OFR publishes findings on US non-cleared bilateral repo margin practices

OFR’s Pilot Provides Unique Window Into the Non-centrally Cleared Bilateral Repo Market
By Samuel J. Hempel, R. Jay Kahn, Robert Mann, and Mark Paddrik

OFR secured the voluntary participation of nine dealers for a pilot data collection. These dealers include primary dealers and nonprimary dealers, bank affiliated and nonbank affiliated dealers, and both purely domestic dealers and dealers that are affiliates of foreign institutions.

Haircuts in [non-centrally cleared bilateral repo – NCCBR] differ dramatically from what is possible through other segments: for Treasury repo in NCCBR, 74% of pilot volume was transacted with zero haircut. This differs markedly from common practices in non-centrally cleared triparty repo, where the median haircut on Treasury collateral has held consistently at 2% for over a decade, and from cleared repo, where minimum margins are typically assessed on a portfolio basis. Our preliminary findings, as well as outreach with market participants, suggest this may be due to the prevalence of netted packages, where a dealer will conduct both a repo and a reverse repo with the same counterparty and same tenor (usually short-term or overnight), but different pieces of Treasury collateral. In effect, these netted packages facilitate trades of one cash Treasury against another, a strategy popular with relative-value hedge funds.

Many market participants reported that zero haircuts are considered reasonable on these trades because they feel dealers face very little risk. In particular, the credit risk on these trades is reduced since repo and reverse repo are matched; in effect, no cash needs to change hands. Nor are there balance sheet costs to the dealers since they can net the repo exposure to one counterparty against the reverse-repo exposure to that same counterparty. It is also unclear to what extent additional portfolio level risk management is conducted.

On the other hand, dealers may face basis risk, since they could lose on the difference between prices on the two pieces of collateral moving against them. In the event of default, the dealer may not receive back the collateral on the repo borrowing from the customer and may be left with the Treasury delivered to them as collateral on the repo loan from the customer. If the value of the collateral they are left with declines relative to the value of the collateral they have given up, the dealer will lose money. Since most netted packages appear to be for relatively short tenors, dealers may believe that large moves in relative prices of Treasuries are unlikely in such a short period. While higher haircuts would protect these dealers better against the possibility of an extreme move in Treasury prices, the risks that dealers take on through these trades should also be counterweighed against the liquidity and price discovery provided by these netted packages.

Going forward, the OFR plans to follow its pilot collection with a permanent collection of data from this segment of the market. This collection will gather daily data from a broader set of market participants and provide valuable insights into the shifting rates and exposures in the NCCBR segment in future years.

The full article is available at https://www.financialresearch.gov/the-ofr-blog/2022/12/05/fr-sheds-light-on-dark-corner-of-the-repo-market/

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