The European repo market is seeing the emergence of an LCR-compliant trading basket that takes the work out of conducting credit analysis on individual bonds, especially in light of national and ECB policy changes. This article looks at the rationale and mechanics behind the basket.
In October last year, the European Commission specified detailed rules for the calculation of the Liquidity Coverage Requirement (LCR). While earlier discussed LCR profile definitions[1] considered the importance of the central bank in their role as lender of last resort for liquidity under stressful market conditions, the “delegated act” on liquidity coverage requirements[2] blends this aspect out. In the new version, the classification of HQLA assets is not always constant as to their eligibility as collateral for standard liquidity operations of a central bank.
The “central bank waiver” for the LCR profile definition looks in a first instance like a hard decision considering the tremendous liquidity effects of the central bank in the time of stressful markets. Nevertheless, if we consider the latest ECB decision in February to exclude Greek bonds from the ECB collateral regime, you could come to the conclusion that a tight link between central bank collateral and LCR regulations would establish also some adverse dependencies.
Therefore an argument against this point of view is that the LCR’s treasury portfolio stays independent from technical, short term central bank decisions. This limits the secondary and cascade effects of their collateral policy decision to the liquidity / LCR management of the banks. In a sense, you could also consider the current LCR portfolio definition as a statement towards market “normality”, towards an interbank world without central banks acting in a quantitative easing and permanent last lender of resort mode, without full allotment funding access and “guaranteed” market maker function on secondary bond markets.
Since the market and ECB is still operating in a stress scenario, the current LCR portfolio definition is still a brave bet on the resilience of the current and future market liquidity. There are some very practical and technical issues to be considered when the central bank eligibility is no longer the driving factor to assess LCR (Level1) quality and liquidity because the available central bank collateral data service[3] is no longer the cost-free golden source of LCR static data.
In fact, the inclusion of covered bonds to the LCR Level 1 portfolio has replaced the previous simple criteria structure with a complex multi-criteria regime. The LCR assessment of covered bonds by individual banks might now require detailed analyses and local market expertise of each individual covered bond and the corresponding regulatory framework. For the time being it looks like most banks are doing these evaluations on their own and that there is only limited support by external static data vendors to make covered bond LCR assessments available as a service to the market. This is an onerous responsibility for each bank to manage on its own.
There might be some help ahead in the form of standardized LCR-compliant basket. The tri-party agents already provide a set of LCR equivalent baskets[4] to their customers which cover at least the most undoubted and clear asset groups as a starting point for further LCR customization. The dominant European GC repo electronic market Eurex Repo currently redefine the trading basket structure (GC Pooling ECB basket) towards a standardized LCR compatible basket definition[5], which combines effectively the requirement for regulatory LCR-Level1 recognition with the collateral acceptance for open market operations (ECB). There is still an ICMA initiative ongoing to define an independent European repo index, which most likely will need to pick up on the LCR profile definitions in order to have a collateral consensus for the underlying index transactions. Finally, we could expect that the repo specials market picks up on LCR assessment uncertainties as a trading opportunity. This may be an opportunity for local market and/or specific bond structure experts to arbitrage LCR information deficits between the market participants.
In this market and regulatory context, the access to standardized, LCR-compliant basket structures for trading and collateral management purpose might become a precondition to manage liquidity requirements in a timely manner. Banks may also be pushed to establish further static data intelligence and analytic power to detect and manage the LCR jewels with excess revenue opportunities on their balance sheets and trading books.
Tobias Duchscherer is an Independent Consultant with CofiNet, Frankfurt, Germany. He can be reached at duchscherer@cofinet.de.
[1] EBA, Report on appropriate uniform definitions of extremely high quality liquid assets, Dec. 2013
[2] Basel III, the Capital Requirements Regulation (EU) 575/2013
[3] E.g.: ECB/German Central Bank, Eligible Assets Database (EAD list)
[4] E.g. Clearstream Banking SA, „LCR compliant baskets“, Announcement June 16, 2014
[5] Similar initiative: MTS S.p.A. Basket1-LCHC Euro-GCPlus