Don’t touch my repo

The repo industry has dire warnings for anyone who wants to rein in its market.

The warnings are a sobering, inside look at how important the repurchase market has become to the world’s flow of credit.

From the International Capital Market Association, a trade association based in Zurich:

The repo market is crucial to the efficient functioning of almost all financial markets; it provides cost effective and secure funding for professional financial intermediaries, which in turn lowers the cost of financial services to investors and issuers.

The industry is speaking out because regulators are proposing reforms that could make repurchase transactions less profitable.

Chief among these reforms are a tax on financial transactions, including repos, and a rule called a leverage ratio* that would require banks to have a lot more capital* for their assets, including repos.

Industry officials say both reforms could make repos uneconomical and lead to a sharp contraction in the market.

A financial transaction tax was proposed by the European Commission in February and later analyzed by UK repo expert Richard Comotto in a report distributed by the International Capital Market Association.

The European Commission said the purposes of the tax are to make sure the financial sector, including the repurchase market, pays its “fair and substantial” share of taxes and also pays back at least part of what taxpayers spent bailing it out during the financial crisis. 

But Comotto said the tax would be a disaster for the 11 participating European Union member states and for their trading partners. (The 11 states are Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia.)

From “Collateral damage: the impact of the Financial Transaction Tax on the European repo market and its consequences for the financial markets and the real economy” by Richard Comotto, April 8, 2013:

It is essential that secured financing transactions such as repo and securities lending are exempted from the FTT, given the essential role these instruments play in the collateralisation of the financial market and the efficient functioning of the money and securities markets. An exemption should also be applied to primary dealers and market-makers in fixed-income securities markets, in order to preserve the efficient pricing and distribution of debt capital.

For a similar report from repo’s cousin, the securities lending market, see “Impact of the Financial Transaction Tax on Europe’s Securities Lending Market” by the International Securities Lending Association, June 3, 2013.

Meanwhile, critics claim the proposed new Basel  and U.S. regulations calling for banks to maintain tough and transparent leverage ratios  could mean that banks will do fewer repos.

“Given the importance of repo to the functioning of global liquidity in the financial system, that could create a major problem for the world economy,” said Chris Murphy, global head of rates and credit at UBS, to reporter Alex Chambers at Institutional Finance Review.

Suppose, critics say:
– a major investment fund has a sudden need to sell securities and no one can get a repo loan to buy them?
– interest rates go up and a flood of investors want to sell their lower-yielding securities but can’t?
– the U.S. Treasury wants to sell Treasuries but buyers can’t get repo financing to buy them?
– broker-dealers can’t get repo loans to finance mortage securitizations?

“Unless we’re going to move into a buy-and-hold world, market liquidity matters,” said Richie Prager, head of trading and liquidity strategies at BlackRock, to reporter Chambers.

No doubt some repo fears are warranted and others are not. The challenge for regulators is to figure out which are which.

Comotto’s report says financial markets and central banks depend on repurchase transactions in many important ways. Using Comotto’s words, but paraphrasing, a financial transaction tax on repo would:

– cause an even sharper reduction in lending to the real economy than is currently being seen;  the flow of credit would suffer

– financial institutions and firms in the real economy would find it harder and more expensive to raise working capital

– it would increase the vulnerability of banks to runs

– moral hazard would increase

– it would cut off a major source of bank funding; banks would face severe structural funding problems; banks would have no source of short-term funding left other than customer deposits and central bank liquidity

– it would cause particular problems for the US dollar funding of banks 

– banks would be less able to respond to unexpected or temporary demands for credit from customers

– the flow of central bank credit would be adversely affected

– the framework of collateralised transactions through which monetary policy is transmitted would be destroyed, creating problems in coordinating the implementation of a consistent monetary policy across the eurozone

– the ability of central banks to monitor the expectations of investors and borrowers would be reduced

– the efficiency with which central banks can signal changes in their policy stance would be diminished

– the European Central Bank would be exposed to increased credit risk in its lending to banks

– the European Central Bank would become partially blind and mute

– market-makers would not be able to minimize the risks of reallocation by allowing investors to buy and sell when they want to

– it would impede the ability of investors to implement flexible investment strategies and allocate capital efficiently

– issuers and investors forced to participate directly in the primary market would have to take greater operational risk or tolerate higher levels of financial risk

– it would make collateral management uneconomic

– optimization of collateral portfolios, a key functionality of tri-party collateral management systems, would become impractical, which would impair the efficiency of collateral usage

– it would reverse the trend towards the collateralisation of financial transactions, which is one of the pillars of the new global regulatory framework being constructed under the Basel regime

– financial stability would be compromised because it would make the movement of collateral prohibitively expensive

– it would inflict immediate and serious damage on the real economy through the disruption to the flow of credit caused by the cessation of the flow of collateral

– secured financing transactions would be replaced by unsecured deposits

– it would force banks to shift back to using riskier unsecured interbank transactions

– banks would face difficulties in managing their marginal liquidity in the interbank market, where they would be restricted to seeking and making unsecured deposits

– there would be no liquidity without an active repo market, given the pivotal role that this market plays in supporting intermediation in the securities market

– it would undermine regulatory initiatives seeking to ensure that financial intermediaries maintain adequate liquidity buffers, since new liquidity regulations are predicated on the assumed existence of a liquid short-term repo market

– liquidity buffers would be harder to build up, other than in cash

– it would exacerbate systemic operational risk by removing the means of borrowing securities to prevent delivery failures

– it conflicts with regulatory initiatives such as the acceleration of securities settlement in Europe to reduce credit and liquidity risk (slight mismatches between deliveries and receipts of securities can burgeon into settlement logjams and firms have less time to rectify mistakes; an efficient short-term repo and securities lending market is an essential means of smoothing settlement and covering those mistakes)

– it would have a stultifying impact on the issuance of securities and therefore on the ability of firms in the real economy to raise capital

– it would damage long-term growth potential of the economy and erode the return on investors’ savings

– there would be serious reductions in investment in the real economy because of the increasing cost and risk of capital-raising

– it would disrupt capital-raising in the fixed-income market

– alternatives would not be able to efficiently price or distribute illiquid securities, such as the corporate bonds, ABS and MBS that directly finance the real economy

– alternatives would not be able to cope with the massive volumes of public debt that governments have to issue

– bank lending would suffer because, without repo and money market securities (which would also be rendered uneconomic by the FTT), access by banks to non-bank financial investors such as money market mutual funds would be severely constrained, forcing a disorderly acceleration of the current process of deleveraging

– the 11 states that have said they want to participate would experience capital flight, which would drain liquidity from the domestic financial markets and drive fault lines across the monetary landscape of the eurozone

– monetary conditions in the 11 states would systematically diverge from those in the rest of the Eurozone, complicating the conduct of monetary policy

– the difficulty of raising working and investment capital would impose a competitive disadvantage on the financial institutions and corporations of the 11 states; they would be disadvantaged against their European Union competitors and even more so against competitors in non-EEA countries

– the 11 states would suffer from the relocation of many financial services; the 11 states would see a reduction in economic growth through an exodus of financial services

– it would cause political and legal frictions in the European Union

– it would undermine the integrity of the Single European Market

Comotto is a senior visiting fellow at the University of Reading’s Henley Business School and affiliated ICMA Centre.

For opposing views, here are two among many supporters of the financial transaction tax and the leverage ratio:

“Europe should embrace a financial transaction tax” by Avinash Persaud, former senior executive at JPMorgan and UBS and executive fellow at London Business School, Financial Times, May 28, 2013.

“Why Basel’s latest leverage ratio is better” by Mayra Rodríguez Valladares, managing principal at MRV Associates and faculty member at the New York Institute of Finance, American Banker, July 16, 2013.

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 * Capital is money that banks make by selling stock or making profits.  A leverage ratio compares a bank’s capital to its assets. Under the new Basel and U.S. proposals, which differ but may be harmonized, a bank would have to hold capital equal to 3-6 percent of all assets, including gross on- and -off-balance-sheet repos. Under existing rules, Basel doesn’t track leverage ratios and the U.S. uses a leverage ratio that tracks repos that are netted and on the balance sheet. For a discussion, see “Why new leverage ratio rules could stifle repo markets” by Izabella Kaminska, Financial Times, July 22, 2013.