Equity Repo in Europe suffering from familiar FI problems

There was an interesting article in September 28th IFR on equity repo: “Repo dislocation hits delta one desks” by Helen Bartholomew. We think it is worth a read.

Equity Repo and Delta one trades are topics we have written not much about. Delta one trades, as the name implies, are transactions with a linear payoff. Hedging a delta one trade is pretty straightforward; it is one to one (or very close to it). Examples are total return swaps (TRS), exchange traded funds (EFT), forwards, and futures. For a dealer to enter into, for example, a TRS on a basket of equities there is the derivative contract, the hedge of going long or short the reference instruments and the securities financing. Apparently the European equity repo market has been the tail wagging the delta one dog recently.

“…Just when equity derivatives businesses seemed to be enjoying an unusually extended period of calm, dislocations in equity repo markets are thought to have taken their toll on a number of delta one desks. Some players could be nursing sizeable mark-to-market losses after the equity repo rate plummeted deep into negative territory through the summer, industry participants said…”

(In this case negative means higher financing rates).

Bartholomew quoted Franck Lacour, head of equity derivatives trading at HSBC: “…“The fact there’s so much uncertainty about FTT and the regulatory environment is putting a lot of pressure on banks to downsize their delta one activity as nobody can absorb the additional forward risk that comes on the back of these transactions…” and “…The cost of long-term financing these positions is now significantly over Libor. There’s limited capacity out there and you can’t take unlimited risk…”

With the long-term cost of financing gone up, several trading desks are said to have mark to market losses on their positions. Losses are rumored anywhere from €10m–€20m up to €200m.

Equity repo in Europe is faced with all sorts of hurdles, most of which will seem very familiar to fixed income repo participants. The threat of the FTT hurts equity financing as much as it would harm fixed income repo. Getting nicked every time a position turns over adds up very fast. While recent legal developments seems to point away from the FTT coming into widespread use, it is still very much a politically driven issue with plenty of anti-bank sound bites to go around. It is too early to write the FTT off entirely. Capital absorbed by equity positions is not cheap. Finding cash lenders to financing equity positions is increasingly expensive. The lend long/borrow short mentality found in FI repo is also evident in equity repo, along with the pressures to term fund positions. This reduces the carry in the trade.

Equity repo appears to suffer from the same issues that fixed income repo does – a slow shrink and rising cost structure.


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