Following a shocking spike in volatility in a key source of short-term funding for asset managers, banks and pension funds, market participants say there is no silver bullet to prevent a repeat. The “unprecedented” volatility in December 2016 in the European market for repurchase agreements, or repos, was attributed to a confluence of factors, including a shortage of high-quality collateral as well as post-financial crisis regulation that the market has yet to fully adjust to.
Repurchase agreements involve a borrower selling securities to raise the cash they need and promising to buy them back at a later date. The securities, often government bonds, act as collateral in the transactions, making repo a form of secured financing.
During a tense few days in late December, repo rates sunk deeper into negative territory, meaning the lender effectively paid more interest to the borrower. This provided ample evidence of a heightened demand for high-quality collateral, as well as a lack of supply. Not even during the collapse of Lehman Brothers in 2008 and the European sovereign debt crisis of 2011-12 did the European repo market suffer such a disruption, according to Andy Hill, a senior director at the International Capital Market Association.
Many had anticipated some degree of repo market stress. As banks near the end of their reporting periods for their annual accounts to investors, they typically limit activity such as repo, in order to ensure that their reported measures of financial health and risk exposure, such as leverage ratios, appear more robust.
But the severity of last year’s crunch caught observers by surprise. One factor arguably exacerbating the situation was the set of post-crisis regulatory restrictions on banks’ capacity to perform their historic intermediary role. Some also attributed the hit to the European Central Bank’s asset-purchase programme buying up some sovereign debt such as German bonds, which are considered an ultra-safe asset and widely used in repo transactions.
This year, the dilemma facing the region’s pension funds, asset managers and hedge funds, is how early — or late — to tap the European repo market for funds, lest they be caught up in a last-minute scramble.