The Big Picture
We all know that Basel III has imposed new costs that limit the capacity of traditional sell-side participants. But, corporates rarely seem to discuss the appeal of a more multilateral repo market to new participants, especially large corporates.
Having grown largely in response to the short-term funding needs of banks, which would lend out securities on agreed terms in return for cash, the repo market has been thrown into crisis and contraction by Basel III (e.g. the leverage ratio on balance sheet assets).
Indeed, a recent report from the International Capital Market Association’s European Repo Council on the future of repo was ominously titled: “Perspectives from the eye of the storm”. At the same time, concerns about counterparty credit risk and expected changes to the regulation of money market funds have placed corporate treasurers on alert for cash management and short-term investment alternatives.
To delve deeper into the evolving motivations of repo market participants, Euroclear invited corporate representatives and other banking experts to a Corporate Treasurer Workshop at its London offices in April 2016. Gösta Feige, Director, Product Solutions, Collateral Management at Euroclear, opened by highlighting the experiences of existing corporate participants, the shifting priorities of banks, and the appetite of potential users.
What the active corporates say
It was clear that the two corporates speakers differed in their use of repo. InterContinental Hotels Group (IHG) pays down bank debt with its excess cash and therefore only has surplus to invest periodically once bank debt has been fully repaid. AstraZeneca does so with regularity.
So why have both recently opted for triparty repo, a secured lending option over traditional unsecured options, such as bank deposits or Money Market Funds (MMFs)? In each case, security played as much of a role as yield, if not more so.
Cash-rich AstraZeneca moved to reduce, but not eliminate, its reliance on unsecured cash deposits and MMFs in the aftermath of the financial crisis and started actively exploring triparty repo three years ago.
IHG, which historically used cash surpluses to pay down debt or pay dividends, looked for new, secure options to invest surplus cash following a major asset sale in 2014. According to Group Treasury Manager Bert Heirbaut, IHG was drawn to the high levels of security provided by taking AAA-rated paper issued by governments and supra-national agencies as collateral for cash placed with trusted relationship banks.
Like AstraZeneca, the firm preferred triparty rather than bilateral participation, largely for operational reasons, opting for the support a triparty agent to manage the selection, valuation, settlement and custody of collateral.
AstraZeneca Treasury Manager Peter Walker-Smith also mentioned the benefits of flexibility in collateral selection as well as the detailed reporting on collateral valuation. By accepting a slightly wider, albeit still investment-grade, collateral set they can pursue greater yield opportunities.
Conversely, some new entrants, like IHG, limit their collateral to AAA-rated government bonds and bonds issued by supra-national agencies. This is inline with their risk appetite and familiarity with repo. However, they can still benefit from yield pick-up compared to the zero-to-negative rates on cash deposits.
According to Walker-Smith, AstraZeneca is willing to consider a range of ratings and terms, using a triparty service to help evaluate opportunities (although very much with an emphasis on its group of core relationship banks), including a matrix that increases the required haircut as the rating declines.
What the experts say
The increased demand for longer-term (3-6 month) and evergreen repo transactions noted by active corporate treasurers reflects changing dynamics on the sell-side, particularly Basel III’s Liquidity Coverage Ratio and Net Stable Funding Ratio.
Higher capital charges attracted by inter-bank lending under Basel III versus borrowing from non-financial institution sources has driven bank appetite for borrowing cash from corporates, especially over the past six months, according to one of the banking experts.
This, and a more general desire by banks to diversify funding counterparties, offers corporates such as AstraZeneca the opportunity to achieve precious incremental increases in yield, in return for a wider range of collateral or a longer time commitment.
In the experience of another of the experts in attendance, the response to this upsurge in banks’ demand for cash from corporates has been informed by individual firms’ risk appetites, with some preferring a very conservative collateral set. Meanwhile others are willing to take on unrated paper, often regarding the rating of their counterparty as a sufficient risk mitigant.
Some unanswered questions
A number of corporates expressed uncertainty about how they would liquidate collateral (to get their cash back) should a counterpart default on a repo transaction.
While holders of collateral will inevitably be better placed than unsecured creditors should a counterparty default, holders of higher-rated collateral should find it relatively easy to liquidate their positions in a worst-case scenario.
Sell-side participants at the workshop advised corporates to speak to their relationship banks about how they could liquidate the collateral they hold were such an event of default by a counterparty to occur.
Other service providers also noted the increased availability of workflow tools to triparty market participants to provide greater transparency on the yields offered for different collateral baskets, the change in value of collateral, as well as compatibility of collateral with eligibility criteria and concentration limits.
Throughout the Euroclear corporate workshop, the development of new tools, the increasing range of service innovations in the triparty space and the secular shift in bank appetites suggest a change in climate the repo market.
In broadening their cash management and investment alternatives, corporates are still finding their way in repo, but they are also finding their feet with the help of bank counterparties and service providers. They are even finding a range of options that meet their specific needs.
With further dialogue, predictions of a more diverse, multilateral repo market will be realised, sooner rather than later.