ICMA's 25th Repo Survey is released, showing market growth. But the really interesting part is about Italian banks and CCPs.

ICMA has released their 25th European Repo Survey, reflecting the market as of June 2013. It shows a larger market, driven by LTRO repayments and greater confidence. But it foreshadows some very interesting developments at LCH in how they treat Italian repos. The report says

“…It is estimated that the market grew over the six months from December, 2012 to June 2013 by 8.6%…”

Comparing year over year (June 2012) results, the market growth was a more modest 2.1%. According to the survey, the value of the European repo market is Euro 6,076 billion, not so far away from the June 2007 peak (Euro 6,775 billion). The repo books of 39 of the 65 institutions in the sample expanded.

“…This contrasts with the reported contraction in the US repo market, where the repo business of primary dealers decreased by 3.3% over approximately the same interval…”

The unwinding of LTRO transactions, the report says, has pushed banks back into the repo markets for funding. On the other side, a rebound in market confidence has also encouraged cash lenders to shift from ECB deposits and capture higher spreads in the repo markets. Smiles all around the repo business.

Looking at the maturities of repos:

“…Short-dated repos (one month or less to maturity) surged to 57.2% from 50.5%. This seems to have reflected the steepening money market yield curve, itself driven by tighter market conditions due to LTRO repayments, which had offered more attractive rates (compared to the 0% on offer from the ECB deposit facility), balanced by caution about lending beyond one month…”

Aside: One wonders how the US markets might respond if market repo rates were higher that IOER? Right now there is no incentive for cash to flow into repo unless it has no choice.

The report says in several places that CCP cleared trading is becoming less important. As markets calm, traders, it was explained, shy away from CCPs with their higher cost/margin structure. This was evidenced by the only modest growth in electronic trading.

“…This may reflect the improvement in general market confidence since the last survey (notwithstanding episodes like the Cyprus crisis), which may have prompted a decision by banks that it was less necessary, in the case of business with more familiar domestic counterparties, to incur the expense of clearing across CCP…. There is anecdotal evidence that many Spanish banks have been able to migrate from CCP-cleared electronic market segment to non-electronic repos, albeit for shorter terms and haircuts deeper than the market average (but narrower than demanded by CCP)…”

The really interesting bit was this:

“…The share of Italian government securities in electronic trading increased, possibly reflecting the increased need for Italian banks to fund themselves through the CCP-cleared electronic market in response to growing concerns over country credit risk…” and “…Anonymous electronic trading may have been increased as a share of all electronic trading by the need of Italian counterparties to use CCP-cleared electronic trading to access the market, given the continuing political uncertainty in Italy…

At first glance, it looks like the CCP (LCH in this case) is absorbing the “same name twice” credit risk. But just recently LCH changed their rule for trades with Cassia di Compensation e Garanzia (CC&G). CC&G is part of the LSE Group, as is LCH. Italian government repo trades that clear through LCH via an inter-operability agreement with CC&G will not have the traditional CCP guarantee. According to a Citibank research piece by Matt King “Italy Gets the Boot” (September 11, 2013),

“…One possible response would have been to increase haircuts. Instead, what they have done is to introduce a series of Articles to their rulebook moving to what they call “cash settlement” in the event of a default by their “allied clearing house” in Italy, Cassa di Compensazione e Garanzia (“Cassa”). Rather than standing between repo lenders and borrowers, as is normal, in this case they would instead liquidate the collateral held and reimburse each lender only the “close out value” received for each trade. In this way they protect themselves, passing on the costs of a default directly to repo lenders. Those costs might be affordable in the case of small counterparties, but in the case of Cassa, could conceivably be destabilizing to LCH itself…”

The LCH rule in question is Article 4.5.4.3, tucked at the end (page 69 of 70) of the LCH “Clearing Rule Book”.  This will protect LCH from reaching into their own pocket to cover a shortfall in the margin value. It may also prevent a repeat of the MF Global “bad boy margin” increase that sent that institution off a cliff.

LCH’s move is really important.  The rule, in effect, is LCH saying our risk management process could get overwhelmed by this kind of correlated risk and we can’t go there. It forces these trades outside of the CCP (or at least makes the CCP protection moot) and is counter to pretty much every regulator’s mantra these days, “thou shall use central clearing to mitigate risk.” But even the FSB said repo central clearing should be targeted to high quality sovereigns. 

One has to applaud LCH for taking risk management to the next level. 

A link to the ICMA survey is here.

A link to the LCH Clearing Rule Book is here.

A link to the Citibank research report is here.

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