The Assault On Liquidation Rights

oktober 24, 2014 in Columns-Artikelen by onze redactie

There is an assault brewing on the liquidation rights for swaps contracts. Banks were recently asked to give up some of their rights under the law when 18 of the largest U.S., European, and Japanese banks met in Washington DC after several months of discussions. Regulators want to delay termination rights of swaps contracts for 48 hours for troubled financial institutions. The banks agreed, and the new protocol will take effect on January 1, 2015.

The goal is a noble one. It’s an attempt to limit “fire-sales” during the worse part of a financial crisis. There’s a good case to be made for waiting 48 hours to have a counterparty that’s recapitalized and backed by the government. Just waiting these two days can prevent the entire liquidation process. On the other hand, those 18 banks are giving up liquidation rights that exist under current law. When an important foundation of a market is altered, even in a minor way, there will be consequences. Not surprising, asset managers and hedge funds are resisting the change. Since those entities are not under the same regulatory umbrella as the banks, regulators will have to compel them to comply with the new rules.

But here’s the part I’m concerned about: included in the 48 hour delay is a hold on margin collateral. That means they’re getting into the realm of the Repo market. If swaps are pushed along this route, Repo could be next.

Defaults

When a company declares bankruptcy, its assets are frozen and the company is either liquidated or reorganized. Either way, no one can touch the assets, except those which are legally exempt like Repo and swaps. Officially, they’re both exempt from the “automatic stay” provision of the bankruptcy code. Repo and swaps counterparties have the right to immediately liquidate all of their outstanding trades with the defaulted entity.

The idea behind the 48 hour delay is to prevent these liquidations and the market distorting fire-sales that result. When counterparties liquidate contracts, it makes a market crisis all the more chaotic. In a way, over the past 30 years, liquidations may have increased market volatility. Lehman Brothers is a good example. They had billions of dollars of swaps trades outstanding and within five weeks of their bankruptcy, 80% of their swaps contracts had been liquidated. It was good to get Lehman as a counterparty off of your books, but the Lehman trustee spent years in the legal system with many of these counterparties trying to claw-back collateral. Avoiding a repeat of the Lehman legal mess is one goal behind the 48 hour delay.

Dodd-Frank

Regulators were give new powers under Dodd-Frank in 2010 to seize a failing bank and keep its units operating. But in order to make it work, you can’t have their counterparties trying to liquidating their positions at the same time. Thus the 48 hour delay in termination rights. Basically, regulators need time to transfer the defaulted entity into a “bridge” holding company. As long as the new entity is well-capitalized and government backed, the swaps counterparties are giving up a bad counterparty for good a good counterparty. And there’s no need to liquidate the swaps contracts. Sounds like a win-win? But again, how much market efficiency and liquidity in normal times is being given up to limit financial market stress during bad times?

Repo Property Rights Established

Repo liquidation rights were originally established after Drysdale, then passed along to municipalities after Orange County. Swaps currently enjoy those same liquidation rights. It’s a system that made Repo and swaps markets highly liquid and highly efficient.

Back in 1982 after Drysdale defaulted, there were no bankruptcy laws on the books nor any court cases to establish the legal status of Repo in a default. No one was sure exactly how the outstanding Repo trades would be treated in a bankruptcy. If Repo was legally a “collateralized loan,” then securities held by a creditor would be stuck in the bankrupt entity. If a Repo was a sale and a repurchase transaction, then the securities could be immediately liquidated. It was a major issue that would have ramifications going forward.

Though Chase Manhattan Bank covered Drysdale’s loss and took over Drysdale to liquidate them, there was no immediate resolution of the Repo liquidation rights issue. The issue came up again just three months later when another firm, Lombard-Wall, collapsed in August 1982. In September 1982, one month later, the Federal Bankruptcy Court of New York ruled that a Repo was a sale and repurchase transaction, making it two separate transactions and thus not a single collateralized loan. The court recognized that allowing prompt liquidation was necessary to continue the orderly functioning of the markets. Two years later, in 1984, Congress passed an extension of the Federal Bankruptcy laws so that Repo on Treasurys, Federal Agencys, CDs and BAs were exempt from automatic stays in a bankruptcy by law. The Repo market was off and running, but one aspect of the bankruptcy code was overlooked – municipalities.

Repo Property Rights In Orange County

On December 6, 1994 Credit Suisse First Boston demanded repayment of $2 billion of the Repo trades that they had executed with Robert Citron, the Treasurer of Orange County, California and they immediately seized $1.25 billion of Orange County’s securities. Later that day, Orange County declared bankruptcy, making it the largest municipal bankruptcy in the history of the United States up until that time.

When the county declared Chapter 9 bankruptcy to seek protection, they thought they were preventing a run on their investment portfolio and they’d prevent their Repo counterparties from liquidating their securities. Chapter 9 bankruptcy is a specific type of reorganization reserved solely for municipalities. When the Bankruptcy Act came into being in 1934, a part of it was called Chapter 9 and it allowed specifically for bankruptcy protection to municipalities. A very important feature of Chapter 9 is that the law specifically did not include Section 559 of the larger bankruptcy code. Section 559 allows a repo counterparty to liquidate repurchase agreements in order to recoup their money. In other words, whereas the whole Repo market was set up so that a creditor can sell the collateral in the event of default, Chapter 9 bankruptcy prohibited – or at least didn’t explicitly allow – it to happen. It was, at the time, an untested loophole in the law. Orange County officials were pinning their hopes that by declaring Chapter 9, their Repo counterparties would have their hands tied and wouldn’t be able to liquidate the securities.

Ironically – and perhaps predictably – when Orange County filed for bankruptcy, the result was the exact opposite. The Wall Street firms interpreted the bankruptcy filing as a default, which it was, and began to enforce the terms of the Repo agreements. That meant they all began liquidating Orange County’s positions.

Merrill was the next one to launch a liquidation salvo, selling off all of $800 million in securities that they were holding . The firm contented that they were legally allowed to sell off the securities, because the Repo legal agreement allowed for liquidation in the event of a default. The Orange County Board of Supervisors begged to differ and they authorized their lawyers to begin filing lawsuits against any Wall Street firm that liquidated securities. They alleged that selling collateral was illegal under the Chapter 9 because there was no mention of Repo agreements in the law. Banks were, therefore, legally obligated to return the securities to Orange County. Their argument, though legally clever, fell on deaf ears and the other liquidations proceeded.

Repo Consequences

All of the same arguments used to suspend swaps liquidation rights could be used to suspend Repo liquidation rights. In the near future, we could see regulators asking Repo counterparties to wait 48 hours before liquidating securities financing transactions. The problem is: Repo is fundamentally different from swaps. In swaps, the two parties agreed to pay the differential (say fixed versus floating) on the notional amount of the trade. It’s all about cash flow. In Repo, the two counterparties actually exchange the notional amount; that is, they exchange cash and securities. If the Repo market were asked to suspend its liquidation rights for 48 hours, the counterparties would be giving up their rights for their cash or their securities for that period of time. It’s a larger issue than waiting for a differential on cash flow for 48 hours.

If the 48 hour waiting period is extended to the Repo market, I’m worried about the unintended consequences. What helps during a market crisis, might hurt the market the other 99.9% of the time. If a bank is teetering on the brink of collapse and their Repo counterparties know their liquidation rights will be suspended for two days, they may pull their funding faster. During that 48 hour waiting period, there will be market distortions. Uncertainty will drive counterparties to panic and act in unexpected ways.

Overall, suspending the liquidation rights for swaps for 48 hours will help address the fire-sale issue, but I’m worried the tradeoff will have unintended consequences. Does market stability during a one week period justify market distortions for the 10 to 20 years in between? That’s a crucial question. I’m not sure the correct answer, but I am certain there are tradeoffs.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Roundup April: Collateral Shortage, Leverage Ratio Impact

april 24, 2014 in Columns-Artikelen by onze redactie

The first round of the April collateral shortage hit last week when $45 billion Cash Management Bills (CMB) matured on April 17th. All in all, there was little market impact, but April 17th wasn’t the largest maturity this month. The big impact is about to arrive on Thursday, when a whopping $76 billion CM Bills mature. According to Wrightson, there’s a net $91 billion worth of bills maturing that day. That will mean $91 billion less collateral in the market or $91 billion more short-term cash.

There’s a new development in the market this year, it’s the Fixed-Rate Reverse-Repo facility. No, it’s really nothing new, but it’s the first time we’ve gone through the April collateral shortage season with a mechanism to set a rate floor in the market. Over the past few weeks, the facility provided the market with between $70 billion and $80 billion in collateral each day and there’s plenty of room for more. The counterparty limit was recently raised to $10 billion. That’s $10 billion per counterparty for 139 counterparties, which means the Fed can potentially dump $1.39 trillion in collateral into the market on any given day.

Interestingly, since the counterparty limit was increased from $5 billion to $7 billion and then $7 billion to $10 billion, there’s been no noticeable increase in daily volume. Why? Pretty simple – there are few single counterparties which happen of have $10 billion in overnight cash looking for U.S. Treasury collateral on any given day. Even though the Fed can continue to increase the counterparty limit, there’s clearly a limit as to how effective further increases will be.

Dodd-Frank Leverage Ratio Update

It happened. The FDIC voted to increase the Dodd-Frank Leverage Ratio to 5% on April 8th. I believe this will have a large impact on the Repo market in the coming years. Let’s rewind a little. There’s already a Basel III Leverage Ratio for banks, and based on economic analysis that I’ve seen, large banks already meet the 3% Basel III Leverage Ratio. By increasing the Dodd-Frank Leverage Ratio from 3% to 5% for large domestic and foreign banks, it means any business which is asset intensive will be affected. Basically, banks will be required to either raise more capital or reduce their balance sheets. But what’s the real cost impact on the Repo market? I’m going to generate some hard numbers*

Assumptions

  1. The Dodd-Frank Leverage Ratio allows Repo netting under FASB 39 and, for a typical Repo book, net assets are about 30% of gross assets. I’m going to assume that $300 million in gross assets nets down to $100 million.
  2. I’m also going to assume that banks require a 10% ROE, that is, their cost of capital is 10%

Before The Leverage Ratios

In the U.S. market, the haircut/margin for inter-dealer Repo transactions is around 0.5%. It’s a function of the haircut/margin money which is pledged to FICC,** the central clearing counterparty. Basically, the Repo market in the U.S. currently works on this model, and the haircut/margin is one factor which determines the bid/offer spread in the Repo market. Previously, banks willfully decided how many assets to allocate to their Repo businesses, but never considered assets a direct capital charge. Using the assumptions above, 0.5% of $100 million equals $500,000. The capital cost of $500,000 at 10% is $50,000. Converting to basis points means that $50,000 is the equivalent of 1.7 basis points on $300 million (gross assets). That is, the capital cost of doing business in the Repo market is/was 1.7 basis points.

3% Basel III Leverage Ratio

Research reports indicate that the large banks already fit within the 3% Leverage Ratio. That is, they hold about 3% of capital in relation to their assets.*** Under Basel, however, there is still an increased cost of capital for the use of balance sheet. Even though bank assets already fit within the 3% ratio, there’s still a question as to whether existing assets are economical. Looking at the Basel III Leverage Ratio, for that same $100 million in net assets, the bank must set aside $3 million in capital. $3 million at 10% ROE equals an annual cost of $300,000. Now, since $300,000 is the equivalent of 10 basis points on $300 million, it means that banks must have a 10 basis point cost of doing Repo build into their businesses in order to comply with the Basel III Leverage Ratio.

5% Dodd-Frank Leverage Ratio

In order to calculate the impact of the 5% Dodd-Frank Leverage Ratio, it means that cost of $100 million net Repo assets becomes $5 million, and at 10%, the annual cost is $500,000. Then, $500,000 is the equivalent of 16.4 basis points on $300 million gross assets. Therefore, on Tuesday, April 8th, the cost of Repo increased by 6.4 basis points for banks doing business in the U.S. The new cost, under the 5% Leverage Ratio is 16.4 basis points.

What Does It Mean?

Naturally, this cost of doing Repo is greater if a bank requires a 12% or 15% ROE. It’s less if the bank is willing to accept an 8% ROE. Keep in mind, the cost of Repo at a U.S. broker-dealer has not changed, and remains around 1.7 basis points. I also want to point out that, at this point, it’s “settled science.” Back before January, we weren’t sure if the Leverage Ratios would allow netting and what the final Dodd-Frank Ratio would be. It’s all settled now. As I’ve written many times before, it will lead to a fundamental change in the Repo market. Banks will be forced to minimize their “market-making” activity in the Repo market. With fewer market participants, spreads will widen. I’ve been asked if this is a bad thing – wider spreads. It’s good for some market participants and bad for others. However, all in all, it’s part of the evolution of the market from the impact of new regulation.

* If you disagree with my methodology or have feedback, please let me know.
** If anyone has a tighter percentage, please let me know. FICC is Fixed-Income Clearing Corp.
*** Please note, it is not based on risk weighted assets (RWA)

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

New Regulation And The Repo Market: Leverage Ratios

april 2, 2014 in Columns-Artikelen by onze redactie

New regulation and bank Leverage Ratios are set to come into effect within a year and, honestly, no one knows exactly how these Ratios will impact the industry, though I will try to estimate their impact on the repo market.

The purpose of the Leverage Ratios is to limit the size of large banks. Theoretically, they will make the banking system less concentrated and therefore less risky. A Leverage Ratio of 3% means there must be 3% of capital reserved to support a bank’s assets. It means a bank can leverage themselves 33 times to one (1/.03) – that’s one dollar in capital for every 33 dollars in assets. A Leverage Ratio of 5% means the same bank can only be leveraged 20 to one (1/.05) – much fewer assets for the same dollar’s worth of capital.

Of course, it’s not really that straight forward. The definition of an asset comes into play, whether an instrument is “off balance sheet” or “on balance sheet,” and then there are special calculations for the denominator of the ratio. One is called the Exposure Measure and the other is the Total Leverage Exposure. I won’t stray from the scope of this article, but it’s something to keep in mind.

The bottom line is that bank balance sheets are becoming more expensive. Assets will have a larger marginal cost when a bank is close to its leverage limits. Some banks are even over the limits right now. In basic terms, the choice is to raise more capital or sell assets. Pretty simple. Of course, if you’re cutting assets, what assets will be cut first? In many cases, it’s the low-risk, low-return assets like repo.

Basel III – Leverage Ratio

The Basel Committee originally proposed a 3% Leverage Ratio that fully comes into effect in 2018. The Leverage Ratio was added to Basel III as a back-stop against the flexibility which banks have in determining their Risk Weighted Assets for capital calculations. The original proposal included a gross calculation for repo positions which would have basically gutted the repo business at large banks. In January, the Committee switched to allow repo netting, which is more in line with EAD (exposure at default rules in Basel III). Now, if a bank is borrowing 100 million 10 year notes from a customer and lending them 150 million 5 year notes, the net exposure of 50 million after some haircuts applies to the Leverage Ratio calculation. That’s a good thing, even though there were cries of influence from the “banking lobby.” The net calculation will make repo trades more expensive, whereas a gross calculation would have gutted the business.

Dodd-Frank Leverage Ratio

Even though the U.S. banking system is following Basel III, Dodd-Frank also has a Leverage Ratio, and Dodd-Frank Section 165 forces foreign banks to follow to Dodd-Frank banking rules. U.S. banks must comply with the Ratio by January 1, 2015, and foreign banks have until January 1, 2016  (though I’ve also read they have an extra 3 years to comply). The eight largest U.S. banks meet the 3% ratio right now, and many foreign banks, like Credit Suisse and UBS, could even meet a 4% Ratio.

Supplementary Leverage Ratio

In the U.S., we’re not happy with just the Basel III and Dodd-Frank Leverage Ratios, we’re going to take it one step further. For the eight largest U.S. banks and the foreign banks, there’s the “Supplemental Leverage Ratio.” Though it’s yet not finalized, the FDIC is pushing to bump it up to 5%, and 6% at the bank-holding company level.

Impact On The Repo Market

Banks have choices to make: raise more capital or shed assets. Deutsche Bank “plans to cut a sizable chunk from its repo business as part of the balance-sheet shrinkage,”**** because they would have negative capital ratios if Dodd-Frank Section 165 was in effect right now. SocGen says Dodd-Frank Section 165 will “decrease its operations in the US and with US customers.”**** A Goldman Sachs presentation not only showed that ”Repo businesses [at large banks] would consume significantly more capital,” they also estimate the costs of doing repo for these banks will increase between 9 and 77 basis points just from the Leverage Ratios.*** Morgan Stanley announced in January 2013 that they’re cutting assets in fixed income and commodities to less than $200 billion by the end of 2016, down from $390 billion at the end of 2011. UBS plans to slash assets by 50% from 2011 to 2017.

According to Barclays, “Can banks address the $30bn of additional capital we identified simply by reducing repo? The answer is yes”* One of the unintended consequences of Leverage Ratios is that bank balance sheets will shed risk-free (lower-yielding) assets (like repo) in favor of more speculative, higher-yielding assets. This will reduce the size of the repo market and bring back wider spreads.

Here’s how it works: say a customer wants an offer from a bank on a security in order to cover their short, there are two possibilities: 1. The bank has the security in inventory and they loan it to the customer; 2. The bank doesn’t have the security and they can’t go out into the market and get it from a portfolio or another dealer in the inter-dealer market. They must tell the customer to trade away. It’s the same potential scenario for a money market fund cash investor or a hedge fund looking for a bid on collateral. I’ve told many clients in my career that my desk was shut down for quarter-end – I couldn’t take on additional assets.

Think of it this way, if you’re trying to book a seat on an airplane and the plane is mostly unbooked, you get the normal price. However, if there are just 5 seats left, the airline jacks up the price. It’s the same in the repo market. As bank balance sheets get close to full, prices (spreads) will increase. It will translate into fewer banks making markets and less liquidity because there are fewer players willing to contribute balance sheet to smooth out market fluctuations.

Month-End

The effects might just occur on month-end when financial statements are produced. Remember when Lehman was around? I used to get the same phone call from the same customers who did all their repo business at Lehman during the month then were forced to trade away on month-end. Possibly, the Leverage Ratios will only limit bank repo desks on month-end. However, keep in mind, you can’t close out 100% of intra-month financing on month-end, customers doing business during the month generally expect month-end financing too. The new rules could translate into a very volatile month-end market with wide spreads as customers hunt for month-end financing.

New Customer/Bank Financing Relationships

Here are some possible new repo market scenarios:

  1. Banks will only fund their own positions. If they’re long, they loan the securities, if they’re short, they borrow them. Repo desks at banks become solely “funding desks.”
  2. Customers could set up automatic funding relationships with a bank or their prime broker. Here, the bank agrees to fund all of the customer’s positions at a pre-negotiated spread. The bank looks at all the revenue generated in all products from the customer, making the financing tied to overall business profitability.
  3. Customers may be forced to hunt around the Street for banks with offsetting positions. Remember, banks no longer make markets for customers so if customer is short 10 year notes, for example, they must look for a bank that is specifically long the security and hasn’t yet loaned it into the market.
  4. There will be more end-user customers joining central clearing counterparties like Fixed Income Clearing Corp, LCH.Clearnet, and Options Clearing Corp (OCC).
  5. There will be more repo trading between end-user customers directly with other end-user customers. I know, I seem to get back to this point all the time.

* Barclays; “Leverage ratio: An attack on repo?”; August 2013

** J.P. Morgan; “Q&A About Leverage Ratios”; August 19, 2013

*** Goldman Sachs Presentation, “Bank Regulation and Funding Market Overview”; January 2014; Page 16. Note, the decision for Basel III banks to go from a gross repo calculation to a net calculation will partially narrow those numbers.

**** The Financial Times; February 25, 2014; Page 15

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Roundup March (Funding Pressure, Fixed-Rate RP)

maart 13, 2014 in Columns-Artikelen by onze redactie

GC rates are moving higher. Is that possible? How can it be? In the current market environment, the Fed continues to buy Treasurys through QE, even though there’s reduced tapering. GC rates are supposed to be trending to zero. What changed since the beginning of March?

Yes, there was new Treasury supply that hit the market on month-end – bills, 2 Year, 5 Year, 7 Year Notes, and don’t forget the 2yr FRN, that’s all new supply. In general, supply usually puts funding pressure into the market for month-end, and for a day or two afterwards. So there’s got to be something else going on.

Some market participants believe that when the Fed increased the Fixed-Rate RP floor rate to 5 basis points it contributed to the pressure. Others believe the Street got long the short-end of the market when the Ukraine crisis hit, expecting a major flight-to-quality if things heated up. When dealer banks are long securities, it means there’s more collateral floating around in the repo market and it pushes GC rates higher. Another repo trader says it has to do with Dodd-Frank. The section which applies to foreign banks doing business in the U.S., which takes effect in July 2015, has a look-back period. If that’s the case, some foreign banks might be paring back their repo books already.

On thing that is clear, when the market GC rates trade very close to the FRRP rate, it does follow the FRRP rate, [see the graph above] but it decoupled recently.

Fixed-Rate RP

The FRRP program is on the move. On March 5th, the Fed bumped up the counterparty limit from $5 billion to $7 billion. Wrightson believes the Fed may add a second round of FRRP and increase the counterparty allotment to $10 billion.** There’s a repo market rumor that the limit will go to $10 billion next and then to no limit at all. Joseph Abate at Barclays believes the Fed will steadily ratchet up the size of FRRP allotments* I don’t expect unlimited allotments and can see them stopping around $10 billion, which theoretically can pump $1.39 trillion in collateral into the market.

On another note, the Fed just increased the FRRP rate back up to 5 basis points. They had increased it to 5 basis points on November 19, 2013, then back down to 3 basis points, and now back to 5 basis points. Why all the moving up and down? Citibank says that the Fed is trying to generate more data on how the supply of cash going into facility varies with changes in the rate.*** That’s as good an explanation as any. So far, there’s no explanation from the Fed, not even something in Greenspanesque Fed-speak. One thing that’s interesting, Yellen confirmed last week that she expected the Fed to keep the FRRP in the 0-5 basis point range. Why?

The spread between GC and the FRRP rate is an interesting graph, then again, it just confirms what we already know. As the market GC rate increases, there’s less FRRP volume done at the Fed. Of course, even with relatively high GC rates, some counterparties will always prefer to have the Fed as a counterparty than someone in the market.

Tri-Party Reform – The Changing Role of The Fed

Fed is now a large part of the tri-party market, when I looked last week, the FRRP program represented 17% of the tri-party market. That’s a part of life in the market right now, but has anyone asked should the Fed be in this market? Think of it as a government takeover of a market. When the government moved further into healthcare, there were cries, protests, filibusters in the Senate, etc. But there’s no one decrying a Fed (government) takeover of the repo market. Should it be a private or public run market?

Here’s the bigger, philosophical question: Should the Fed be running a repo matched book? The Fed has clearly entered the repo matched book business. With the FRRP program, they now provide cash to money market funds and cash investors – one function of a bank matched-book. They also run a securities lending program to cover their customers’ (the Street’s) shorts. Has the Fed become the prime broker to the banking industry? What’s prime brokerage? It involves financing (repo), execution (auctions), the lender of last resort (back up lines of credit), they cover a customer’s shorts (securities lending), they provide securities settlements (Fed Wire system), and even raised capital in the past through the TARP program. But they never went so far as to “walk the dog” for top prima-donna traders. I never realized it before, but our central bank really provides prime brokerage services for banks.

U.S. Treasury Fixed Rate Note

Just one more market commentary about the Treasury FRN before I put it to bed, maybe permanently. The Fed re-opened existing the 4.5% of Jan 2016 at the end of February, so it’s now a double issue. It never attracted many shorts, even when it was a single issue – trading between $1 billion and $1.5 billion in the inter-dealer broker screens each day. In the repo market, at least until there’s some market event to change it, I don’t expect FRNs to trade as a Special, perhaps they’re joining the ranks of the TIPS program in the repo market.

* “US Weekly Money Market Update”; Barclays; February 28, 2014

** “Money Market Observer”; February 24, 2014, Wrightson

*** Citi Research; ”Short-End Notes”; February 28, 2014

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

The Future of the Bank Repo Desk

november 20, 2013 in Columns-Artikelen by onze redactie

Post-crisis financial regulation is changing the way banks and financial institutions do business. As a vital part in the operation of banks and the functioning of financial markets, the bank repo desk will have to evolve and adapt to the new regulatory environment. While much of the eventual impact of the regulation remains uncertain, some is predictable:  repo will become more expensive and more transparent; some disintermediation of banks is likely, though not inevitable; creativity and innovation in how banks fund themselves and their clients will be critical; as will a growing focus on collateral management. Despite these challenges, the neo-regulatory landscape will also provide opportunities. The key is to spot these, and to start positioning now.

Introduction

The ‘Repo Desk’ has traditionally been at the heart of the capital markets divisions of investment and commercial banks, providing the main source of funding for the bank’s trading activities[1], while also  making markets to finance the bank’s diverse client base. Furthermore, repo desks tend to be the focal point for taking short-term interest-rate risk; are a vital component in the pricing of a whole range of securities and derivatives; and are the primary interface between the bank and central bank monetary operations. Yet despite these important, and even critical, roles, repo desks are often perhaps the least understood corner of the trading floor. Partly this could be because of the diversity of functions they serve, but also it is due to the intricate (and all too often ignored) ways in which repo markets can influence the pricing and liquidity of a whole range of underlying securities and derivatives[2]. In this paper, I attempt to identify the probable trends and significant changes in how repo desks are likely to operate in light of the rapidly evolving regulatory environment[3].

The raft of local and global regulatory initiatives following the financial crisis of 2007-10, which is designed to reduce systemic risk in the banking and financial sectors, is already having huge repercussions for the trading and market-making activities of banks. Yet anticipating the full impact of this regulation on repo desks is not straightforward. Many of the initiatives tend to be sweeping rather than product or market segment focused, and in many instances, it would seem reasonable to assume that those driving the regulation have given little or no thought to the repo market. In some cases, such as the drive for greater transparency in trade reporting, the likely impact for the repo market is indirect, and may prove to be relatively nuanced. Whereas proposals such as the European Financial Transaction Tax (FTT), or the accounting treatment of repos in the calculation of leverage ratios, would be far more direct, even having an existential resonance. The fact that much of the regulation is work in progress, and (quite rightly) being scrutinized, challenged, and modified, also makes it difficult to predict the long-term effects on repo. However, there are a number of consistent themes and impetuses underlying the regulatory changes that will almost certainly mean that repo desks will need to review the way they do business and evolve accordingly. I will try to highlight some of these key forces.

Repo just got more expensive…

One thing we can be fairly certain of is that the cost of trading repo for banks will increase. The only question is by how much? Underlying this is the requirement of Basel III that all banks hold more and better quality reserve capital, which in effect will make all trading and financing activities more expensive. It would seem inevitable that there will be far more focus on the return on capital of various trading functions within banks, including repo, as desks and business units fight for their share of a decreasing and more expensive balance sheet. Low margin, capital intensive trades will become harder to justify, or will need to be more prudently priced. For some repo desks, this may come as a culture shock, but for many, particularly those at banks that are already used to fighting over smaller balance sheets, and where return on capital is engrained, this may not be such a challenge.

However, as banks that already treat balance sheet as a limited resource are well-aware, much of their repo activity is made possible through the ability to net counterparty exposure. That is, the offsetting of repos and reverse-repos with the same counterparty, in similar securities and matching maturities. Given that by its very nature much of the repo market is high volume and low margin, this accounting provision is critical, since it effectively takes the lion’s share of repo  activity off the balance sheet. For many banks, this provision could be under-threat. Basel III introduces a Leverage Ratio, a non-risk weighted ratio of total exposure to capital[4]. The purpose is to prevent an excessive build-up of leverage on banks’ balance sheets, and it is intended to be a ‘back-stop’ for risk weighted asset (RWA) based capital ratios. In the US, this has been taken further with a proposal that bank holding companies (BHCs) adhere to an even higher Supplementary Leverage Ratio (SLR)[5]. Whether by accident or design, neither of these proposals allow for the netting of repo exposure, suggesting that exposure be measured purely on a gross basis[6]. A report by JP Morgan suggests that the current size of the global repo market that is currently treated off-balance sheet (estimated at more than $7tn) would require major banks in the US, Japan, and Europe to hold additional capital of around $180bn[7]. In reality, the effect is more likely to be a huge deleveraging of these banks and a significant contraction of the repo market. Somewhat ironically (and perhaps counterintuitively to the intent of the regulation), it would be the high volume, low-RWA segment of the market (namely high quality government bonds such as US Treasuries) that would be hardest hit, as the Leverage Ratio supersedes other capital ratios as the primary limit on assets. This could precipitate a shift in the focus of repo desks away from high-volume, low risk, low margin, bread-and-butter activity, to more selective, high-risk, high-margin trades.

The proposed European Financial Transaction Tax (FTT), were it ever to happen, would have an even more direct and even seismic impact on the cost of trading repo. Affecting all EU financial institutions, it would effectively place a flat levy on all secondary market trades, including a 0.10% charge on the value of all repo and securities financing transactions (SFTs). The impact of a flat fee would have a disproportionate impact the shorter the maturity of the transaction, to the point of absurdity. On an overnight trade, for instance, it would equate to an additional cost of 36.5%. Given that the tax is levied on all sides of a transaction, this would mean a 73% charge for an over-night match-funded trade. Analyses suggest that this could effectively close the European repo market for all transactions of under six months’ maturity, and reduce the size of the market by as much as 66%[8]. The knock-on effect of the FTT in contracting secondary and derivatives markets would only further reduce repo activity[9]. If the FTT is implemented as planned[10], then any discussion on the future of repo desks, at least in the Eurozone, is irrelevant, and you can stop reading now.

However, while the FTT, at least in its proposed form, should never happen, it is still very possible that some form of levy on repo and SFTs could be imposed by the EU. Further sources of rising costs are also likely to come from regulation pushing for the greater use of central counterparties (CCPs) for repo transactions, which will demand more stringent margin requirements, and the possible introduction of mandatory hair-cuts for some trades[11].

All of this will mean that repo desks will need to become even more discerning in the repo trades and activities they select, and more savvy in the allocation and pricing of balance sheet.

…and more transparent

Both Dodd-Frank and MiFID II call for greater market transparency and reporting of trades, which would include all repo and SFT activity. From an operational perspective, given the size and turnover of the global repo markets, this is a gargantuan challenge, for both those doing the reporting and those doing the monitoring. Automation and technology will clearly play a role, and this could significantly increase the appeal of trading repo through electronic platforms, not only for repo desks but also for their clients. Where CCPs take on the onus of trade reporting, this should also help to make them a more attractive proposition.

Other than these operational considerations, this should have little impact on the activities of repo desks. What may, however, is the reporting of positions and risk. Repo matched-books (the positions repo traders hold on their books that ensue from market-making in repo) can be horribly complex, and while most banks should be adept at monitoring and managing the imbedded interest-rate, credit, and counterparty exposures, some may not be.

A further sense of scrutiny could also arise from regulations designed to restrict high frequency trading[12] (an interesting proposition for a high frequency market), as well as the much contested Volker Rule, which seeks to prohibit banking entities from engaging in proprietary trading[13], and which could encroach on the gray-area between matched-book related positioning and proprietary speculation.

But what will almost certainly arise out of the demand for greater transparency and reporting is the need for repo desks to think more carefully about the trades they take on, the positions they run, and the way they manage their risk.

Collateral is king

One aspect of the new regulations that has filled up the columns of the financial press more than any other is undoubtedly related to the expected surge in the demand for collateral. Both Dodd-Frank and EMIR require that most derivatives trades be cleared through CCPs, with far more stringent initial margin requirements than counterparties are willing to accept through bilateral trades. While nobody is quite sure of the exact impact this will have when fully implemented, the OCC estimates that initial margin requirements, globally, could reach $2tn[14]. Furthermore, the collateral that is pledged as margin will need to be of relatively high quality (primarily major currency government bonds). This has led commentators to predict an unprecedented increase in demand for such collateral to meet margin requirements. Furthermore, Liquidity Coverage Ratio (LCR) requirements under Basel III should add to the demand for high quality liquid assets (HQLAs), which include reverse-repos in high-grade government bonds. Rules limiting the rehypothecation of certain assets could add further pressure.

The question that is writing headlines is will there be enough good quality, unencumbered collateral to meet the demand? And where will this collateral come from? Accordingly, ‘collateral management’ has become the newest game in town, and with it a range of concepts such as ‘collateral mining’ (the sourcing of securities to borrow) and ‘collateral transformation’ (the simultaneous lending and borrowing of securities with different credit ratings). For many users of OTC derivatives, who are beginning to adjust to the realities of the new regulations, collateral management is an exciting and mysterious new world awaiting discovery, a land of treasure hunters and financial alchemists. Yet for repo desks, collateral management, by any other name, is as old as the ark and what they do best. This would suggest an opportunity.

But first, we should perhaps not get too carried away by the anticipated shortfall in rehypothecatable quality assets. The demand for margin, in all reality, is likely to be less extreme than predicted (as trading derivatives becomes more expensive, volumes should decrease). There may be more accessible collateral out there than we think, and already there is some talk of central banks recycling government debt purchased through their QE programs. And then there is always cash, which for many may be much easier to manage and post than collateral.

But it is reasonable to assume that certain collateral types will see an increase in demand and value, and being able to source, price, and manage these securities, as well as the ability to fund and recycle lower quality assets, could provide an even sharper edge for the bank repo desk. The full potential for repo and securities lending has not yet been tapped, and repo desks and their emissaries should be sharing the wonder that is collateral management far and wide; before somebody else does.

Cutting out the middle-man

Given the general increase in the cost of trading repo, with banks being hardest hit, it would not be surprising if some repo and SFT activity moved out of the banks, and became the dominion of other, less onerously regulated entities. Some business could be taken on by alternative investment funds with capital to spare, and already a number of larger hedge funds operate their own repo desks, some in competition with the banks. Meanwhile, the regulatory push toward using CCPs could create an environment where buy-side counterparties could easily trade directly with each other, negating the need for an intermediary bank. Buy-side to buy-side platforms for repo and securities lending are already being built, and are likely to garner popular support. Some even question the necessity for the bank repo desk in the neo-regulatory world.

However, while some disintermediation is likely, and, in the case of low margin, capital intensive business, may even be welcomed by some banks, we should not be too quick to write the obituary of the bank repo desk. What is often overlooked is the market-making service that repo desks provide. Were they simply standing between counterparty-A and counterparty-B, and taking a spread, then indeed their role could be questionable. But this is rarely the case. Repo desks are usually required to provide pricing to a whole range of clients, with different funding and investment requirements, in a raft of different securities and credits, whenever they require it. Accordingly, their trading books (somewhat confusingly known as the ’matched-book’[15]) are invariably a complex portfolio of assorted repos and reverses, in a multitude of securities, covering a whole range of periods, and loaded with interest-rate and credit risk, which the repo trader must adroitly manage. It is this liquidity and pricing repo desks provide that give them their value.

While some of the repo market could possibly function without the bank repo desks, at least some of the time, there is an inherent risk in completely disintermediating their role. If repo desks are unable or unwilling to make markets, this could leave a huge hole, particularly for more bespoke or less vanilla financing requirements. There could also be a lack of immediacy for counterparties in filling their trades, as borrowers and lenders wait to find complimentary interests. And in times of market stress, without the liquidity back-stop that repo desks provide, funding markets could freeze[16]. Unless there are non-bank institutions ready to take on the role of market-making in repo and SFTs, the bank repo desk will be around for a while longer.

Getting creative

One thing we learn from history is not to underestimate the ability of markets and participants to adapt to and survive new regulatory initiatives[17]. The same should be true for the repo market, particularly given the engrained culture of resourcefulness and creativity of repo desks. In the neo-regulatory landscape, this aptitude for flair and ingenuity will be even more imperative. Balance sheet management (and more importantly, off-balance sheet management) will be critical, and we should expect new products and funding vehicles to accommodate this. Relocating businesses to less arduously regulated centers or entities seems inevitable. As already discussed, repo desks will need to hunt down more sources of cash and collateral, as well as finding ways to fund and recycle low quality assets. They will also need to become more innovative in creating new instruments and funding tools, such as the recent promotion of repo-backed commercial paper. In many respects, this all points to the survival of the most creative.

Whether one views this as regulatory arbitrage, or market efficiency, we can be confident that it is going to happen, with the smartest banks leading the way.

Cooperation makes it happen

Perhaps the most visible change in the structure and functioning of the traditional repo desk will be in its need to better cooperate and coordinate with other funding functions of the bank. As already highlighted, the ability to optimize the management and financing of the bank and clients’ assets will be critical. This will require the ‘de-silofication’ of funding centers and with it the possible centralization of collateral and liquidity management. This will involve repo desks working more closely with their equity finance and stock-loan desks, as the definition of collateral is broadened to all cash funded securities. They will also need to coordinate closely with their prime brokerage division to ensure consistency and efficiency in the pricing of client financing and the rehypothecation of client assets[18]. Greater interaction with the bank’s treasury and cooperation in liquidity management (particularly in meeting LCR requirements), also makes eminent sense. Operations, too, need to be part of this equation, supporting the smooth movement of collateral and the efficient posting of margin.

Figure: A model for an integrated collateral management function

What we are likely to see is the creation of a formalized, centralized, integrated collateral management function, connecting all these various desks and business units. However, collateral management will not be an optimization algorithm (although clever technology will certainly be involved), nor will it be an operations function (even though the ability to efficiently allocate and move collateral between centers and systems will be critical). Rather, it will be structured around the ability to source, price, fund, allocate, and recycle collateral effectively and efficiently, and to manage the inherent interest-rate, credit, and counterparty risks that go with it. It will be market and client facing, as well as connecting to the bank’s internal business units. Essentially, it will look a lot like a repo desk, only with a far broader mandate.

Conclusion

It is almost impossible to predict how the various ongoing regulatory initiatives will pan out, their eventual impact on global capital markets, and with that the repo market. In some respects, this makes it difficult to plan for every eventuality, not least when some of the proposals, such as the accounting treatment of repo in leverage ratios or the FTT, are such potential game changers. But in light of some of the themes and objectives underlying the regulation, there are some identifiable certainties for the neo-regulatory environment, for which bank repo desks can and should be preparing themselves.

Repo will become more expensive to trade, and more transparent in terms of the risks and returns. Repo desks will need to think more carefully about the businesses that make sense, how they manage their risk, and how they utilize limited balance sheet. Disintermediation will pose a threat, but so long as repo desks can offer high levels of service and pricing, their franchises should remain intact. Repo desks have often been a force for innovation in the financial markets, and never will this have been more pertinent. Creativity will be key as they find new and more efficient ways to finance their bank and their clients. Collateral management will become ever more of a focus, and no function should be better suited than the bank repo desk when it comes to the sourcing, pricing, and recycling of collateral. Greater cooperation between the repo desk and other funding businesses, and even the creation of integrated financing and collateral management functions, will make more sense as banks look to optimize their business advantages.

In some respects, and despite all the challenges, the new regulatory environment may offer a number of opportunities for the bank repo desk. Of course, some will fare better than others. The key will be to spot those opportunities early, and to position for them now. Waiting until the regulatory dust has settled could be too late.


[1] Repo desks have traditionally almost exclusively focused on fixed income products and their financing, while Stock Loan or Equity Finance desks serve a similar function for equity-type securities

[2] I used to give a presentation at Goldman Sachs entitled ‘r is not a constant’ (where ‘r’ is the repo rate), illustrating exactly this point in the context of government bond futures.

[3] See Hill A, 2013, Bank Regulation: A Crib-Sheet for RepoTraders, for a concise overview of regulatory initiatives impacting the repo market

[4] It is currently proposed that the Leverage Ratio be 3%, to become binding from 2018

[5] The FDIC, OCC, and FRB are proposing an SLR of 5% for BHCs, and 6% for the largest BHCs. This would be enforceable from 2018.

[6] i.e. the total value of either reverse-repos or repos

[7] Financial Times, 2013, Why new leverage ratio rules could stifle repo markets, July 22 2013

[8] See Comotto R, 2013, Collateral damage: the impact of the Financial Transaction tax on the European Repo Market and its consequences on financial markets and the real economy, ICMA-ERC, April 8 2013

[9] See Hill A, 2013, Robin Hood or King Ludd? A discussion of the implications of the proposed EU 11 Financial Transaction Tax on the Euro Repo Market, May 2013

[10] Currently scheduled for implementation in January 2014, but likely to be put back to mid-2014

[11] Both recommendations of the FSB; see FSB, 2013, Strengthening Oversight and Regulation of Shadow Banking: Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August 29 2013

[12] Proposed under MiFID II

[13] Currently proposed under Title VI of Dodd-Frank; implementation has been delayed until mid-2014

[14] Cited in JP Morgan, 2011, Regulatory Reform and Collateral Management: The Impact on Major Participants in the OTC Derivatives Markets

[15] One possible explanation for this extremely misleading name might be the fact that to ‘balance their book’, the repo trader needs to ensure that every long position is funded, while every short position is borrowed, at least for that day. So on an ‘overnight’ basis, one could argue that the repo-book is indeed ‘matched’.

[16] One could even argue that by restricting or disintermediating the market-making activity of bank repo desks, this is creating a procyclicality risk, which is somewhat counterintuitive to the objective of the regulation.

[17] Perhaps with the notable exception of the introduction of a Financial Transaction Tax in Sweden in 1984, where secondary market trading in Swedish securities dropped by 80% (what survived migrated to London), while derivatives trading fell almost to zero. Unsurprisingly, the tax was abolished two years later.

[18] Traditionally, repo desks and the prime brokerage divisions have been kept at arm’s length, primarily due to the legal separation of client services and capital markets. However, where client confidentiality is ensured, there is no reason to prevent closer coordination in their financing and collateral management functions.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Banks are Becoming Government Debt Funds – an Unsustainable Development

september 12, 2013 in Columns-Artikelen by onze redactie

We have previously reported that the changes of the financial regulation, e.g. Dodd-Frank, Basel III and EMIR intentionally drive increased demand for collateral in financial transactions. In most cases the regulation dictates the collateral should largely be government bonds. Obviously the hidden agenda is to create a demand for government debt since governments continue to debt leverage and force their central banks to increase the monetary supply. They do it since it’s much easier than forcing structural reforms of labor markets and incentivize entrepreneurship and innovation. We reckon pouring even an infinite amount of new money on countries like Greece, Japan, Spain, Portugal won’t lead to anything, except sooner or later high inflation. More money does not increase economic output. Only entrepreneurship, innovation and hard work do and many times the economies are effectively demotivating it through over-regulation and obese bureaucracies, read this example from France.

If we add more money into an economy not producing more output, high inflation is eventually what we’ll get. We’re especially worried about Japan, already having government debt reaching multiples of GDP and a money supply out of proportion with its economic output. Interest rates need to raise sharply when, not if, inflation takes root in the Japanese economy. Imagine if the government debt reaches an astounding 400% of GDP, Japan will not be able to service its debt and instead have to default. Japan is one of the most over-regulated economies in the world. What Japan needs more than money are huge efforts to revitalize the economy through introducing more competition and innovation. Japan definitely doesn’t need more money; Japan needs reforms, huge reforms and Japan needed them yesterday. The unprecedented money printing almost follows the same strategy as a Ponzi Scheme.

It’s obvious that our leaders realize the problem but they fear reforms will jeopardize their power ambitions. So instead their concerns revolve around finding investors to their ever increasing pile of debt. Recently the G20 pushed for forcing banks investing in even more bonds, mostly government bonds most likely. We’re not surprised but our concerns increase.

The major central banks (the Federal Reserve, the Bank of England, and the European Central Bank) together with the IMF have a magic opportunity to forcefully push for structural reforms and communicate it in a way so everyone understands the necessity of them. Instead we’re struck with how much time they spend on discussing the risks of the Federal Reserve on exiting monetary expansion (“tapering”) versus the need for implementing structural reforms. The relations seems to be 99 to 1. Listen for example to this video from CNBC with the very clever and reasonable Christine Lagarde. What is she really saying?

Watch video CNBC – Lagarde

Kind regards,

Magnus Lind

About the author: Magnus Lind

Magnus Lind chairs and is the founder of Treasury Peer™. He has a background as an international business executive in Europe, SE Asia and North America. Magnus has gained exposure to international and multicultural management from having customers and suppliers in more than 30 countries. He has started companies in 7 countries and acted as CEO, board director, investor and entrepreneur for 20 years through the NFS Group, a financial technology consultant divested in 2012. Magnus started www.treasurypeer.com in 2008.  Find out more and – click here – to see his website.

New Repo Regulation And What It Means For The Future

september 4, 2013 in Columns-Artikelen by onze redactie

The Repo market is being bombarded from all different regulatory angles these days. Most banks have Repo businesses across many geographies, so it leaves them with different regulation for the same Repo transaction. Dodd-Frank affects the largest U.S. banks, foreign banks through Section 165, U.S. broker-dealers with assets above $50 billion, and perhaps even challenges the bankruptcy treatment of Repo. The Financial Transaction Tax affects Repo activity at some European banks, Basel III affects all banks at all levels, and just recently, the Financial Stability Board in the U.K. joined in on the action.

Dodd-Frank

Dodd-Frank Section 165 applies to foreign bank subsidiaries in the U.S. and specifies that capital held at the parent level cannot be assumed to support a U.S. subsidiary. In practice, it means that 26 foreign banks will establish Intermediate Holding Companies (IHC) and hold more capital to support their U.S. bank and broker-dealer. More capital means more expense for foreign banks to hold assets in the U.S., and that will naturally affect their Repo market activity. It was estimated the IHCs will create a $330 billion reduction in the size of the U.S. Repo market, equal to about 7% of the entire market.

Automatic Stay Exemption – Partially Chipped Away

Since 1985, the Repo market has been exempt from the “automatic stay” provisions of the U.S. bankruptcy code. This means is that Repo transactions can be immediately liquidated once a counterparty is in default. It has been the heart and soul of the Repo market, and it now appears that Dodd-Frank has chipped away at it. A report from the Securities and Exchange Commission (SEC) in July 2013* put the “automatic stay” exemption for Repo in doubt. A footnote in the report stated that certain exemptions for Qualified Financial Contracts (which Repo is included) are now subject to automatic stay. A entity, which is a party to a Repo transaction, with a “covered financial company may not exercise any termination rights …. ” until 5:00 pm the day after the FDIC appoints a receiver.

My reading is that Repo is no longer exempt from the automatic stay once FDIC takes over a failing institution.** In the event of a default, a counterparty must move fast to liquidate because they only have until 5:00 pm on the following day before they’re stuck in bankruptcy court for months or years waiting to get their cash or securities back.

Leverage Ratio

There’s talk about a Leverage Ratio being imposed on banks. That, of course, is a way of limiting the size of banks through a backdoor capital requirement. It’s not finalized, but so far there’s speculation it will apply to Dodd-Frank SIFIs (Significantly Important Financial Institutions), which will be required to hold a minimum of 5% capital on all of their assets. Naturally, there are so many ways to take leveraged risk these days that limiting assets doesn’t necessarily reduce bank risk overall.

The principal take-away from this possible new rule is that a minimum amount of capital will be required on all assets. It will hit the Repo market the hardest. Soberlook did a piece using Barclays calculations that shows that Repo now uses about 1% in bank regulatory capital, and that capital usage will bump up to 5% for SIFIs under the Leverage Ratio.

Basel III – Additional Capital Required For Repo Or Not?

The amount of capital needed to support the global Repo market under Basel III is still unclear. A couple of months ago, the Financial Times estimated that $180 billion in additional capital was needed moving from Basel II to Basel III, estimating the average capital set aside for Repo trades was about 2.5% of the entire market. That seems high to me, especially since Basel II had relatively high charges for Repo trades to begin with.

Then, some analysts at JP Morgan came up with a similar number. According to them, all Repo transactions in the U.S., Europe, and Japan make up a $6.8 trillion*** market. Under their study, Repo assets are about 10% of the $77 trillion assets of commercial banks in those countries. They say, under current accounting rules, much of the $6.8 trillion in Repo assets do not show up currently in banks’ Risk Weighted Assets. The J.P. Morgan analysts argue that the new Basel III rules will create an additional capital requirement of $180 billion, assuming a 3% capital requirement is applied.

Financial Transaction Tax (FTT) – Putting Some European Banks Out of The Repo Business

There’s been no new news on the FTT over the past couple of months. The European Commission failed to persuade all 27 EU member countries to implement the tax and there are 11 EU member countries, led by Germany and France, who have pledged to move forward with it anyway. If all goes well, the 11 member tax will be launched around the middle of 2014.

There’s been an important discussion as to how the 10 basis point tax is applied to Repo. If it’s 10 basis points as a rate of interest, then adding .10% on Repo trades makes being an intermediary in the Repo market impossible. If it’s charged as “fee,” then it’s 10 basis points at an annual rate and the equivalent of 36.50% for an overnight trade – making all overnight and short-dated Repo trades impossible.

FSB – Mandatory Repo Haircuts

And just when you thought all avenues of new regulation were already on the table, a new one pops up! This time, there’s a fear by regulators, mostly in Europe, of repeated lending of the same security, re-hypothication as it’s called in the Repo market. Basically, it’s the same securities being loaned from one counterparty to another over and over. Now, my first reaction is to question why there’s anything wrong with that in the first place. Could you imagine limiting how many time a security could be bought and sold?

In August, 2013, the Financial Stability Board (FSB) in the U.K. released a study on securities re-hypothication and what they planned to do about it. They joined the European Commission, which has been looking at an outright ban on how many times an asset can be transferred through financing. The FSB solution, however, is to require mandatory haircuts on securities financing, and so far from what I’ve read, the proposed haircuts do not exceed those already imposed by the market. I have two points to add: First, if the market is already policing itself, why add further burdens? Second, I can’t recall one instance during the financial crisis when re-hypothication was an issue or added to market contagion in any way.

Here’s What It All Means

These are my long-term projections on the the effects of new regulation and increased capital requirements on the Repo market. Note, these projections apply to those entities affected by new regulation and capital requirements.

  1. Repo Matched-Books Eliminated - No more “market making” in Repo, securities finance, and/or stock loan for customers. The costs will become too high for customers who only trade Repo with a bank. The matched-book businesses will disappear at the large banks. One might argue that spreads will widen to reflect the additional costs, but I believe other players will fill the vacated space.
  2. Re-Engineering The Finance Business - There will be significantly more trades with central counterparties (CCPs) and exchanges. Salespeople covering central banks and quasi-government entities (e.g. IADB, World Bank) will suddenly become best-friends with the Repo desk. These entities are mostly exempt from regulatory capital charges and taxes. Large banks will be in the Repo business to finance bank positions and multi-product clients only.
  3. Trading Repo Direct - Repo business will evolve between end-buyers (e.g. money funds) and end-sellers (e.g. hedge funds) – effectively eliminating the middle-men in the Repo market. Not because the end-buyers and end-sellers want to eliminate the middle-man, large banks will just find the cost of standing between two counterparties too costly. The entire market will evolve away from the dealer-to-customer model that’s existed since the dawn of finance. Instead, “customers” of the Street will join the CCPs like FICC and LCH.Clearnet.
  4. Regulatory Arbitrage - Wherever there’s a regulation, there’s a loophole or an exemption somewhere, and where there’s a business need, firms will find a way to make money. There will be increased Repo market-making activity from entities that can compete in the securities financing markets. Perhaps the pendulum will swing back to favor the large U.S. broker-dealer, or some kind of off-shore entity.
  5. Shrinking Repo Market - Many pundits have projected that the Repo market will shrink drastically from its current $4.6 trillion in the U.S. and $7.5 trillion in Europe. Added regulation and capital requirements will certainly mean a smaller market, in general, but claims of a major hit to the Repo market are deceiving. As more Repo business is done direct, it will appear the Repo market is shrinking when fundamentally it is not. Say currently a German bank borrows from a securities lending bank, and then lends those securities to a hedge fund. Suppose with new regulations that transaction becomes too expensive and the German bank middle-man is priced out of the market. The hedge fund still needs to borrow the securities and the securities lending group still has those securities to lend. Those transactions will happen, just not through a large bank middle-man anymore. On paper, the volume of that Repo transaction was just cut in half, but in reality there was really no fundamental change in the size of the Repo market.

* Detailed in a Bloomberg News Article, “Automatic Stay May Harm Repo More Than Liquidity Rules:  Skyrm”; by Alex Harris; August 5, 2013.

**If someone with a legal background understands this new rule, please feel free to contact me. Everything will naturally remain confidential.

*** That number is low compared to most Repo market size estimates

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Dodd-Frank implementation

juli 16, 2013 in Cash Management, Publicaties, Risico management, Treasury Algemeen, Wetten en regels by onze redactie

Dodd-Frank implementation

Eurofinance: Regulation, regulation, regulation. Are you prepared?

juni 19, 2013 in Events by onze redactie

EMIR, SEPA, Dodd Frank, Basel III, FATCA, FTT and so on. Needless to say, these days corporate treasurers are faced with increasing regulatory requirements impacting their daily processes, systems and strategies. This course focuses on the impact of these regulatory changes on corporate treasurers and the broader finance function. Together with an update on what all of these regulations mean for you, our experienced tutor will take you through concrete examples as to how these regulations have been implemented in practice: from impact analysis to design, implementation and on-going compliance monitoring.

Register online now

FTT And The Destruction of The European Repo Market

mei 14, 2013 in Columns-Artikelen by onze redactie

According to some, it’s a done deal.  Trade processing vendors are already updating their systems to process the Financial Transaction Tax, which was only proposed by Brussels in February and not yet even ratified.  If adopted by the EU member states, the tax would begin in January 2014.  The European FTT as it’s called, it’s also called the Tobin Tax, is a tax of 10 basis points (0.10%) on securities transactions and a tax of 1 basis point (.01%) on derivatives transactions.  The tax is expected to bring in $35 billion to $40 billion a year in tax revenue, which sounds impressive, but it’s really to punish banks and bankers for the financial crisis.

The key part about any FTT type of tax is that it only works if everyone agrees to participate.  So far, the British government has refused, and even threatened to sue the EU, figuring the tax is really a backdoor way to tax London’s financial markets.  The unique part about this tax is that, unlike other taxes, it is collected no matter where the financial transaction takes place.  It applies to any transaction that takes place anywhere in the world, so the only way to escape the tax is to cease all financial services in the 11 countries of the EU.

The Swedish FTT

This isn’t the first time a FTT was implemented.  Sweden* imposed a 0.50% tax on stock trades in 1984 and increased the tax to 1.0% in 1986, expanding it to include other types of equities.  At the time, Sweden had currency controls which slowed down the negative consequences of the tax.  But even with the controls, the average volume of stock trading fell by 30% on the Stockholm exchange and for the 11 most traded stocks, volume fell by 60%.  Still, the Swedish government liked the tax so much, it expanded it to include bonds in 1989 and effectively crashed the Swedish bond market, causing a 85% reduction in Swedish bond trading and a 98% reduction in derivatives trading.  Where did all the trading go?  Once Sweden abolished their exchange controls in 1989, it all moved London.  But there’s a good ending to the Swedish story:  once the FTT was removed in December 1991, much of  the trading volume moved back to the Swedish market.

Other Transaction Taxes

Some European governments have already imposed their own FTT earlier this year.  Hungry initiated a transaction tax of 0.10%, and so far, raised only half the revenue that was expected.  Italy launched a FTT in March and the TMF Group estimates the tax has cut trading volumes by 38%.  France, imposed the highest FTT of them all, expecting tax revenue to be €530 million to date on the 0.20% tax, and so far again, only €200 million was raised, far below the estimate.  In the United States, although the White House has officially opposed a FTT, two Democrats introduced a FTT of .03% back in November 2011, claiming it would generate about $35 billion a year in tax revenue.

Waking Up To The Implications

From past experiences, it’s clear the FTT is unlikely to generate the tax revenue that’s promised.  Trades move to other locations and smart institutions find ways of avoiding the tax.  Luckily, some European officials realize the consequences.  Maya Atig, the head of the French DMO (French Treasury) stated that the Tax could drain European market liquidity by 15%.  The Director General of the Italian treasury, Maria Cannata, stated that policy makers must be mindful of “the importance of not damaging the government bond markets.”  Wait a second, where were these people when the tax was being discussed in February?  Any European treasury that issues bonds should be very concerned.  If the tax damages their bond market, it will make it harder for them to borrow money in the future.

The tax could actually be much higher than it appears on the surface.  The International Regulatory Strategy Group (IRSG) estimates the effective rate of the tax is actually 100 basis points, or 1%, rather than 10 basis points.  Assuming a bond is traded about 10 times in its life then the tax would be applied 10 times.  If true, it would have a significant impact on European bond market trading.

Effects On The European Repo Market

Gabriele Frediani, the head of the electronic fixed income markets at MTS, said the tax would cause trading in the European Repo market to fall by 99%, “The Repo market would disappear overnight.”  For me, that sounds like the worst case scenario.  But here’s one shred of good news:  Repo trades will be treated as a single transaction under the tax instead of two trades.  At one point, it was understood that Repo was being treated as a buy and a sell transaction, creating two tax events for every one Repo trade.  After market participants raised serious concerns, it was decided that Repo trades will be treated as a single transaction instead of two.  In addition, all Repo trades with a central bank will be exempt from the tax, demonstrating that governments still know how to take care of themselves.

Still, the Repo market will bear the largest burden of the tax, it will reduce Repo market activity in many ways, making hedging more costly, increasing the costs of secured financing, and eliminating financial intermediation (market making) in the Repo market.  Quite possibly, the FTT will speed up a trend which is already transforming the financing markets.

Effects on Dealer Intermediation

As proposed right now, the FTT adds a 10 basis point tax on every Repo trade.  Now remember, for a market maker, that’s a 10 basis point tax on both sides of the transaction.  The costs for a market maker really just widened by 20 basis points.  Borrow securities from one client and lending them to another client just became economically unprofitable.  And when businesses are unprofitable, what happens to them?  They disappear.  The Repo and securities financing markets are already commoditized and margins are thin, so here’s what could happen after the tax is implemented:

  1. Spreads could widen to account for the increase in costs, making bid/offer spreads in securities finance about 25 basis points.
  2. No more securities finance intermediation by dealers.  Instead, dealers will only offer their own long positions and cover their own short positions.  Basically, they would exit the Repo market making business, and fewer market makers it means less liquidity and a less efficient market.
  3. A “direct” Repo market would evolve.

Direct Lending

“Direct Lending” is already a hot topic in the Repo market.  Instead of hedge funds going through a dealer to cover their shorts and that dealer covering the position through a Securities Lending group, the hedge fund would borrow directly from the Securities Lending group.  Of course, in order for this to work, the beneficial owners (pension funds, municipalities, etc.) must accept leveraged investment funds as counterparties.  Direct Lending makes a lot of sense.  Leveraged funds are the ultimate borrowers of many securities, including stocks, Treasurys, corporates and emerging markets securities, and “eliminating the middle man” has been a good business strategy for hundreds of years.

That brings us back to the FTT.  Securities dealers and market makers are already under stress in the securities financing markets.  Dodd-Frank, Basel III, increased capital requirements, and limited balance sheets are reducing market activity anyway.  The FTT will speed up this process, moving the securities finance markets away from market making intermediation and into a Direct Lending market.  The tax will speed up the transformation of the European Repo markets from a dealer-based market into a marketplace where the end-borrowers of securities go directly to the end-suppliers of securities.

* “We tried a Tobin tax and it didn’t work”; Financial Times; 4/16/2013

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.