Catching the next wave of OTC derivative margining
The securities financing and repo markets have been impacted by a wide range of regulatory reforms in recent years which have fundamentally changed their shape and purpose. But are we beginning to approach a new normal?
Not yet, according to participants in the opening panel session of the Euroclear Collateral Conference, titled ‘The future of securities financing’, moderated by Godfried De Vidts, Director of European Affairs at NEX and Chairman of the ICMA’s European Repo and Collateral Council.
What does the future hold?
At one level, it’s too early to predict the future of securities financing and repo with much certainty because the regulatory reforms impacting market participants are far from complete. As pointed out by Mario Nava, Director of the Financial System Surveillance and Crisis Management Directorate in the European Commission’s Directorate General for Financial Stability, Financial Services and Capital Markets Union, Basel III’s Net Stable Funding Ratio (NSFR) does not even come into full force until 2019.
The NSFR is one of a number of Basel III requirements that are widely held to diminish sell-side repo appetite. But Nava said blaming Basel was a catch-all excuse, arguing it is difficult to disentangle prudential reforms from other developments, including macro-economic policies and changes in market infrastructure, as contributing factors to falling volumes among traditional market participants. Nevertheless, market regulators and supervisors are alert to the need to refine the regulatory framework to take account of unintended consequences. “There are two underlying principles to good regulation. First, never think you know; always consult the market. Second, give things time to settle,” said Nava. The Commission’s review process for amending the European Capital Requirements Regulation and Directive (CRR/CRD IV) and related activity under the Capital Markets Union would help to improve existing regulation, he added.
Catch-all or not, Basel III is seen as front and centre of the regulatory reforms that have shaken up the market, indirectly or directly. In polling during the session, 49% of conference delegates said Basel III represented the biggest regulatory threat to the securities finance and repo markets, while 32% cited the Securities Financing Transactions Directive. To underline the point, 100% of responding delegates voted answered ‘no’ to the question: Is the regulatory storm behind us?
What next for the humble repo?
Whether or not the regulatory storm is over, post-crisis reforms have already permanently changed the nature of the securities finance and repo markets, suggested Grigorios Markouizos, Global Head of Fixed Income Finance at Citi. Having historically been a venue where banks met their short-term funding needs, the repo market is now effectively a forum for collateral exchange for a wider range of market participants. This change has been driven as much by the reforms in the OTC derivatives markets – where the exchange of collateral is becoming mandatory for both cleared and non-cleared transactions – as by Basel III.
“Previously, the impetus for a repo transaction was the cash leg, but there has been gradual shift, reflecting the growing need of firms to move collateral more efficiently, in a world where more transactions must be secured. Repo cannot be viewed in isolation because it is a collateral transformation mechanism for other markets, whereby, increasingly the securities collateral leg is the driver of the transaction” said Markouizos.
Paul van de Moosdijk, Senior Treasury Manager at Dutch Pension Provider PGGM, confirmed the growing importance of the repo market to his firm’s adjustment to the new regulatory framework for OTC derivatives, as well as noting declining sell-side appetite. “We are increasingly having to source cash to pay initial and cash margin to support interest rate swap positions. Our only real option is the repo market, but we have fewer reliable counterparts as banks are either removing or lowering their balances,” he explained.
What about less traditional players?
Reduced appetite for repo business among some sell-side market participants opens up new opportunities for non-traditional players.
“Insurance firms can benefit from lending out high quality liquid assets into the market in order to enhance yield. Returns are attractive in absolute and relative terms. In current market conditions we are increasingly cautious” he said, flagging concerns about liquidity. “We are following the market closely as the structure of the market changes.”
With liquidity suffering at a time of uncertainty for many financial market participants, what are the most appropriate remedies? When polled, 35% of delegates said they wanted to see the reforms to regulatory measures mooted by Nava, but more (37%) favoured market infrastructure innovations, such as central clearing of repo transactions. Around a quarter (27%) called for a wider range of non-banks participants.
Could client clearing help?
Though agreeing with the need for market infrastructure innovation, Citi’s Markouizos warned of the difficulties inherent in adapting the securities finance and repo markets in order to encourage more non-bank participation. Client access to central clearing may lower bank exposure to counterparties, he acknowledged, but this could also increase systemic risk management. Client clearing models are being developed by central counterparties (CCPs) in response to mandatory central clearing for OTC derivatives such as interest rate swaps, while central clearing of repo transactions is also being promoted as a means of stimulating volumes.
“CCPs work well with a small core of similar participants, but risk management problems can arise with a larger, more disparate membership. Some types of institutions are not able to handle the risk management implications, while others wish to be explicitly exempted, which could break down the principle of risk mutualisation between members. Client clearing is not a panacea and should be explored very carefully,” he said.
To date, non-bank participation in the repo market has been executed largely via Tri-Party Agents (TPAs), providing a range of services including day-to-day collateral management. What would be the impact of more client clearing on TPA-facilitated repo market volumes, asked De Vidts, which currently account for 10% of overall market activity? Johan Evenepoel, Head of Treasury, ALM and Liquidity Management at Euroclear Bank, suggested the two would co-exist. “Client clearing requires the CCP to interpose itself at the trading level, while the TPA is only involved in the automation and management of administrative tasks relating to the trade, e.g. real-time reporting of collateral valuations. But we should explore ways of combining the best of these two worlds, as has already begun through the development of products such as €GC Plus and GC pooling,” he said.
More change is needed
In keeping with the polling results, panellists agreed that progress is needed on a range of fronts to overcome the liquidity challenges faced by securities finance and repo market participants. From greater market infrastructure flexibility in support of cross-border collateral mobilisation to better credit risk management and cross-desk coordination among market participants to simplified and standardised documentation, the panel discussion suggested there is much to occupy the securities finance industry whilst the wheels of regulatory reform gather momentum.
“We may see buy-side to buy-side solutions, but I don’t know whether they will become a major part of the market. We need to chip away at the problem from many angles, sometimes using tools we have not even begun to think about,” noted Citi’s Markouizos. “As banks cut back, pressure will build and more new solutions will come to market. But this doesn’t change the fact that repo is a complicated, technical product with multiple drivers that have to understood.”
Change may be the only constant for securities finance and repo markets, but panellists left delegates in a cautiously upbeat mood about their prospects. At the end of the session, 43% said they felt optimistic about the future of the repo market, while a third felt negative, with almost a quarter remaining uncommitted.