"It's starving us out." "It's squeezing us dry." "It just doesn't understand our problems." This is what you'll hear if you ask the average German repo-trader what he thinks of the central bank. Next will come the wistful remark: "This market could easily be three times as big."
What so incenses these traders is the Bundesbank's insistence that repos be subject to the same minimum-reserve requirements as sight demand deposits.
In any country, a repo involves an agreement to sell securities immediately and repurchase them later. The party originally holding the securities pays a return to the counterparty to compensate for what is, in effect, a cash loan. In Germany, however, it must also lodge 2% of that loan with the Bundesbank free of interest. According to Michael Braumöller, head of treasury at Salomon Brothers in Frankfurt, this 2% rule is enough to drive business away from Germany. "The minimum reserve creates a cost of 8 basis points [bp]. When I have to forego 8bp, many trades can easily turn into loss-making deals."
About 50 banks claim to engage in Deutschmark repo business, but the leading banks say only about 10 to 15 are genuine
players, and they are doing more and more of their business in London. Some, such as WestLB, are building up London repo operations as quickly as possible. Braumöller estimates that only a third of the $30 billion Deutschmark repo market is based in Germany; the rest is in the UK.
JP Morgan, for example, covers only short positions from Frankfurt, while all repo trading, Deutschmarks included, is handled
from London. Landesbank Hessen-Thüringen (Helaba) does not attempt any repo business in Frankfurt. Deutsche Morgan Grenfell (DMG) now does most Deutschmark repo business in London, where its global repo business is based. "If it weren't for the minimum reserve, we wouldn't have been obliged to go to London with such haste," says Holger Beck, head of repo and securities lending at DMG in Frankfurt. The tactic appears to have paid off however: DMG is now thought to have a third of the Deutschmark repo market.
It is telling that Deutsche Bank board member Rolf Breuer has been a persistent and high-profile advocate of abolition of the minimum reserve. Since the Bundesbank is still so sensitive about Deutsche's regrouping of capital-market and investment-banking activities in London, minimum reserve on repos has become a patriotic issue for some. "This is about bringing money back from abroad," says Torsten Scholz, head of repo at WestLB in Dusseldorf.
Others say that the German market continues to lose importance in relation to London, and that should encourage the Bundesbank to act. "If the Bundesbank abolished the minimum reserve, it would at least have a chance of getting some liquidity back here rather than seeing it go the other way," says Andreas Graser, in charge of repo and securities lending at Commerzbank. "It has nothing to lose."
Workable solution
There is nothing new about the minimum-reserve rule, however. Banks operating in Germany have had to cope with it since the birth of the Euromarkets. And even though the requirement was as high as 12.1% until March 1994, some repo business began to develop in Germany in the early 1990s. This weakens the claim that the minimum reserve is to blame for the state of the German repo market. Bundesbank directors frequently point out that 2% amounts to no more than the working balance a prudent bank will hold.
Several years ago the German banks reached an informal arrangement with the Bundesbank that enables them to get around the minimum reserve most of the time. By lending bonds to its London branch, a German bank establishes a claim on it. It can then repatriate funds from London free of the minimum reserve requirement. Thus funds from London may be drawn on to support a large volume of repo trades in Frankfurt, with only the balance at the end of the trading day subject to the minimum reserve.
The Bundesbank is prepared to condone this "balance arrangement" as long as it is sure the banks are using it only to make repo business possible and not to circumvent the minimum reserve. Some argue, however, that it is one and the same thing.
The reason the Bundesbank clings to the minimum-reserve requirement has little to do with repo business: its real purpose is to contain the volatility of the money market. Nevertheless, traders have been told that the Bundesbank will retain the minimum-reserve requirement until it is sure that banks will not take the opportunity to route deposits through repos instead of the money market. That would take those funds out of the minimum reserve, alter the money supply figures and thus reduce the significance of M3 as the principal indicator for German monetary policy.
"The Bundesbank is between a rock and a hard place," says Oliver d'Oelsnitz, head of government-bond trading and financial innovations at DG Bank in Frankfurt. "On the one hand they want to protect their sovereignty and on the other hand they would like to promote Frankfurt as a financial centre. "Its philosophy on the minimum reserve and repos is that if it ain't broke, don't fix it. But the market has been trying to convince the Bundesbank that [the system] is broke."
Stung by criticism that it does not understand the repo dealers' concerns, the Bundesbank has initiated a voluntary survey of the Deutschmark repo market, as used by German banks. It sent out a questionnaire to dealers in February and March this year asking them for detailed information on the volume of trades with various sets of counterparties; which currencies the deals were in; whether demand for cash or for securities was behind the deals; and where the deals originated. Other questions sought dealers' opinions on developments in the market, evidently attempting to gauge the effects of the minimum reserve.
Defining the problem
One common complaint is that while the Landeszentralbank Hessen (LZB), the Bundesbank's regional branch in Frankfurt, understands the damage done to the local market by the minimum reserve, it does not pass on this information to the Bundesbank proper. It is the LZB which maintains the day-to-day links with the banks and which therefore is more likely to hear their comments on the workings of the market.
The survey is over, but the Bundesbank is still analyzing the answers it received. There is disappointment at the central bank that many banks refused to respond to the survey and concern that it may still not provide sufficient clues about changes in the flow of funds from money market to repo market if the minimum reserve on repo is lifted. Indeed, Bundesbank sources hint that the onus is now on the banks to prove that the minimum reserve damages German-based repo business.
Since Hans Tietmeyer, the Bundesbank president, is lobbying for the planned European Central Bank to use a minimum-reserve requirement for all deposits, it would be extremely unlikely for the Bundesbank to abolish it, even partially, at this stage. Nevertheless, some German repo traders are confident that Tietmeyer will exempt repo business within a matter of months.
In theory, liquidity should then flow back to Frankfurt, Dusseldorf and Munich. At present, the minimum reserve depresses yields on repo business by between 6bp and 8bp, depending on the maturity of the paper, traders say. If and when it is lifted, Frankfurt repo prices will be about the same as London's. Since half of all Deutschmark-denominated bonds are placed in Germany, argues d'Oelsnitz of DG Bank, there is potential for repos to be repatriated. "The market is where the cash is."
But, others suggest, there will still be little interest within Germany, where most counterparties are cash providers such as banks. Most demand comes from German institutions looking for "specials". They usually find them outside Germany.
German corporates are so rich in cash that they find it impossible to place as much cash as they would like in exchange for repos; moreover with the minimum reserve, "we're not in a position to offer a reasonable price to the corporates", says Scholz of WestLB.
Germany's universal banks are also cash providers, since they can coordinate their cash and securities portfolio without having to do deals with outside institutions. "If the market is short of securities, we can simply take them out of inventories at our trust bank," says Matt Keller, global head of repo at DMG. The German universal banks which have no trust bank typically deal with investment bank counterparties in London.
Learning curve
It is indicative that the balance arrangement, which was supposed to cancel out the disadvantages of the minimum reserve, has been in place for several years without luring repo users back to Germany. A Frankfurt trader argues that the balance system does not entirely make up for the minimum reserve, as there is the cost of doubling up with traders in London, plus tax disadvantages. All in all, repo trading is still more expensive than it need be, he says.
If and when the minimum reserve does fall, the cash-rich German corporates will come under pressure from the banks to return to their German "house banks". But those banks will have to begin their marketing efforts from scratch. Since they have been unable to take cash in domestic repo deals for so long, links have been severed. A senior treasurer at a large Munich-based corporate says he does no repo business at all with German banks, mainly because of their lack of expertise. He goes straight to bulge-bracket firms in London. The same story can be heard from bankers. DMG's Keller says that settlement problems and lack of expertise are the main problems in the German market (see box opposite).
The removal of the minimum reserve will also mean tough decisions for Germany's universal banks. Until now, Germany's 3,000 mostly tiny savings banks and credit unions have shown little interest in repos. The Landesbanks manage liquidity for the savings banks, while DG Bank fulfils the same function for the credit unions. Scholz of WestLB says that so far it has not been a priority for his department to acquire repo business from the savings banks, since that would presumably be at the expense of WestLB's treasury department.
But when the EU's capital-adequacy directive becomes law in Germany by the beginning of next year, these small banks too will have to back their positions in securities with equity capital.
Secured products
That is a reason to avoid using capital for refinancing and to do secured business as much as possible. Previously, banks engaged in unsecured securities lending, but they are now keen to use instruments, such as buy-sellbacks (where the bank provides cash to buy securities), which use up less capital.
"The repo business is bound to increase due to the need for banks to move their trading into secured products," says Braumöller of Salomon.
At the same time, local banks are experiencing a fall in cheap deposits, as customers abandon their savings books in favour of higher-yielding investments.
Treasury departments may find themselves competing with fixed-income departments, which usually take responsibility for repo business at German institutions. Already, internal controllers are putting pressure on traders to identify the best refinancing rates offered in the entire market. "When the controllers confront traders with the cost of capital, that will be the day when things change," says d'Oelsnitz of DG Bank. Walter Kraushaar, DMG's head of equity repo trading, confirms that change is happening gradually at DMG in Frankfurt.
If the lifting of the minimum reserve does enable German banks to offer competitive rates to more counterparties, the result will naturally be more competition, not just within institutions, but throughout the market.
DMG's Beck concludes that margins will get narrower for everyone. The typical margin on a Deutschmark repo deal, he says, is already down to 5bp and falls to as little as 2bp in "very competitive situations".
Nevertheless, German institutions will have to undercut London-based firms if they hope to snatch business back. "If prices [in Germany and London] become the same after the abolition of the minimum reserve, then everyone will have to stay in his own market," says Beck. A price war seems inevitable.
If that's what changing the minimum-reserve requirement leads to, German bankers may wonder why they bothered.
Settlement joins the migration It was no coincidence that Rolf Breuer, a Deutsche Bank board member but also chairman of the German Stock Exchange (Deutsche Börse), chose a recent stock exchange event to renew criticism of the minimum reserve requirement. Deutsche Börse, too, is upset that the minimum reserve is robbing its settlement house Deutsche Kassenverein (DKV) of a huge volume of bond settlement business.
According to DKV's chief executive Jörgen Blitz, the minimum reserve requirement on German repos is to blame for the fact that DKV settles only a minority share of the Deutschmark-denominated bond market. Because the German repo business has been transferred to the Euromarkets, argues DKV, its arch-rival, Euroclear, now owes 60% of its Deutschmark bond settlement volume to the repo business.
Although the vast majority of equities repos denominated in Deutschmarks are still settled through DKV; that is small comfort because the fixed-income market involves much larger volumes.
Blitz hopes that price competition will help and says that he has succeeded in reducing settlement prices to a lower level than rival settlement houses.Yet market participants argue that a critical mass is more important. "Even if DKV offered settlement for nothing, the market wouldn't automatically go there," says Holger Beck, head of repo and securities lending at Deutsche Morgan Grenfell in Frankfurt.
According to Beck, even a big market player such as DMG is not powerful enough to dictate where the market will do its settlement business by leading the way to one or another settlement house. So like others, DMG splits its Deutschmark settlement business between Euroclear and DKV to reflect the division in the repo market.
Perhaps wisely, Blitz is not waiting for the Bundesbank to remove the minimum reserve in order to see a surge in settlements activity. Instead, he believes that most of the potential for new business will eventually come from the 40-odd institutions that trade remotely on the Deutsche Börse and DTB - the German derivatives exchange - via access points in London, Paris, Amsterdam, Zurich and New York. Remote dealers on Deutsche Börse's IBIS electronic trading system have an automatic link to DKV and can settle trades on DKV's Cascade system using the same terminal.
But the catch is that DKV users must also have an account at one of the Landeszentralbanken, the regional branches of the Bundesbank, and an account is granted only to banks and brokers which have a functioning back office in Frankfurt or another German city.
That explains why German institutions can settle via DKV (even if the trades are done in London) but foreign institutions without a Frankfurt operation may not. "That will change at the very latest when we have a single currency," says Blitz.
But some traders say nothing will change as long as the repo business suffers from a lack of settlement efficiency, both at DKV and at its foreign competitors, Cedel and Euroclear. While the DKV can offer real-time settlement for trades between two DKV users, same-day settlement against cash on a routed order is still not possible.
Blitz promises that by the end of this year, DKV will have installed a new delivery repo system allowing both sides of a repo deal to be done with a single order, with the report issued before maturity and a re-purchase order generated automatically on the agreed return date. At a later stage, DKV will introduce tri-party repos, which are already a strong source of new business at Euroclear. Compiled and written by Katharine Morton |