Centrally cleared repos for non-financial institutions- fact or fictions?
Many financial markets have been coming to terms with a more closely regulated and process-driven modus operandi in recent years. Overall, the aim is to reduce systemic risk, while maintaining or even enhancing liquidity by encouraging a wide range of participants.
A major theme has been the move of many transactions from bilateral to central clearing, to mutualise risks and limit contagion arising from the failure of a single entity. Rules have been introduced in larger jurisdictions mandating clearing of the most liquid and standardised OTC derivatives via Central Counterparties (CCPs). At the same time, banks have been voluntarily increasing the amount and range of transactions they clear via CCPs.
In the repo market for example, most interbank transactions are now centrally cleared, but this is less frequently the case for deals involving non-bank market participants. This is potentially a problem because corporates, asset managers and asset owners are increasing their participation in the repo markets, and indeed are being seen as a valuable source of liquidity at a time when Basel III’s net stable funding ratio is altering and in some cases diminishing banks’ appetite for repo market activity.
In theory, central clearing of repo transactions by non-banks would reduce risk and help to increase appetite for these non-traditional participants, thereby raising overall volumes and liquidity. But opening up central clearing to new clients and new transaction types is not a straightforward process.
The growing interest in more frequent and more direct non-bank repo market activity stems mainly from two separate market developments. Corporates are looking for secured cash lending opportunities as an alternative to their existing short-term cash investment options, typically bank deposits and money market funds, from a counterparty risk but also from a yield perspective. The interest of asset managers and owners in the repo markets lies mainly in their need to secure eligible collateral assets for posting at CCPs in support of OTC derivatives positions, as mandated by the Group of 20 in 2009. Depending on the asset mix of their portfolios, these buy-side firms may seek access to cash or high-grade government bonds via repos.
Nokia, the Finnish multinational telecoms and IT firm, has been increasingly active in the repo markets for the past three years, providing cash in return for a relatively conservative collateral set from banks, on a tri-party basis. “Our priority has been to reduce and diversify counterparty risk, in comparison to unsecured lending, while also looking to increase yield where possible,” says Bas Alberti, senior treasury manager at Nokia.
One of Alberti’s current priorities is to widen and deepen Nokia’s relationships in the repo markets. On the one hand, this means implementing global master repurchase agreements (GMRAs) with a wider range of counterparts, which can take an average of six months. As such, Alberti, is keen for banks to adopt generic GMRAs but also recognises the need to accommodate specific terms for different counterparts. It also means gaining a deeper understanding pricing offered by banks. “For the most part, this is a matter of discussing the priorities and appetites of different banks. Electronic platforms have a role, in terms of helping us to gather market intelligence and improving straight-through processing. But they’re a ‘nice to have’ for us right now rather than a game-changer,” says Alberti.
Moreover, he does not yet see central clearing as a major factor in Nokia’s repo market participation. “As cash givers in the repo market, we are less focused on the need for central clearing right now. But this would change if we were both givers and takers of collateral,” he says.
Creating new solutions
MTS, an operator of regulated fixed income trading venues across Europe and the US owned by the London Stock Exchange Group, is looking to expand the repo market tools and functionality it offers, in response to increasing interest from non-traditional market participants. Head of product development Oliver Clark believes regulatory change and the prospect of central clearing are having an impact on buy-side interest. “Demand is solidifying, driven in part by the possibility of client clearing of certain trades,” he says.
Traditionally, any central clearing has been conducted on behalf of buy-side clients by clearing brokers, which pay into the back-stop default funds of CCPs, as well as managing the margin payments of their customers. But the advent of central clearing of OTC derivatives by all market participants has necessitated more direct relationships between the buy-side and CCPs, as well as a reappraisal by the latter of their risk management and default arrangements. Clearing of non-bank repo transactions potentially requires a further shift to the traditional clearing model. As asset managers and asset owners look to mutualise greater counterparty risks at CCPs by centrally clearing a wider range of off-exchange transactions, are they prepared too to share in the default arrangements?
Buy- and sell-side market participants have had their reservations in the past, as clearing touches on the core raison d’être of different kinds of financial institutions. But the increasingly multilateral nature of the post-crisis environment is changing attitudes. “Reduced access to balance sheet is now resulting in banks reconsidering buy-side involvement in clearing,” says Clark at MTS.
Among CCPs, LCH-Clearnet has been one of the firms taking a pro-active approach to client clearing, proactively proposing new models for buy-side membership. However, the process of consultation has been a complex one.
Olivier de Schaetzen, head of Product Solutions, Collateral Management, Euroclear, says that wider central clearing of repo transactions will reduce the level of regulatory capital required by counterparty banks, but acknowledges there is a price to pay. “On the other side of the equation, there are the contributions to the default fund and the haircuts applied to certain assets to consider,” he says.
Greg Markouizos, head of Fixed Income Finance at Citi, says the challenge facing CCPs is complex. “Lots of end-user transactions involve collateral that has not traditionally been cleared by CCPs. Moreover, CCPs don’t necessarily have the risk appetite or expertise to clear such instruments. As central clearing expands from a limited number of sell-side firms, CCPs will have to manage risks arising from buy-side business. They will need to develop new credit risk capabilities to do this safely. Adding new instruments and/or counterparties involves a lot of effort and complexity,” he explains.
Euroclear’s de Schaetzen agrees with Markouizos that the question of extending membership to the buy-side requires considerable care and probable compromise. “There are potential benefits from connecting non-traditional liquidity providers, but CCPs will have to think carefully about how the appropriate default fund and margin regime. It will be important to avoid increasing the risks to existing clearing members,” he asserts.
At present, discussions are ongoing, with changing appetites on the buy- and sell-sides for repo market providing impetus for innovation. “There is no magic solution,” says de Schaetzen.