Bloomberg article on the impact of regulatory reform for the repo market: is it cause and effect?

An article in Bloomberg “Repo Market Decline Raises Alarm as Regulation Strains Debt” by Liz Capo McCormick & Anchalee Worrachate featured some interesting observations about how the regulatory environment is reducing liquidity. It is worth a read.

The article quoted our own Josh Galper. He said,

“The repo markets are really the grease in many financial market systems,” Josh Galper, the managing principal of securities-finance consultant Finadium LLC in Concord, Massachusetts, said in an Aug. 14 telephone interview. “Any increased friction in fixed-income markets, such as decreased repo or increased taxation, and the outcome usually is much less liquidity in government-bond markets, higher costs to borrow, more volatility and less security.”

The repo market looks to be on a slow shrink. Is the driver regulatory change? We can certainly name lots of things that negatively impact, either directly or indirectly, the securities financing market. Higher capital requirements overall, the threat of leverage ratios which could make repo returns look less attractive, LCR, DF counterparty exposure rules, the drain on collateral as a result of central clearing of derivatives & the commensurate reduction in collateral velocity, the prospect of eliminating repo netting or changing the calculation to make statement date netting moot– just to name a few. When the repo market is less fluid, the capacity of the cash markets to absorb flows is diminished.

But there are other forces that impact the well being of repo. The reduction of collateral that comes from QE (along with LTRO in Europe) undoubtedly hurts the repo market. QE/LTRO, combined with the seeming endless amount of short maturity money that needs to be invested in high quality assets, keeps collateral scarce and rates at zero. For that cash, letting it sit in clearing banks is an unacceptable credit risk, even if means giving up return.

While a dysfunctional repo market begets cash market problems, it isn’t the only cause. For example, the Volcker Rule reduces liquidity, especially on”story” paper. Prop desks used to be the go to guys when a dealer needed to take down funkier paper from a client but could not flip it easily. Prop desks often ended up creating hedged trades or structures with the paper. Without that capacity to absorb, trade, and hedge risk – leaving “sell” as the only option left — markets can become very volatile. The hedge funds try to fill the gap, but they are pickier and take bigger spreads – not to mention have to go to the repo desks to fund the whole thing.

Once the Fed starts to reverse course (no pun intended), lending their collateral out to sop up reserves and raise rates, will the repo market have the capacity to facilitate this or has the market permanently shrunk? We wonder if the “diminished capacity” folks might be crying wolf in order to quash some of the proposed regs? A good trader always talks their book. And lots of those excess bank reserves – sitting there at the Fed and earning 25bp – may come out to play in repo when repo rates > IOER. Will the banks substitute the Fed as counterparty for contingent repo risk (the dealer + UST/Agencies/MBS) – probably yes. Will the capital and other regulatory rules require higher spreads for the business to still make sense for the dealers – yes again.


A link to the Bloomberg article is here.

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