In a report published by the Committee on Payment and Settlement Systems (CPSS), central bankers discuss issues related to the clearing and settlement infrastructure for repos that have the potential to affect the repo markets, and recommend that stakeholders in each market review options to further strengthen the clearing and settlement infrastructure in this huge non-transparent shadow banking system.
“The report concludes that it is worthwhile for the stakeholders in each market to review how the clearing and settlement arrangements for repos could be further strengthened.”
Bank of International Settlements
The report – “Strengthening repo clearing and settlement arrangements” – presents a comprehensive survey of the clearing and settlement arrangements for repos in selected CPSS member countries. In particular, it sheds light on the experience with these arrangements during the financial crisis.
The analysis shows that repo clearing and settlement arrangements vary considerably across countries and markets.
Due to the substantial variety in repo clearing and settlement arrangements, the identified issues are not relevant to the same extent in each market, the BIS says in a statement.
The report identifies several issues related to clearing and settlement arrangements for repos that have the potential to affect the resilience of repo markets.
(For example; the risks related to the extension of significant amounts of intraday credits within some repo settlement arrangements; the lack of transparency of some repo infrastructure roles, responsibilities, practices and procedures; concerns regarding the protection against counterparty credit risk in repo transactions; and inadequate capabilities for liquidating repo collateral in the event of a cash borrower’s default).
The report has been prepared for the CPSS by a working group consisting of representatives of central banks that are CPSS members plus the Central Bank of Luxembourg, led by Andy Sturm of the Swiss National Bank.
Based on experiences from the recent financial crisis, the working group was commissioned by the CPSS to investigate the extent to which the clearing and settlement arrangements for repos – the practices, procedures and systems used for clearing and settling repos and liquidating a defaulting cash borrower’s collateral – contributed to the instability evident in some repo markets.
On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds.
The Central Bank’s Playground
The over-the-counter repo market is now one of the largest and most active sectors in the US money market, and the largest users of repos, and reverses, are the dealers in government securities.
As of June 2008 there were 20 primary dealers recognized by the FED, which means they were authorized to bid on newly-issued Treasury securities for resale in the market. Primary dealers must be well-capitalized, and often deal in hundred million dollar chunks.
In addition there are several hundred dealers who buy and sell Treasury securities in the secondary market and do repos and reverses in at least one million dollar chunks.
The balance sheet of a government securities dealer is highly leveraged, with assets typically 50 to 100 times its own capital. To finance the inventory, there is a need to obtain repo money in large amounts on a continuing basis.
Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks.
Generally the alternative of investing in securities that mature in a few months is not attractive by comparison. Even 3-month Treasury bills normally yield less than overnight repos.
Repos are widely used for investing surplus funds short term, or for borrowing short term against collateral. Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways.
The US FED, and other central bank,s uses repos to manage the aggregate reserves of the banking system.
Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan against collateral.
The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration but are most commonly overnight loans. Repos for longer than overnight are known as term repos.
There are also open repos that can be terminated by either side on a day’s notice.
In common parlance, the seller of securities does a repo and the lender of funds does a reverse. Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent depending on maturity.
The overnight repo rate normally runs slightly below the FED funds rate for two reasons:
Firs;t a repo transaction is a secured loan, whereas the sale of FED funds is an unsecured loan.
Second; many who can invest in repos cannot sell FED funds. Even though the return is modest, overnight lending in the repo market offers several advantages to investors. By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk.
They also incur very little credit risk because the collateral is always high grade paper.
A securities dealer must have an account at a clearing bank to settle his trades.
For example; suppose company X has $20 million to invest short term. After negotiating the terms with the dealer, ABC has its bank wire $20 million to the clearing bank. On receipt, the clearing bank recovers the funds it loaned the dealer to acquire the securities being sold, plus interest due on the loan. It then transfers the sold securities to a special custodial account in the name of X.
The next morning the dealer repurchases the securities from company X, pays the overnight interest on the repo, and regains possession of the securities.
Assuming a 5% repo rate, the interest due on the $20 million overnight loan would be $2,777.78, which is based on a 360-day year. If both parties agree, the repo could be rolled over instead of paid off, thus providing another day of funds for the dealer and another day of interest for the speculator (company X).
Necessary to the repo market, just as in the private loan system, the existence of a discernible amount lended against the market value of the collateral pledged.
This difference between the market value and the collateral pledged is called a “haircut”.
Fixing The Balance
A dealer who holds a large position in securities takes a risk in the value of his portfolio from changes in interest rates. Position plays are where the largest profits can be made.
However, many dealers now run a nearly matched book to minimize market risk. This involves creating offsetting positions in repos and reverses by “reversing in” securities and at the same time “hanging out” identical securities with repos. The dealer earns a profit from the bid-ask spread.
Profits can be improved by mismatching maturities between the asset and liability side, but at increasing risk.
As dealers move from simply using repos to finance their positions to using them in running matched books, they become de facto financial intermediaries.
In borrowing funds at one rate and re-lending them at a higher rate, a dealer is operating like a finance company, doing for-profit intermediation.
Clearing banks charge a fee for executing dealer transactions. They prefer not to issue large dealer loans because it ties up the bank’s own reserves at little profit.
But the truth is; there is not enough capacity in all of the clearing banks in New York to provide dealer loans sufficient to cover the financing needs of the large securities dealers.
Non-Transparent Shadow Banking
The enormity of the repo market is rumored to be as large as 10 trillion dollars, but this can not be confirmed as no regulatory agency controls the market.
This market is considered a part of the so-called “shadow banking” system, the large “dark pools” of liquidity that no one knows who owns or who’s using them. However, it’s a pretty good guess that the major global financial institutions is the main operators, often through their hedge funds and other Special Purpose Vehicles (SPV).
In the last couple of years, the repo agreements have also played an important role in the central bank’s quantitative easing policy.
The report from CPSS outlines options and measures through which several of the issues mentioned above can be addressed.
The report concludes that it is “worthwhile” for the stakeholders in each market to review how the clearing and settlement arrangements for repos could be further strengthened.
As a first step, the report suggests that the providers of such arrangements in each country should, jointly with market participants, regulators and the central bank, attempt to develop a common view on the relevance of the identified issues for their market.
As a second step, according to the report, could be that each provider evaluate which measure or combination of measures would be best suited to address the relevant issues in its specific circumstances.
In sum; the report provided by the central bankers suggest that the the central banks, and their primary dealers, should make up their own suitable rules.
Damn, it feels good to be a banka!
Here’s a copy of the full report:“Strengthening repo clearing and settlement arrangements”
Related by the Swapper:
- European repo market grows to record 7 trln euros (reuters.com)
- More mystery in quarterly repo patterns (ftalphaville.ft.com)
- Home Repos Hit Recession High (newser.com)
- European repo is back from the dead, says ICMA (ftalphaville.ft.com)
- The largest arbitrage ever documented (ftalphaville.ft.com)
- NY Fed accepts $225 million MBS for reverse repos (reuters.com)