Over the past few decades, repo has become the key short-term funding instrument of banks and a growing home for the liquid assets of non-bank financial and corporate investors. Repo also performs a variety of other functions essential to the efficiency of the financial markets. Also, because of its collateralised nature, regulators have promoted repo as a means of mitigating risk.
In the aftermath of the crisis, when unsecured funding evaporated, new regulations such as Dodd-Frank in the US and EMIR in Europe are driving a further extensive collateralisation of financial markets. This has benefited the repo market, which is the principal venue for ‘collateral transformation’ or the trading of collateral between those who have it and those who do not.
At the same time, however, regulators have become concerned that collateral could facilitate the build-up of excessive leverage; expose banks to the less regulated ‘shadow banking’ system; make bank financing too sensitive to the cyclical fluctuation of asset prices; and as a form of market-based funding, make the financial system too vulnerable to contagion. So another set of regulatory initiatives have aimed to curb the use of repo, in an effort to force banks to reduce leverage and bulk up their capital ratios, as well as to try to enhance the stability of bank financing and control linkages between banks and less regulated financial entities.
What is a Repo?
A repo is a combination of an immediate sale of an asset at one price and a simultaneous commitment to repurchase the same type of asset in the future at a different price. For example, a bank could sell securities worth €10m to another bank for €9.8m and commit to repurchase the same amount of the same issue in one week’s time for €9.82m.
If, at the end of the repo, the seller defaults on his obligation to repurchase, the buyer can liquidate the asset they have bought to recover some or all of this cash. Moreover, if, during the term of the repo, the buyer finds that they have an unexpected need for cash, they can sell the asset until the repo matures. The buyer is therefore also protected against liquidity risk. In order to provide good protection against credit and liquidity risks, the asset sold in a repo needs to be very liquid and of high quality. For this reason, the typical asset bought and sold in the repo market is a government bond.
The fact that collateral in a repo is sold rather than being pledged, which is the traditional manner of giving collateral, is an essential feature of the instrument. Selling avoids the legal complications of pledging, thereby giving greater confidence to the lender of cash, which translates into a lower repo rate and easier access to funding. Repo is also typically transacted under legal agreements, such as the Global Master Repurchase Agreement (GMRA) published by the International Capital Market Association (ICMA). If one party defaults, the other has a contractual right to set off or net the value of what he is owed against the value of what he owes the defaulter. The value of netting under agreements like the GMRA was amply demonstrated by their smooth performance after the default of Lehman Brothers in 2008.
Who Uses Repo?
Repo was initially employed by central banks to refinance the banking sector and it has since become the standard tool of monetary policy implementation. After World War Two, repo also became a short-term market funding tool for banks, initially in the US and, since the 1990s, in Europe and elsewhere. For investors holding funds too large to be eligible for deposit insurance or guarantee schemes, and without access to the risk-free deposit facilities of central banks, repo is the only means of protection against default. Investors have included money market mutual funds, other liquidity managers and some pension funds and insurance companies. On the other side of the market, repo has also been a crucial funding tool for hedge funds and other leveraged traders and investors. An interbank market has also emerged and is vital to the ability of banks to manage their liquidity.
Another major driver behind the growth of the repo market has been its use, not as a means of borrowing cash, but of borrowing securities. Banks need to borrow securities in order to fulfil delivery commitments, particularly if they are market-makers. It therefore underpins the liquidity of the secondary bond market, which is in turn essential to the pricing of new issues in the primary market. The ability to borrow securities is also needed in order to sell short, either for investment reasons or to hedge long positions in other securities and derivatives.
By 2007, immediately before the crisis, the combined US and European repo markets may have grown to perhaps almost €15-20 trillion in outstanding contracts. Following the Lehman default in September 2008, there was a sharp contraction of about one-third in the repo market, as banks rapidly deleveraged. In Europe, there has since been a recovery, occasionally interrupted by renewed market stress and by the official responses (for example, the three-year lending by the ECB under its LTRO facilities in 2011/12 reduced the need of eurozone banks for market funding).
But another consequence of the crisis has been the arrival of a wider range of new investors, who are seeking to reduce exposure to the shrinking banking sector. The repo market is seeing the entry of more pension funds and insurance companies, as well as corporate treasuries, central banks managing currency reserves and sovereign wealth funds.
For new participants in the repo market, as for established ones, the challenge is the prudent management of collateral. Good practice hinges on the careful selection of counterparties; accepting only collateral that has a minimal correlation with the credit risk of the repo counterparty, is sufficiently liquid to be accurately and continuously valued and, if necessary, can be quickly liquidated; ensuring that falls in the value of collateral are offset by margin calls; and reinforcing legal rights by documenting transactions under a robust legal agreement such as the GMRA.
Another challenge is the operational side of collateral management: having to move, value and maintain collateral. This is especially the case for firms such as corporates, who do not normally deal in securities. For many such investors, the solution is to make use of tri-party repo agents. In effect, by using tri-party agents, an investor outsources its collateral management.
While the regulatory promotion of collateralisation by the Basel Accords has been a powerful force behind the growth of the repo market, the financial crisis has resulted in regulatory concern about collateral and collateralised instruments such as repo. Regulators worry, among other things, that collateral made it too easy to borrow and facilitated the build-up of excessive leverage, particularly in the less regulated so-called ‘shadow banking’ system. They also worry that banks’ capacity to borrow is too sensitive to the cyclical fluctuation of asset prices. Therefore, while much of Basel III, and local regulation such as Dodd-Frank and EMIR, are forcing greater collateralisation on the financial market, other regulatory initiatives are seeking to reduce the role of collateralised markets like repo. The Financial Stability Board (FSB) set up by the G-20 to tackle shadow banking has been examining, among other things, ways to contain the repo market, including the mandatory deduction of minimum haircuts from the value of collateral. But the principal tool to rein in the repo market is likely to be the Basel Leverage Ratio. This prescribes a minimum amount of capital relative to a bank’s exposure. The critical feature of the Leverage Ratio is that the measurement of exposure, in contrast to the rest of the Basel regime, is not risk-weighted. Regulators want a simple backstop to the risk-weighted calculation of capital requirements. It was recently announced that netting would not be allowed in the calculation of exposure (so there can be no offsetting of opposite transactions, even with the same counterparties). The result is a severe constraint on banks’ balance sheets. The impact will be greatest on transactions in assets with the lowest risk-weights (as these will need more capital to meet the unweighted Leverage Ratio) and the lowest return on equity. Banks’ repo books will therefore be under pressure and repo financing will cost more.
But whatever regulators have in store for repo, it is nothing compared to the impact of the proposal for a Financial Transactions Tax (FTT) in some EU countries. In its current form, the FTT would simply destroy the repo market in those countries by making repo transactions totally uneconomic and severely damage the repo market in other European countries with serious consequences for financial markets.
Although the FTT has been set back by two European legal opinions, there remains strong populist political support. Many observers expect the FTT will be quietly watered down so that it resembles UK Stamp Duty or the transactions taxes imposed in France and Italy, which focus on equity. But the risk of something more serious has not yet gone away.
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