At mid-year, repo is like an ancient fable

Today’s repurchase market is like the ancient fable of the six blind men and the elephant, where the blind men offer very different descriptions of what each saw when they touched an elephant in a different spot.

The only thing repo experts seem to agree about is that something important is going on, and it bears watching,

“The overarching message is that repo markets are in a state of transition,” William C. Dudley, president of the New York Fed, wrote in April. He added, “The transitional phase of repo markets requires close monitoring by policymakers.”

When each looked at the repurchase market, here’s what the Bank for International Settlements, consultancy Finadium, analyst Zoltan Pozsar, professors Ralph Koijen and Motohiro Yogo, central banker Vítor Constâncio, the Trump Administration and veteran repo trader Jeff Kidwell saw.

What the Bank for International Settlements saw

New York Fed president Dudley made his April remarks in the preface to a study of repo, “Repo market functioning,” prepared by a committee for the Bank for International Settlements.

When that committee looked at repo markets, it saw periodic volatility in prices and rates, especially in Europe and the United Kingdom, that suggests repos aren’t flowing as readily as they once did. Maybe higher capital requirements, taxes and fees since the financial crisis are making repo unprofitable? Maybe there’s a shortage of collateral?

This could be a good sign, showing that excessive leverage in the financial system, which fueled the financial crisis, is coming under control as regulators hope. Or it could be a bad sign, that (1) cash lenders and borrowers will turn to riskier trades to meet their needs, (2) in a crisis traders will not be able to use repos to raise cash and instead will have to sell assets, which can trigger fire sales and contagion and (3) central banks won’t be able to conduct monetary policy with repos as efficiently.

The committee saw that traders are trying to meet or evade the new capital requirements by making other arrangements, such as using central clearing which lets them net their repo, doing business with non-banks instead of banks, exchanging securities for securities instead of cash,  and replacing repo with derivatives like swaps.

The committee concluded:

Given that markets still appear to be in transition, it is too early to reach clear-cut conclusions as to the case for policy measures to address these changes. It is thus recommended that a further study of repo markets be undertaken within the next two years.

What consultantcy Finadium saw

Josh Galper, managing principal at Finadium, a financial services consultancy, said he thought the Bank for International Settlements report was interesting and frustrating.

When he looked at the repo market, he saw a market hamstrung by regulation and unable to meet the needs of today’s financial markets, including helping markets avoid crises and crashes.

He recalled the February report from the International Capital Market Association Closed For Business: A post-mortem of the European repo market break-down over the 2016 year-end, which concluded that an unprecedented collapse of the European repurchase market in the last days of 2016  – something that did not happen even during the Lehman crisis in 2008 – was caused mainly by regulation and a shortage of collateral.

Galper concluded in an April 18 post:

We’re not arguing for any sort of massive regulatory repeal here. But a continued insistence that the repo market is just transitioning and that while requiring observation, everything is basically okay, misses a major fact of today’s financial markets. Banking activities exist to support economies and economic growth. Regulation has forcefully and effectively blocked this chain of activity from happening in the private sector repo markets ….

What analyst Zoltan Pozsar saw

A week before Galper’s post, economist Zoltan Pozsar looked in a different direction and saw something encouraging. Pozsar, a research analyst for Credit Suisse, has authored a number of studies of the repurchase market since the crisis, including for the New York Fed and the International Monetary Fund.

Pozsar saw the Securities and Exchange Commission’s money market reform, in which the SEC had said that in October 2016 the shares of so-called prime money market funds would begin trading at their market price instead of a fixed $1 per share.  This new rule triggered a gigantic migration of $800 billion from prime money funds to government-only money funds, which still trade at $1.

Pozsar observed in his Global Money Notes #9:

During the weeks before the SEC’s money fund reform deadline, twice as much money left prime money funds than during the weeks following Lehman Brothers’ bankruptcy in 2008. While the outflows in 2008 caused panic and required the Federal Reserve to step in as dealer of last resort in the global dollar funding market, the financial system made hardly a peep this time around despite significantly greater outflows.

Pozsar attributed this achievement to a Basel III requirement that globally active banks hold enough high quality liquid assets like U.S. Treasuries to cover 30 days of cash outflows. He concluded:

The Basel III compliant global banking system passed its first liquidity stress test with flying colors.

What professors Koijen and Yogo saw

At the same time, April 2017, New York University finance professor Ralph Koijen and Princeton University economist Motohiro Yogo looked at repo’s smaller sister, securities lending, and also saw something encouraging … at insurance companies.

Almost a decade after giant insurer AIG collapsed in 2008, mainly because it had ventured into the risky businesses of securities lending and credit default swaps, the two professors took a deep look at the Risk of Life Insurers: Recent Trends and Transmission Mechanisms.

In the early 21st century, they found, insurance companies increasingly lent their investment bonds for cash and reinvested the cash to goose profits.  Insurance company assets pledged in these securities lending arrangements grew from $49 billion in 2002 to $130 billion in 2007,  Koijen and Yogo reported. 

The bond borrowers could ask for their cash back at almost any time, and that was one way AIG ran into trouble in 2008.  AIG had reinvested the cash in mortgage- and asset-back securities, and when markets began failing and the bond borrowers wanted their cash back, AIG had to sell the securities at a loss to come up with the cash. AIG lost at least $21 billion through securities lending, not too far from the $34 billion it lost with credit default swaps, said Koigen and Yogo.

Regulators tightened up, and securities lending  by life insurers was only $47 billion in 2013, the authors said.

Koijen and Yogo concluded:

Given the new reporting requirements and the smaller scale of activity, securities lending no longer appears to be an important source of risk. However, the experience during the financial crisis is a cautionary lesson ….

What central banker Vítor Constâncio saw

Vítor Constâncio has seen a lot since he became vice-president of the European Central Bank in the dark days of 2010. Like analyst Pozsar and professors  Koijen and Yogo, Constâncio thinks that much of what he sees now is encouraging,   he told a Frankfurt conference in May.

“We have to recognize that the implemented regulatory reforms made our financial system more robust and stable,” he told the audience.

But he’s worried about the repurchase market, he said.

Undeterred by industry complaints of a dangerous shortage of collateral, he said he sees too much leverage. He said he is worried about industry efforts in advanced economies to unwind some of the important post-crisis regulation “in a sort of desperate drive to go back to the old normal that led the world into crisis.”

Especially he is concerned about re-use and re-hypothecation of repo collateral.

We need to take up this agenda again, even if not easy in the current environment. Indeed, the trend seems to go in the opposite direction. There is a push to exclude repos from the Leverage Ratio calculation underway that not only weakens the standard but also eliminates the only brake to banks’ capacity to the unconstrained creation of inside liquidity.

He also urged extending regulation to shadow banking.

Leaving market-based finance outside of the macroprudential perimeter would not only leave the door wide open for the transfer of credit intermediation outside the banking perimeter, but we would also close an eye on the inherent liquidity and leverage risks of securities finance transactions and asset management.

He concluded:

Major and concerted efforts at all levels of regulation are needed.

What the U.S. Treasury saw

A month later the U.S. Treasury came to a different conclusion. On June 12 it released A Financial System That Creates Economic Opportunity, which presents some of the Trump Administration’s proposals for changing bank, savings association and credit union regulations.

This is the first of several promised reviews of financial markets by the Trump  Administration. Yet to come are reports on capital markets, asset management, insurance, institutional investing, non-bank financial institutions, financial technology and financial innovation.

Treasury Secretary Steven T. Mnuchin said in the June report that he saw a need for reforms after the financial crisis:

The financial crisis of 2008 revealed longstanding flaws in the structure of both global and American financial regulation. Widespread and extensive government guarantees undermined market discipline, resulting in moral hazard on the part of investors, lenders and borrowers. Reform was desperately needed if future financial crises were to be avoided.

But now he sees a banking industry that  is over regulated, and he published 147 pages to propose change.  His ideas for reducing the impact of new regulations on smaller banks will likely meet with broad support. Other ideas will not. (Editor’s Note: For a simple list of the Treasury proposals, see Appendix B of the report. See Appendix C for a helpful review of current capital and liquidity regulations.)

In general, Mnuchin wants to increase the supply of credit to the economy.

His report includes a number of proposals that could affect the repurchase market, such as: Relax rules for calculating various capital requirements, limit the banks that are subject to single-counterparty credit limits and look for ways to make private-label securitization work better.

Mnuchin also proposes to: Limit the banks that are subject to the Liquidity Coverage Ratio, expand the types of securities that can meet the High-Quality Liquid Asset standard and delay implementation of the Net Stable Funding Ratio.

These are the post-crisis standards that try to ensure banks will be able to meet their financial obligations during the next crisis. They are the rules that Credit Suisse analyst Pozsar said helped the global banking system pass its first post-crisis liquidity stress test “with flying colors” last year.

Mnuchin thinks they go too far. From the U.S. Treasury report:

Capital and liquidity requirements must work together in providing a cushion against potential losses and providing adequate funding to reduce the risk of insolvency during periods of distress.

Conversely, an excess of capital and liquidity in the banking system will detract from the flow of consumer and commercial credit and can inhibit economic growth.

Further, Mnuchin proposes several ways to ease up on the bank leverage ratios that Vice-President Constâncio of the European Central Bank said in May he fears will be weakened.

From the U.S. Treasury report:

The current interaction of the leverage ratio, particularly the enhanced supplementary leverage ratio, and other rules creates incentives that discourage critical banking functions, including taking low-risk deposits, providing access to centrally cleared derivatives for market participants, and providing secured repo financing, which supports market liquidity.

(The Federal Reserve is “taking a fresh look” at the enhanced supplementary leverage ratio, Fed governor Jerome H. Powell told Congress in June.)

The U.S. Treasury report summarizes:

Finding the correct regulatory balance impacting market liquidity and the extension of credit to consumers and businesses is required to fuel economic growth.

What a veteran repo trader saw

Jeff Kidwell, writing in his June 14 blog Repo Commentary, said the U.S. Treasury proposals have “everyone’s head spinning: outright traders, risk managers, legal departments, and repo and securities lending personnel.”

For several years Kidwell has watched new regulations transform the repurchase market.  In every blog post, he remarks:

After more than 34 years in the Repo & Securities Lending industry, I look at our market and see so many changes, many of them now permanent. We traditionally had a credit intermediator, the broker/dealers (originally just the primary broker/dealers) and later, prime brokers, who were the pipeline, through their respective repo matched books, for collateral providers to trade with cash providers, without the two sides ever knowing about each other or facing each other.

That lack of knowledge of the other side of the repo matched book came at a couple of costs, first, the bid/offer spread that went to the dealers and second, the defaults of the Financial Crisis and the impact on some of the dealers that cost many clients and investors’ money.

Kidwell often writes that since the crisis a lot of repo transactions have  moved away from dealers as middlemen, going instead to other arrangements, such as bilateral and central clearinghouse trades.

Clearly, with that pipeline becoming severely crimped by post-Financial Crisis regulatory reforms, consolidation and bankruptcies, and the resulting drop of about 60% in balance sheets being used for their respective repo matched books at broker/dealers, new pathways/pipelines needed to be found for cash provider and collateral provider clients.

Will the Trump Administration’s new proposals change all of that, Kidwell asks in his June 14 blog:

The big question for Repo & Securities Lending participants is, how much of this will happen, if any, and when, and how broker/dealers respond? Will the dealers reset the regulatory clock back to pre-Dodd Frank days of ample balance sheets for less expensive repo matched books, with compressed bid/offer spreads, larger US Treasury outright positions, shorter tenor repo trades, and a return to being the intermediators of the repo market?

Also, what does this mean to the CCP (central counterparty) efforts for repo and securities lending, whose major premises were to eliminate dealer intermediation and insert a central counterparty for credit upgrade and balance sheet netting/reduction?

This could also have an impact on the niche dealers who flew below the SIFI (systemically important financial institutions) radar, leveling the playing field.

Kidwell concludes:

How REAL is this recommendation?




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