As the repo market moves from what it was to what it will become, the current state of flux is creating fear and loathing, with just the slightest hint of optimism across trading desks. We spoke with a cross-section of dealers to hear their views on the US market. Dealers were quick to comment on repo liquidity, pricing and mis-pricings, and the impact of regulation, but not always in that order nor in expected ways.
“Banks and dealers that are subject to Volcker, and other like rules, are (dealing with) more friction on the balance sheet,” said a repo professional at one of the largest US banks. “There’s less stop-gaps, or buffers, in the market so liquidity is a little bit more choppy than it used to be.”
It’s a notable shift from principal to agency-type models, as dealers seek to identify the other side of a trade rather than moving it onto their own balance sheet before transacting. “It’s just a different market than it used to be,” he added.
Decreased liquidity is particularly acute in short-term overnight repo, said another repo dealer based in the US from a large European bank. “A lot of short-term repo has been taken in by government money market funds, as they switch from prime funds to govvie funds. They’re taking all the short-term repo paper that’s for sure.”
In Treasuries, some bigger banks are doing all of their reverse and repo business through the customer base, drying up liquidity for FICC trading in the dealer to dealer market. “You see just some short-term axes. We had been looking at longer dated versus a specific asset, financing specific issues for certain dates, matching them. But for now, we’re on hold waiting to see what sort of direction the Fed (takes),” said a repo professional based in the US at a smaller bank.
Such comments come in the wake of remarks at the end of March by Fed Chair Janet Yellen, who struck a decidedly dovish tone. Last December, market observers were speculating there might be three or four rate hikes this year. Now, that’s more likely to be two moves maximum, with some commentators going as far as expecting interest rates to stay flat.
“We are just waiting on some kind of indication, if (the Fed tips) their hand in any way. But it’s becoming harder and harder to find someone to take the other side of those longer term trades, even though that’s what the Fed wants with liquidity ratios and HQLA. They want to see rolling liquidity and long term funding, but we are just not in a position to take too many views because of all the restraints,” he said.
On the bright side, demand to borrow HQLA is “very high” amid a shortage of supply. But here too, there’s bemusement at anomalies in the market’s pricing behaviour. “I would have thought that repo rates, certainly in the overnight market just to satisfy that demand, I would have thought that we would be at lower levels in terms of financing than we actually are,” said a repo trader from the same bank. He also noted that, in terms of funding Treasuries on a term basis, rates are at LIBOR-flat to LIBOR-plus, which is about 44 basis points. It doesn’t compare favourably to monthly commercial paper, even from the asset-backed world, he explained.
“If LIBOR was 44, the yield on that commercial paper where you’re taking credit risk is maybe a 40, or high 30. I would have thought between the function of demand for HQLA, that funding costs would be lower,” he said. “But they’re not, and I don’t know how that changes. I think that’s mystifying a lot of repo market participants.”
The repo expert from one of the largest US banks said that these anomalies are partly due to central bank policies, while another head of fixed income repo from a European bank said that adaption to the new repo landscape is why such a “disconnect” is happening.
One repo desk head, however, said that liquidity in the repo market is “sound”, and that decreases are offset by a corresponding decrease in the need for liquidity as balance sheets and risks reduce. The problem is that during specific periods of stress, there’s been impacts to liquidity, but more in terms of price reaction as opposed to the ability to get a price.
“What you see is not a dry-up, therefore a lack of liquidity, (but) greater volatility in pricing, which is a reflection of the decrease of the liquidity to some extent,” he said. “Anecdotally from what we see, and I’m speaking clearly in the interdealer market more specifically, where it’s more transparent to see prices, during stressful periods (pricing swings are) more pronounced,” he said.
What’s keeping repo traders up at night?
Almost all the people we spoke with referred to some version of regulations. “The concern about the fragmentation and liquidity impacts will be, in the interdealer market, due to the suspension of trading in GCF. That’s pretty poor timing, and in a world where regulators would prefer as much ease of activity as possible at a place where they want liquidity to increase, it appears to allow interbank trading to dissolve. It’s not an ideal scenario,” said the repo desk head.
There’s also the unknown of how the market will react to the next major market shock, he added, noting however, that the Fed raising rates is unlikely going to cause an unplanned move, given Yellen’s tendency to flag any action.
One repo dealer at a European bank said: “From the 2a-7 funds, it’s going to be interesting to see how all this ends up with the floating NAV. A concern of ours is: how many clients stay in prime money market funds, or (will they) go into government money market funds only? Are we going to see a decrease in balances across the board (and be unable) to make the spread? And this is going to impact both equities and fixed income.”
Some light penetrates the gloom, but only just
A repo trader from a smaller bank based in the US said there’s some hope that there’ll be more activity in corporate bonds, whether high yield or investment grade. That optimism comes with a major caveat, however. “People don’t know what type of capital hits are going to come. You’re looking at investment grade having 10% to 15% haircuts on liquidity ratios, and that handcuffs people quite a bit, because you are not able to pick up the yield without charging extensive haircuts. For a highly rated investment grade corporate bond to charge a 15% haircut, it just kills the business. It’s kind of an egregious charge, but that’s the environment we’re in.”
A European bank’s head of fixed income repo said that optimism lies in trusting the market’s ability to innovate and find the new equilibrium, or as he puts it: “a classic case of opportunity breeds innovation”. It might be early days to identify any specifics of what the future will look like until the dust settles, but he does think that trade structures are one area to watch.
“People will look at being more innovative in their trading, even in the simple products like a repo transaction… you will see less of a percentage of your plain vanilla trades, and you will have an increase in the percentage of non-traditional, not in terms of collateral, but non-traditional structures,” he said.
