Euroland puts its faith in repos

Repurchase agreements (repos) will be the backbone of the new order after European economic and monetary union (Emu). The implications for the debt repo and securities lending markets in Europe are profound. There will be less impact on the nascent equity repo and securities lending markets, those are driven by the search for higher returns.

John Langton, chief executive of the International Securities Market Association (Isma) is bullish about the future of the debt repo market in Europe. "Cedel and Euroclear reckon that half their combined [annual] turnover of $53 to $54 trillion - that's 12 zeros - is repo business. That's half a trillion dollars or so a week," he says. "It's going to be one of the major arms of operating monetary policy in the EU, so it just has to grow and grow."

An established international repo market already exists in London, and it will grow with monetary union. "Over the last six months, repo activity has been focused in German domestic bonds and several liquid domestic bonds in Italy," says Greg Harmon, senior vice-president at State Street Bank & Trust. "The euro will blur some of the lines as participants will be able to deal with each other where before there were fairly clear-cut domestic markets, and the international repo market will become much more liquid."

The new European Central Bank bank will use repos as its main regulatory tool for open-market operations. The government debt of all 11 countries participating in the union will be eligible as tier-one capital and must be accepted by any of the national central banks. Currently central banks accept only their own collateral and their own list of other eligible bonds, but after monetary union, the government bonds of the more debt-ridden countries - such as Belgium and Italy - will be trading in the same tier as France and Germany. Eleven countries will be issuing debt in a single currency. As a result there will be more buyers and a more complete yield curve for market participants to hedge off. Even so, each central bank will have its discretionary list of tier-two capital which is eligible for repo. So certain (non-government) paper may still only be acceptable in its own markets.

It is not yet clear whether the collateral of all 11 countries will trade at the same price in the general collateral market. "Maybe not," says the head of repo at one US bank who does not wish to be named. "Let's say there is a lot of Italian paper and a dearth of German paper. You wouldn't necessarily put German paper into Germany if it were more efficient to finance Italian bonds in Germany. The big question then is whether the Bundesbank would end up with 80% Italian bonds and only 20% of its own. It may not matter, though."

An even more pressing practical matter for debt repo is how collateral will be treated and transferred by central banks. The central banks are trying to move towards a correspondent clearing model whereby the French central bank, for instance, could accept some collateral sitting in an account in Italy. "The European system of central banks wants this to happen and Euroclear wants to play a correspondent banking role," explains Peter Eisenhardt, product manager of repo at JP Morgan. "They are trying to link up, and they will link up, but as yet nobody has the time or money to create perfect and instantaneous communications and links. It doesn't make things worse, but the repo market does have the practical matter of collateral to think about."

At the moment, says Saheed Awan, senior manager of collateral products at Cedel Bank, there are two possible models for collateral management under consideration: one is a hub approach whereby national central banks have accounts with a domestic Cedel Bank depository and every time one of its country's banks wants to draw collateral the agencies are informed to move collateral to that central bank's account so credit lines can be activated. The second is interlinking the national central banks in the European system of central banks with a real-time system that would activate instructions to transfer the collateral via Swift to a payment mechanism such as Target. For obvious reasons, Awan prefers the first option. "It would be cleaner and faster," he says.

US model

The single curve for the euro makes the development of credit trading highly likely. "The repo market in Europe is moving more to the US model," says Harmon. That, he says, is demonstrated by the way in which repo bond dealers are realigning their trading desks, from looking at countries to looking at different parts of the same yield curve.

But at the moment, the move towards a US model is only superficial, some players argue. "Lots of trading desks are already organizing along the yield curve in the same way as the US treasury market - zero to two years, two to four, 10 years and long bonds. But I don't think the repo market itself is going to move that way too quickly," says Eisenhardt. Adds Andy Dyson, repo product manager of fixed income securities at Deutsche Bank: "We maintain as much flexibility as possible, as a lot of the [monetary union] process has been driven by political expediency. We could run our operations in an infinite number of ways, but we are trying to keep a lot of local presence.

"In part it's an issue of general collateral," continues Dyson. "If a small Italian bank, say, clears in Italy and is used to taking BTPs it is hard to say that it will move immediately to clearing [elsewhere]."

Local clearing arrangements bring with them their own problems for investors. For instance, investors who are cash rich may choose to use tri-party arrangements to get around some of the more onerous tasks of engaging in the market. But the principal tri-party products are not in the local markets. General collateral rates must be available in the same day in Euroclear, but if the collateral is in a local market, it will take an extra day to go through the system and that makes it cumbersome to move from one to another. "You may find stipulations written into these deals and you can assume that there may be a slight difference as a result in where things trade," says one repo head. "You can't necessarily say that everything that settles in Euroclear will be at a better rate because many of the domestic markets - such as Italy - are very liquid, but a tiering may emerge." In the longer run, local clearing agents are likely to move to their own automated tri-party arrangements, which will give them a boost.