As the repo market moves towards year-end, a number of cross currents are creating tricky dynamics that dealers will have to come to terms with. We have compiled a list of items that dealers might want to keep an eye out for as festivities begin, and after they end. (This is part 2 of a 2 part series).
Part of the challenge is that the actual number of repo desk personnel available is shrinking at the same pace as balance sheets: Morgan Stanley, RBS and Deutsche Bank have been announcing a combined loss of tens of thousands of jobs. It’s getting harder to even find someone to talk to about financing needs.
With some 25 years’ experience as a repo trader, Oscar Huettner, managing principal at LGM Financial Consulting, points out that it’s not just numbers, but also the reality that markets are entering a tightening monetary policy cycle, whatever the size and pace.
“It’s the first time the Fed has moved interest rates for seven years, the first interest rate increase in nine-and-a-half years, and it’s the first change in creating a tightening cycle in 11 ½ years,” Huettner said. “If you look at the turnover on desks, you have a huge portion of the people that are currently staffing desks who have never had to deal with a change in interest rates. I do wonder as rates rise in the States, how well those people will be able to cope.”
Huettner also notes that the “jigsaw puzzle” of year-end will be made that much harder due to numerous regulatory constraints having more and more of an impact on the market: “The cumulative effect of the leverage ratio, the liquidity coverage ratio, and the stable funding ratio highly constrain what desks can do and will give the market less liquidity.”
How much that impacts rates directly, if at all, is difficult to guess however, Huettner added: “I don’t know that there’s any sort of big bang that happens at year-end, but that said, the market is not as liquid and fluid as it used to be.”
He warned that ultimately repo markets may end up being unable to perform their traditional role – as a kind of lubricant to keep the financial markets functioning.
As an example, he pointed to the recent sell-off in junk bonds – a part of the lack of liquidity is also a lack of capacity for dealers or repo desks to take down a large amount of inventory because they’re balance sheet constrained.
“It worries me that in a volatile market, moves will be exaggerated simply because there’s not enough liquidity in the bond market, and there’s not enough capacity for dealers to take down and fund inventory if that’s necessary,” Huettner said.
Jeff Kidwell, head of Direct Repo at AVM, sees a significant amount of defensive pricing as year-end approaches. At time of writing, the 30-day rate is implying 2.32%, or 232 basis points, rather than the current Fed Funds of 0.35% and bid/offer quotes for the year-end (Dec 31 – Jan 4) of 0.75%/0.45%. That’s happening because dealers are trying to raise rates high enough when bidding for collateral to avoid getting stuck owning it at a rate that ends up much lower than the prevailing market rate at that time, he explained.
But there’s a host of other factors at play creating uncertainty that’s making things difficult and potentially distorting the repo rate, he added.
Large primary dealer dynamics
Cash providers favor term trades, but they are reportedly in very small amounts and only in GCF (general collateral financing) on DTCC’s GCF facility. Moreover, it appears that there are only collateral providers there, and of those it’s mostly third-tier dealers or smaller broker dealers, which don’t have that much liquidity with cash providers. This means they are at the mercy of larger primary dealers.
“They are throwing in the towel on their GCF to get funded, and so you are seeing the GCF rate back up faster than the DvP (delivery for payment) rate. That’s an odd dynamic,” Kidwell said.
Two clearing banks, two GCF rates
The final piece of the Fed’s triparty reform is to eliminate the significant amount of intraday credit between the two clearing silos – BNY Mellon and JP Morgan – for GCF trades. DTCC recently announced that as of 2017, it will no longer clear GCF between the two silos. That means there will be two completely different GCF rates within FICC (Fixed Income Clearing Corporation). It also puts a monkey wrench in FICC’s CCP effort, which was going to include money funds and broker dealers, and will now have to contend with two clearing banks.
Pricing Fed tightening
Markets may be reacting too much, too fast to the Fed’s tightening cycle – a regular pattern over the last 20-some years during these times. Some three 25bps in rate hikes have been priced in by mid-year 2016 but the central bank is likely to move more slowly. There’s also the uncertainty of coming off zero interest rate policy: new tools from the Fed, such as RRP (Reverse Repo Program) and the IOER (Interest on Excess Reserves) rate, aim to impact unsecured deposits at banks to balance things out, but how that plays out with end of ZIRP is yet to be seen.
Is there going to be a band of rates that is set by the Federal Reserve? And how might that impact commercial paper (CP) and LIBOR rates, many of which are used to hedge repo, or hedge the outright securities that repo is involved in? The positive news, Kidwell said, is that so far the reaction to the Fed’s change in monetary policy has been fairly calm, and GC repo rates have (not including the year-end) only increased marginally, particularly overnight, where they traded at 0.4% early this week. “There is a belief among some market participants that we are quickly seeking out a GC repo rate equilibrium.”
Swap spreads between interest rate derivatives and US Treasuries have plunged to unseen levels, and keep going lower. Swaps are priced on LIBOR (London Interbank Offered Rate), which, if a reminder is needed, affects some $500 trillion in securities contracts. With the LIBOR scandal changing the way banks and traders are allowed to collaborate, what’s ended up happening is that the banks that set the rate are using CP as a benchmark. CP rates have traditionally been lower than repo – meaning that an unsecured rate is lower than a secured rate backed by good government collateral.
So, the situation becomes that an unsecured rate like Libor doesn’t actually trade anymore – it is being based off of CP, a completely different money market instrument. “It is distorting LIBOR… it is not reacting as quickly to the move for Fed tightening, the move for balance sheet, it’s not pricing anything about regulatory reform. But repo is,” Kidwell said.
And some good news as well…
It’s not all doom and gloom, however. Both Huettner and Kidwell have some optimistic notes to help ring in the New Year. The market can look forward to the expansion of Direct Repo and direct lending markets, new short-term products for cash providers, and possibly the fruition of some of the repo and securities lending CCP initiatives, Kidwell noted.
Huettner said: “Repo traders as a group are some of the most resourceful participants in the global financial markets. They have traditionally preformed three vital roles; credit intermediation, maturity transformation and the ability to provide vast amounts of liquidity to numerous market participants even when the needs of those participants were not always aligned with one another. The job has become much harder; the daily jigsaw puzzle has become multi-dimensional, but the needs of their customer bases must still be met.
“To be successful going forward, repo desks will have to reconfigure themselves; whether that is through greater use of CCPs and cleared repo, agency trading or alternative cleared products. This is where the future lies.”
The first part of this series is available at “Repo prepares for a ‘scary’ year-end, part 1” from December 17, 2015.