Market observers are calling foul over the absurdity of collateralized repo getting too expensive, so much so that unsecured liquidity is now cheaper. There are also concerns that a “perfect storm” is brewing for the four days of year end starting December 31.
The problem, said Andy Hill, a Director in ICMA’s (International Capital Market Association) Market Practice and Regulatory Policy Group, can be summed up in two words: Leverage Ratio – a non-risk based measure that’s supposed to capture all on- and off-balance sheet liabilities of a bank, and keep risk in check.
But there’s a big question mark on whether it’s fit for purpose, and the industry is raising concerns over the consequences. One major point of contention is the lack of uniformity in global implementation. US banks have been applying it for some time, UK banks have started recently, whereas European banks are starting come online in patchwork fashion, much like Asian banks.
“This creates an unlevel playing field right away,” Hill said, adding that the same is true for other differences such as applied percentages and where it is being absorbed. “You have different leverage ratios depending on the institution or jurisdiction, so it could be 6% for a large American bank, it could be 3% for a small European bank. And where is it being applied? At the trading level? If my leverage ratio cost of unnetted reverse repo is 45 basis points, does that hit my P&L as a repo trader? Or does it get absorbed somewhere else across the bank?”
Results from a recent ICMA survey show a worrying trend in the European market: repo liquidity is becoming a loss-making service reserved for choice customers. Buy side firms interviewed by ICMA indicated that it was getting tougher but they were still getting some form of liquidity from their banks. But respondents happen to be big institutions, which conduct business across a huge swathe of banking services.
“Clients are going to get repriced, it will be absolutely selective. It used to be the case that you would fight to give liquidity to any client,” Hill said. “If you could make a spread, business was business. Now, you don’t have the balance sheet and it’s expensive. You are only going to give repo activity to the selected few.”
That’s in combination with an abundance of regulations: Net Stable Funding Ratio, and, in Europe, Securities Financing Transaction Regulation (SFTR), CSDR (Central Securities Depositories Regulation) mandatory buy-ins, and the provision under BRRD (Bank Recovery and Resolution Directive) for resolution stays.
It’s regulatory overload at any level, explained Hill. “If you want repo liquidity, you are going to have to pay for it… (with) wider bid-ask spreads, but also you are going to have to pay for it in other forms by the other business that you do with your bank.”
In a recent post, Securities Finance Monitor pointed out that the Leverage Ratio is not the fail-safe mechanism that regulators make it out to be. Rather, it creates its own set of benefits and genuine risks in the marketplace.
“It’s all about how people respond to the regulations that results in the transformation and shifting of risk,” said Craig Pirrong, Professor at the University of Houston. Based on the way banks are currently trying to shuffle risk about, both internally and externally, he is cynical on the outcome. “Risk has not been eliminated. In the attempt to banish the devil we knew, we’ve teamed up with some lesser-known demons.”
Jeff Kidwell, head of Direct Repo at AVM, couldn’t agree more. He sees a perfect storm brewing for the market as year-end approaches (spread over four days starting December 31). “Repo rates are getting extremely expensive because of balance sheet costs, capital utilization, Basel III, LCR (Liquidity Coverage Ratio) and triparty repo reform, and so are seeing much greater moves, (of) much greater magnitude than LIBOR (London Interbank Offered Rate).”
Meanwhile, the market is skittish in anticipation of the Fed hiking interest rates. “What happens when you come off ZIRP (zero interest rate policy)? Does a move in the fed funds rate have an impact directly to the repo rates? All of these things are affecting it and that’s what’s making it a very scary year-end,” Kidwell added.
Next week: what should dealers be watching out for?