The collateral question and the role of repo

The ever increasing demands on collateral in the post financial crisis regulatory landscape have, increasingly, called into question whether or not there is sufficient collateral of sufficient quality to safely and efficiently oil the cogs of the post-trade world. Collateral has taken centre stage and the industry, almost universally, has been discussing potential shortfalls prior to the implementation of key regulatory mandates such as central clearing of trades.

“The scarcity of collateral is somewhat overhyped, but it is good that there is awareness,” says Godfried De Vidts, chairman of ICMA’s European Repo Council and director of European affairs at ICAP. “There is roughly $80 trillion of collateral globally, but of course not all in euros or dollars; that is the first restriction. Then, not all collateral is useable at the central banks or CCPs, both have by various degrees restricted the type of eligible collateral to highly liquid bonds. When you see the continuous push to clearing of derivatives and the threat, in particular in Europe, of buy-ins, we may get to a position where eligible Euro dominated bonds may have limited supply. As that collateral is sometimes used for the liquidity coverage ratio by banks, we may not have the right supply of collateral in the right currency at the right moment: that’s where I see that we need to be much cleverer in our approach.”

De Vidts is a keen advocate of innovation and believes that an environment should be created whereby it is actively encouraged. “Regulation always offers opportunity,” he argues. “Policy makers in Europe have not embraced innovation in a way that will help reduce capital requirements and collateral demands. Things went far too fast. We need to also consider what collateral management can, and needs, to achieve.”

Collateral management needs to achieve the goal of ensuring that there is sufficient collateral in the right places, at the right time. The plethora of regulations that are, to a large extent, arriving at the same time need to be carefully considered in regards to the impact of their implementation.

With increased collateral demands and capital charges and buffers in place, there are a number of unintended consequences that will arise out of all the regulation that is being implemented. There was something of a rush to draft and implement financial regulations in the wake of the 2009 G20 Pittsburgh meeting that outlined the central tenets of the new financial landscape.

The combined effect of all of this regulation is having a profound impact on the repo market in Europe. “Whatever happens now with all the regulation, there has been so much of it that the market has become much thinner,” cautions De Vidts. “There is little to no liquidity left in the bond market, even in the US including in government bonds. It is going far too fast. All of these regulatory initiatives, which make sense individually, have the cumulative effect of making repo unprofitable for banks. Hence banks reduce the use of repo and are starting to reduce activity with non-banks and smaller banks. Indirectly they are reducing the liquidity of bonds.”

Repo, the lending of cash in return for a security, and reverse repo, the transaction in the opposite direction, is widely used for short term lending and is a money market product, part of the so called ‘shadow banking’ world. As a result, the repo market has also come under the gaze of regulators, despite a robust reputation; repo markets came through the financial crises well. The repo market will also be an important source of eligible collateral for use elsewhere in the financial system.

Other factors such as QE (Quantative Easing) are also taking their toll. “QE is taking €60 billion per month – you can see that we are at a crossroads,” states De Vidts. “Markets have changed because of regulation and are not functioning as they should do. The consequences could be grave unless we see necessary adjustments.”

If liquidity dries up in the repo market, then there will be far less movement of cash and securities through the economy. This could lead to a similar scenario that started the previous financial meltdown, whereby a local US liquidity crisis was mismanaged into a global crisis.

To avoid risk taking at the CCP level through the acceptance of lower quality securities and bonds as collateral, the European Central Bank and the national central banks that are partaking in the QE programme need to make the government bonds that they are buying up readily available for lending back into the economy. There are lending programmes in place, but they are seen as very expensive when compared to usual repo rates, with some central banks charging as much as 40 basis points for lending out their bonds one a one week deal. The function is also not available to all market participants.

“It is good that there is a function in place, but it is not harmonised, it is disjointed and not helpful to the market,” says De Vidts. “It could have been better organised. We have to keep in mind that €1.2 trillion is being brought up and that €1.2 trillion is going out of the market for the first two years. We must optimise the lending facility and it must be open to all participants, not just a few. It is early days and we are only just discovering the consequences. The programme has to become more open. There is already a squeeze and it does not need exaggerating.”

QE is taking large amounts of government bonds out of the market, but it is replacing them with cash. The shape of the collateral could shift to incorporate the posting of non-government collateral, rather than European high quality government bonds. This is one way of easing fears around collateral demand and the provision thereof.

Another area of concern for collateral supply into the market is the potential provision of central clearing of repo transactions. As we have discussed previously, this could, in effect, result in collateralising the collateral[1]. “We were the first market in Europe to embrace clearing,” says De Vidts. “As a market we endorse CCPs as they take the counterparty risk and reduce it via netting and margining. So in principle we endorse CCPs. This does not mean, however, that they eliminate the risk, they just concentrate it. This means that you need a very robust CCP environment. One of the issues is whether you contaminate the repo market with exposure to the risks of other products being handled by the CCP, or do you ring fence it? As the risk builds up in the CCP, market participants must ask whether there are enough instruments to cover the event of failure? In the meantime we are still waiting for recovery and resolution for CCPs. At the end of the day, central banks are going to have to bail out failing CCPs.”

Great care must be taken with the repo market for, inadvertently, the throng of regulations is already impacting it. As we looked at previously[2] a small subsection of CSDR could have a huge impact on repo activity and mandatory clearing, QE, capital and liquidity buffers will too. With the potential for a shortfall in the amount of collateral available to market participants, the repo market has a central role to play in easing this burden and moving collateral around the market place to ensure that there is the right amount of collateral in the right places, and at the right times.

Tags: RegulationICMAQECSDRrepo marketsCollateralCCPCCPs