The prospect of mandatory clearing of US Treasuries (USTs) is driving awareness of buy-side repo clearing access in Europe. While European regulatory bodies are refining their assessment (a summary of the regulatory agenda can be found here), the buy-side and sell-side are pondering the cost vs. benefits of voluntary centrally cleared repo transactions. For Non-Bank Financial Institutions (NBFIs) especially, access to clearing requires more than flicking a switch – it needs strategic planning. This article highlights approaches to voluntary centrally cleared repo for both intermediaries and NBFIs and the capital relief these models have the potential to offer.
1. Cost vs. benefits:
The cornerstone
When assessing voluntary centrally cleared repo, the cost vs. benefits will be the tipping point. Price improvement on the Fixed Income Clearing Corporation (FICC) Sponsored Delivery vs. Payment (DVP) access model has been reported up to two basis points (bps), for institutions that provide price improvement.
European access models are not directly comparable to the US offering due to market structure. The UST repo market is mainly overnight (O/N), whereas the significant maturity ladder in Europe ranges from O/N to three months. US models have a wider focus on execution mode (done-with and done-away) rather than entity types, while European models offer a single-entry point for execution but have an access differentiation based on entity type (regulated or unregulated).
Funding charges, margin and operations
In Europe, the cost centres and benefits for centrally cleared repo transactions on a matched book strategy can be assessed relatively easily.
The biggest saving is expected to be on balance sheet capacity and the associated funding cost, as a cleared matched book would be balance sheet ‘neutral’.
From an agent’s perspective, there is an opportunity to capture additional franchises through enhanced capacity or to consolidate current franchises by offering improved pricing.
From the perspective of NBFIs, there is an opportunity to diversify liquidity access and enhance liquidity risk management. NBFIs will now be subject to a haircut (through margins), while the bilateral market usually trades at zero-haircut for government collateral. But assuming contingent variation margin, the margin requirement for NBFI repo transactions should be partially offset by the reduction of margin for the agent acting as principal.
While repo transactions are collateralised and hence do not necessarily weigh much on credit risk, clearing does provide risk-weighted asset (RWA) relief, as well as exemption from the credit valuation adjustment (CVA) requirement.
For non-centrally cleared repo, the use of the CVA-Basic Approach could be a drain for material portfolios, especially given the RWA multiplier effect on additional buffers (e.g. G-SIB Conservation).
For maturity transformation, the assessment of the saving is slightly more complicated to define due to the mismatch of ‘netting set’ for both the Leverage Ratio and CVA charge, and it will largely depend on the agent’s book strategy. Nevertheless, savings are still expected.
By signing up to a single rulebook with the Central Counterparty (CCP), NBFIs will be able to potentially transact with any clearing member without the burden of signing a new Global Master Repo Agreement (GMRA), which has proven to be challenging in periods of stress.
As models work for both done-with and done-away, the agent can decide to not act as principal but still sponsor the transaction. Although it is expected that the initial offering will be mainly on a done-with basis until the NBFI cleared repo market reaches a critical mass.
There are operational and IT investment costs required to be able to access centrally cleared repo, given the divergence in bilateral and cleared practices. However, amortising this cost against the benefits of clearing should happen relatively quickly through additional liquidity for strategy deployment and potentially improved pricing from the NBFI’s usual brokers/dealers.
Moreover, increasing regulatory scrutiny of bilateral practices is bringing standards closer to those of clearing, which should act to reduce the necessary uplift to access clearing.
2. Counterparty risk:
The new axle
The current legal framework between the buy-side and sell-side will need to be refined to reflect the new agent liability towards the CCP within its sponsoring activity.
In addition to the rulebook signed by both parties (with the NBFI becoming a member of the CCP), a revised bilateral agreement between them will ratify the credit risk assessment performed by the agent considering its extended responsibilities towards the CCP.
The liability will be dependent on the type of access models (sponsored or guaranteed), the execution mode (done-with or done-away) and the ancillary services offered (e.g. paying agent).
3. Accounting and capitalisation:
The icing on the cake
Depending on the ancillary services proposed by the agent and the way the risk is measured internally, the agent should be able to define a clearing access cost for its clients.
One dimension of the cost will be the capitalisation of its agent services risks (e.g. paying agent) and its agent liability risks (resources towards the CCP).
The former can be viewed as a bilateral risk and should be managed per the current risk framework. The capitalisation would then measure the risk of the agent not being reimbursed for initial margin (IM) payments that were made in the name of its client and could be regarded as an ‘unsecured loan’.
For the latter and given that these access models have been devised since the revision of the Capital Requirement Regulation (Basel Framework), there is uncertainty as to how agent resources should be treated from an accounting perspective and capitalised.
Given the mandate, there is currently a sharp industry focus on accounting classification and capitalisation for the UST repo access model.
LCH RepoClear’s proposal for accounting treatment
Based on the nature of the models available in Europe, and the clear segregation and consumption of resources, the agent’s role and responsibilities should not be considered as constituting a financial guarantee of the performance of the trade (the settlement) but rather a collateral commitment relative to the performance of the sponsored member (the default).
Therefore, the sponsoring activity should not directly impact the agent balance sheet, and the agent resources pertaining to its sponsoring activity should be considered as an ‘unused commitment’ (and be treated as an off-balance sheet item).
Moreover, and given the way waterfall process is defined, Initial Margins and Default Fund contribution (DFc) registered in the name of the NBFI’s member should be viewed as a credit risk mitigant when capitalising the risk of the agent resources being consumed.
Indeed, agent resources would be at risk only if the defaulting client’s IM/DFc cannot cover the loss the CCP would face during the liquidation.
These two elements are crucial when assessing the viability of such access models, as they could affect the agent’s binding constraints, namely the balance sheet and RWA.
The very low footprint driven by these extra-liabilities allow the agents to progress on pricing centrally cleared repo transactions compared to the current bilateral price.
Conclusion
Bilateral and cleared activities can be carried out in parallel and while there are commonalities, processes will inevitably differ at some point.
Such divergence may unnerve clients, which are not always familiar with clearing processes and requirements. This is why the relationship with the sponsor or agent is crucial for navigating this new cleared environment.
There is an investment cost associated with the clearing activity across risk management, IT and operations, which needs to be factored in against the benefits of centrally cleared repo activity and the overall strategy. On balance, it is expected that additional capacities through these models will amortize the investment cost relatively quickly.
LCH RepoClear stands alongside its members and industry providers (including trading venues and custodians) to make this process as smooth as possible, and allow reliable and optimum access to liquidity.
Wael Damiati is Director, LCH RepoClear Product, LSEG
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