How would you describe the European repo market at the moment?
The market is depressed due to the various effects of regulation, specifically, Basel III’s liquidity coverage ratio and capital requirement, as well as the net stable funding ratio (NSFR), among others. Repo isn’t a profitable business at the moment and banks are looking to reform the way to do business to tackle this. Repo is so capital and balance sheet intensive and therefore it’s first in line for cuts when restructuring happens.
However, with that said there are some regulatory reviews happening in Basel on the NSFR to investigate if some of its measure that can be considered too far reaching. At the moment, the proposals are threatening to kill what is an essential market because you can’t have a buoyant government bond market or provide facilities as primary dealers that are obliged to provide two-way quotes without repo. Some banks will tell you that everything is fine because they’re still able to borrow what they need, but when you look at the whole market it doesn’t have the liquidity profile you would like to see—it’s already diminished and that’s not good.
There are so many things that are intrusive into the repo market to the point where some banks are having to internally rationalise the way they do their financing, which in some cases means bringing their equity desk and fixed income desk together.
Ultimately, all of these issues have largely been ignored until recently and it’s only when the market finally dries up that we will understand that repo is the blood in the heart of the market that keeps it working.
Is anything being done to stop the repo market grinding to a halt?
Yes, awareness is growing all over the world. We have to accept that we’re not going to dramatically change regulation but we are able to finetune it where we can—and we have already started to do that. For example, there has been an extension of the delay for repo in the Central Securities Depository Regulation’s (CSDR) buy-in rules. Hopefully we will see a change because it’s an unworkable framework as it disincentivises agent banks to provide such a service as they would be at risk of being fined.
Not all regulators have grasped the importance of the repo market yet but some crucial people within these organisations are starting to. The right people need to understand that a lot of the regulation coming in now requires the use of central clearing and/or more high-quality collateral. Except at the same time, high-quality collateral is being taken out the market, which creates an environment where you’re building castles on sand. Central counterparties (CCPs), some of which are moving closer to being considered ‘too big to fail’, need a functioning repo market, and if that stalls then CCPs will be left in limbo. I believe the education process is happening, but it’s slow progress.
How important is the role of central banks in monitoring financial markets? Can they do too much?
From a securities lending point of view, it’s important to remember that ultimately beneficial owners will want their bonds or their equities back and their inclusion in market liquidity is only temporary. Therefore, the issues that can come from central bank quantitative easing (QE) policies is very real and needs to be closely monitored. It’s not going to help liquidity in the long term, which after all is at the core of our financial system.
It’s fundamental that investors feel confident in their ability to enter and leave the market when they want to. If they lose that confidence then it will quickly stifle the market. Sufficient liquidity is essential to ensure that participants can enter and leave without moving the market too much, but if you keep chipping away at the market’s robustness it will ultimately take its toll. QE is only one of many factors to consider when analysing the problems with the current repo market though.
How much of an effect has the on-going low and negative interest rates environment had on the wider securities finance market?
The repo market has always built-in conditions for dealing with a negative interest rate environment, and it works. Negative interest rates have a much bigger impact on the securities lending space because why would you accept cash collateral for a security in a negative interest rate environment? Negative rates mean you turn to securities for collateral, which in turn puts more pressure on that pool on top of everything else.
I personally advised many senior policy makers not to go negative a while ago because it causes far too much disruption and should be done for as little time as possible, if at all.
How is the buy side of the industry fairing?
There has already been some re-pricing going on in the market as transactions get more expensive, which the buy-side obviously doesn’t like. The new environment demands that if you want something you have to pay the higher price. It will come to the point where banks will just about break even but they will want to still make profit and so it will be the pension funds and insurance companies that will be real ones that pay. Ultimately it is the real economy that will pay the price.
How should the market move forward in order to benefit everyone?
We need to accept that some parts of the regulation we have isn’t very helpful and be practical about what needs to be done to fix that. More open dialogue is needed. We need to go back to basics and trust each other to do the right thing. Markets will always grow naturally if you let them and I believe we will get through this current situation