The Investment Industry Association of Canada’s (IIAC) Repo Sub-Committee examined the potential advantages of implementing risk mitigants in the Canadian marketplace (haircuts) given practices observed in other global markets. Given the recent volatility in global rates it was deemed worthwhile to re-examine the exposures in the Canadian market and to identify potential risks to market functioning.
The intent of the paper is to acknowledge changing market risks, while recognizing that the Canadian market is composed of predominantly high-quality liquid assets traded by high credit quality counterparties. As the Canadian Repo market evolves and grows, there needs to be reflection on the fact that the current market practice of near zero haircuts will need to be revisited.
The Canadian repo market comprises large counterparties of high creditworthiness that trade predominantly high-quality Government, Provincial, and agency assets. As a result of the longstanding stability in the market, there is limited observable application of risk mitigants in the market, including haircuts, for repo dealers that support this activity.
Similar to regulated intermediaries in other adjacent repo markets, dealers in Canada support the transformation of collateral and manage counterparty and duration risk which allows participants to access core functions including short-cover, cash management, leverage, and liquidity. The underlying fixed income collateral is subject to interest rate risk; given the recent volatility in global rates it is worthwhile to reexamine the exposures in the Canadian market and to identify potential risks to market functioning.
The Canadian repo market has not historically included haircuts on the high-quality collateral underlying these financing trades. Short-term government bonds will generally experience less significant price volatility from interest rate moves; conversely, longer-term bond prices are highly sensitive to rate volatility which has been evidenced over the past 18 months.
Cash providers are indirectly exposed to collateral price declines through the secured lending (reverse repo transactions) they provide to the demand side. This is because in the unlikely scenario that a demand-side counterpart should default, the cash provider(s) would need to liquidate the bond collateral to recover their deployed cash.
The contents of the paper include: an industry and product overview, a review of global repo haircut conventions, key highlights and quantification of indirect collateral price movement over time, among other observations and supporting resources.