on the US tri-party repo market, says it is too early to pass judgment on efforts to address risk in the US. He says that "reforms are underway, but the progress is painstaking" and expects the Federal Reserve Bank to continue to monitor it closely bearing in mind its importance to the wider financial system.

Concentrated market
Globally, as its vast market is concentrated in a few huge institutions, repo has drawn the attention of regulators for its potential to create systemic risk. Says Jaswal: "The US market is fairly concentrated. The top three dealers account for 40% or more of the collateral for most securities except agency mortgage-backed securities. The top ten cash borrowers account for approximately 85% of the value of triparty repo securities being financed and the top ten cash investors provide about 65% of the funds invested, which adds to the overall systemic risk.

It is important for the regulator to have real time updates on changes in market concentration to be able to take any meaningful action." In a paper presented to a Federal Reserve Board conference in March, two academics from New York University’s Stern School of Business recommended you are not creating regulatory arbitrage. A publicly owned CCP would work in some situations, but you want competition so the presence of two major clearing banks in the US is less of a concern than if it was a monopoly."

Jaswal agrees that the case for a standalone resolution authority has yet to be proven, but is more supportive of the concept of a central clearing facility. "The role of BNY Mellon and JPMorgan has been questioned and it might be a good option to have a single central party clearer that is closely monitored by the regulator," he says, adding that repo markets in Germany and Switzerland have made more progress on risk reduction through the influence of product innovation and central clearing.

According to Bruce Tuckman, director of financial markets research think tank at the Center for Financial Stability, there is concern across the repo market regarding the potential for lenders to run from financial institutions in a manner that has systemic implications. The extension of intra-day credit by clearing banks and the fact that clearing happens inside just two major banks in the US are specific issues for tri-party repo. "Not only do these banks have other interests that potentially conflict with their clearing function, but problems at these banks could spill over into the broader repo market. Almost nothing has been done with respect to this issue and that of intra-day credit."

Improved data
Tuckman accepts that the Federal Reserve Bank of New York’s Tri-Party Repo Infrastructure Reform Task Force has made significant progress in improving the use of technology to the point that intra-day credit extension by the clearing banks could be significantly reduced and that one of its significant achievements was to collect and publish reliable market data. However, he also suggests that greater use of technology is not being pursued aggressively across the industry and that improving technology so as to effectively eliminate intra-day credit extension in an automated and robust manner is still some way from being achieved.

"A key reason for systematic concerns with respect to the liquidation of collateral in the event of a repo borrower’s default is the illiquidity of some repo collateral," he adds. "There is very little risk that the liquidation of US Treasury collateral will disrupt markets, but there is risk that the liquidation of certain collateralised mortgage obligations might do so." A promising method of addressing these concerns, says Tuckman, is to inhibit repo borrowing on illiquid collateral by restrict certainly ing safe harbour protection to the more liquid collateral types.

Safe harbours allow lenders to deal with borrower defaults outside the bankruptcy process by, for example, liquidating collateral. He believes this would ensure repo liquidations no longer posedsystemic threats because only relatively liquid collateral would be put on the market in the event of a counterparty default. "Repo clearing, in the sense of a central counterparty [which includes centralised liquidation] could be useful and risk mitigating for the market if implemented appropriately.

The Depository Trust & Clearing Corporation (DTCC) currently clears many repo trades and its market coverage has been expanding. Forcing repo clearing by legislation, however, would be a mistake. The market and clearing houses are better protected by the process through which the market, perhaps with nudges by regulators, settles on which collateral types are suitable for the outsourcing of risk management and which counterparties are suitable for clearing house membership."

John Rivett, global head of collateral management at JPMorgan Worldwide Securities Services – one of the two major US clearing banks for tri-party repo – points out that the Committee on Payment and Settlement Systems (CPSS) recommendations do not suggest that central clearing facilities are the optimal solution in all cases. "In fact, the CPSS argues that some of the general limitations to CCP clearing might be particularly relevant for repo markets. Bilateral as well as tri-party arrangements can all be combined with central clearing and the respective services are complementary.

For example, CCPs increasingly look to employ tri-party agents to manage the non-cash collateral." Central clearing for repo business is already widely adopted among inter-dealers in many markets whilst the repo financing segments tend to gravitate towards tri-party arrangements, he continues. "There is a case to establish central clearing as one alternative, but it should not be seen as the only solution." Different agendas Rivett acknowledges that the US and Europe have different agendas in terms of risk reduction but says there is some commonality in terms of objectives.

"For example, CCPs are much more at the core of repo infrastructure in Germany than the US or Canada. There are many other aspects that should be considered when looking at how advanced a market is in terms of risk reduction, such as differing contractual basis, the level of automation and credit arrangements." Despite the above, Jaswal expects European repo market volumes to grow over the remainder of this year and the US market to remain flat, while Comotto predicts "modest recovery" in Europe over the remainder of this year and says changes in composition will be important, with the possibility of increased tri-party activity.

"There are new players entering the triparty market in terms of customer usage, albeit not in massive numbers," he adds. "The long-term question is the impact of regulatory change, which is an unknown." Rivett expects tri-party market share to grow on both sides of the Atlantic in 2012 with the regulatory environment encouraging certain participants to look at tri-party arrangements to solve collateral and risk issues outside the traditional repo market, such as for handling CCP collateral.

"As such, there is a clear trend to expand tri-party structures supporting additional exposures," he concludes. John Edwards, director of fixed income at ICAP Electronic Broking suggests that technology has produced greater cost savings and efficiencies post-trade than on trade execution by supporting straight-through processing for settlement and clearing, reducing manual errors on trade booking and facilitating a reduction in staffing in middle and back offices for processing transactions.

"Straight-through processing has had a hugely positive impact on repo market liquidity, particularly on electronic trading systems. We have seen major institutions that have implemented full post-trade, end-to-end processing significantly increase their turnover." The benefits have been more keenly felt in the inter-dealer repo market than in the B2C space to date, according to Oliver Clark, money market product manager at MTS.

"In the interdealer B2B market, settlement infrastructure is well developed across Europe and the automation of settlement instructions by the trading platform is expected. However, in the B2C market we only have partially automated processing. Trades are matched and tickets and settlement countervalues are generated by the electronic platform but at this time we do not automatically send these trades to the tri-party agents.

The buy-side is not yet as sophisticated in terms of internal systems as the banks and requires more manual intervention, although we anticipate this will soon change." Liquidity has been boosted by the ability to execute a larger number of tickets and by peripheral systems that enable the automatic upload of large inventories. "In the past, traders would have shied away from executing a general collateral ticket with 25 sub tickets because of concern over whether it could be processed accurately and without errors," says Clark.
The speed and efficiency of an automated, electronic workflow reduces information lag and improves risk management, adds Jon Williams, head of US markets at Tradeweb, and leads to greater market liquidity. "The sooner a trade is passed to the clearing bank, confirmation of trade details between the counterparties can take place and help reduce risk of manual error and other communications issues or threats to trade workflow."

EquiLend CEO Brian Lamb describes the post-trade repo processing market as consisting of ad hoc solutions, disparate service provider solutions and one-to-one solutions. He says the post-trade repo processing functionality of his firm’s fixed income and repo trading and post-trade services platform enables users to mitigate risk and increase efficiency and scalability by doing more trading with fewer errors and omissions.

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