A new report from Finadium assesses the landscape for US repo dealers in an untested era of rising US interest rates, Quantitative Tightening (QT), regulatory constraints and ample reserves. This report evaluates three questions: 1) what will dealer capacity be under QT; 2) will dealers have the desire to conduct repo beyond their primary dealer and most important client relationships; and 3) what happens if they choose not to?
An assumption in this transitional time is that repo activity will gravitate away from the Fed’s Reverse Repo Facility (RRP) and towards US repo dealers, including the 25 primary dealers and many smaller broker-dealers. Theoretically, higher benchmark interest rates and more collateral in the system should push what dealers are willing to pay for financing above the RRP rate, and spreads may widen beyond the sub-one basis point range they were through 2021. This in turn could reignite the private sector repo markets that have been in competition with the Fed’s own repo offerings for the last two years. But the $1.7-$1.9 trillion held by the Federal Reserve’s Reverse Repo Facility (RRP) may start to find other investments once market rates and collateral liquidity are attractive enough to warrant a change.
The needs and risk appetites of the major dealers have shifted along with changing regulations and market conditions. Smaller dealers have the interest but may not have the capacity to meet large cash investors. New programs like the Standing Repo Facility should place a cap on repo rates, so long as the market is comfortable avoiding the stigma of actually using it.
A potential for dealer disinterest in bilateral repo exposure provides an opportunity for other US repo models to grow, notably DTCC’s FICC Sponsored Repo, forms of guaranteed repo and Peer to Peer (P2P). FICC Sponsored Repo has been a success for some time, and DTCC officials have said for years that their platform should see increased volumes as QT becomes a reality and more collateral moves back to the private sector. Proponents of other repo models are also hopeful, especially if the offer of credit indemnification removes an impediment to buy-side willingness to conduct repo with a non-bank entity as a counterparty. Both CCPs and guarantees or indemnifications offer balance sheet relief to dealers and, hopefully, expanded distribution for cash providers. These options are no longer just a buy-side response to reduced dealer balance sheet capacity; these can now be opportunities for investment and distribution in their own right.
This report should be read by any market participant interested in US repo and dealer balance sheet dynamics, as well as firms looking for collateralized trading opportunities using central counterparties (CCP) and various transactions models that avoid dealer balance sheets including guaranteed or agency repo, and Peer to Peer (P2P) financing. While there are many unknowns, the report provides a framework for working through the major decision factors and ramifications that may evolve based on upcoming market activity.
A direct link for Finadium subscribers to this report is https://finadium.com/finadium-report-desc/us-repo-dealers-rising-rates-and-quantitative-tightening/
For non-subscribers, more information is available here.