The Basel effect
Although it is still muffled by abnormal liquidity levels and a persistent low-interest rate environment, the Basel effect is already being felt in the repo market. A sometimes painful period of adjustment is upon us.
In the long term, Basel III and related post-crisis banking reforms will bring numerous benefits. One of the advantages of the higher levels of scrutiny to which banks’ balance sheets are being subjected, for example, is increased transparency, and ultimately tougher market discipline. The more a counterparty knows about a bank’s funding position and the assets and liabilities on its balance sheet, through increased levels of regulatory disclosure, the more accurately it can model its risk, and therefore price transactions accordingly. This might be good for both individual firms and aggregate systemic risk, by reducing the scope for mispricing, not just in the repo market, but in all interactions with banking counterparts. But these benefits will take some time to evolve. Stress tests are based largely on historical not real-time data; new reporting requirements are only now being gradually introduced. A period of adjustment will be required as banks and regulators refine new processes. Even after that, it will take time for new types of information to be assessed for relevance to and subsequently incorporated into existing risk management models, whether in the repo markets or other types of transactions.
In the meantime, banks, their counterparts and clients are tackling the short-term effects. In the European repo market, there is evidence of dislocation and mismatches in supply and demand as banks’ appetite for certain types of counterpart and transaction changes. In a landscape being reshaped by low interest rates, Quantitative Easing (QE) and Basel III, the economics and rationale underpinning repo market activity are being shaken up. As such, the challenge for banks is to optimise their existing book of business while adjusting to this remoulded landscape. With Basel III’s new leverage, liquidity and funding ratios forcing banks to reappraise their position, many wonder: Is it possible to comply with Basel and make a return?
Searching for viable funding
The impact of Basel III’s Net Stable Funding Ratio (NSFR) on secured and unsecured lending is complex and at times contradictory, but its penalties for short-term transactions with interbank counterparties are already reshaping the repo markets. Specifically, the NSFR is driving banks to look for cash for longer periods from non-financial counterparts. Anecdotally, corporates talk of banks urging them to widen their collateral sets, and to agree to longer tenors. This goes against the grain for the naturally cautious corporate treasurer, who is reluctant to take on financial risk without a clear incentive.
To tempt them in, banks will need to innovate. This might be a painful process at first, but it could well lead to a more resilient market, characterised by improved valuation techniques and more precise margin management methods that ultimately add value and transparency to clients while keeping within the boundaries set by Basel. Already, there are examples of banks constructing transactions more efficiently and developing new structures and products in an effort to draw in liquidity from non-traditional repo market participants with increasing appetites but cautious natures.
Banks are accommodating the search for yield by offering bespoke evergreen or extendable transactions to corporate counterparts but in other respects must collaborate with market infrastructure operators and other service providers as they develop new mechanisms and platforms. Such collaborative efforts range from providing liquidity on electronic trading venues such as MTS’s ACM or Tradition’s DBV-X, adopting the universal Global Master Repurchase Agreement (GMRA) developed by Euroclear as part of its RepoAccess service, and working with central counterparty clearing houses to evolve default rangements and risk-management mechanisms to permit new access models for non-traditional players.
Change can create opportunities for muchneeded dialogue. The need for banks to run more evenly matched trading books under the NSFR has made it harder for their prime brokerage arms to supply liquidity to hedge fund clients. With their traditional maturity transformation role proscribed, a more transparent and constructive dialogue is now taking place between prime broker and hedge fund on how to fund trading ideas cost-effectively.
At a time of many market structure developments as well as regulatory reforms, banks must also investigate the opportunities for greater efficiency afforded to them by TARGET2-Securities (T2S), the pan-European securities settlement system. T2S has only completed its first wave of migration, but as more countries link up, the ability of banks to move collateral around Europe – and in particular the ability to auto-collateralise purchases of eligible securities – could revolutionise their collateral management processes and the way they operate in the repo markets. Similarly, changes to the Eurosystem’s Correspondent Central Banking Model will also offer greater flexibility, which banks will increasingly take advantage of as the new rules and processes are clarified.
The bottom line is that the cost of doing business in the repo market is going up. When commodities prices spike, manufacturers adapt their production processes, pushing their expertise and competitive instincts harder than before. In some respects, this is no different to current developments in the repo markets. Long-term market participants from the sell-side that still have the appropriate client base, product range and strategic profile for repo business, will not quit.
The European repo market faces three big challenges at present – scarce liquidity conditions caused by QE, the global macro-economic conditions that are keeping interest rates low for unprecedented periods, and the new regulatory conditions, stemming from Basel III. While one might argue that the present ‘perfect storm’ will pass, but the biggest of these changes is the most permanent. The Basel effect is only just beginning to play out; the banks that treat it as a permanent part of the landscape will be best positioned to ride out the storm.