Global repo market reform going nowhere fast
Regulation of the global repo market is inching closer – particularly in the US – but is hindered by a lack of consensus on how to proceed internationally, as well as the oft-touted concerns about the impact on credit flows to the real economy.
Blink and you might have missed it: prudential authorities in the US and Europe have been examining ways of regulating repurchase contracts since the 2008 financial crisis, for which some have claimed a “run on repo” was responsible. Proposals range from improving transparency by collecting better data, particularly on leverage, to the highly controversial idea of changing bankruptcy laws to remove the exemption on securities provided as collateral.
The Financial Stability Board (FSB) has been leading the international effort tasking work-streams to analyze current repo practices and potential risks, as well as gaps in regulation, and come up with macro-prudential requirements.
Interim policy recommendations centre on moving repos and securities lending transactions to trade repositories, and clearing these trades through central counterparties.
Specifics include minimum margin or haircuts for securities where the repo is for financing purposes to mitigate pro-cyclicality by limiting the build-up of leverage in the financial system.
The FSB also wants to see improvements to market practices such as margin maintenance.
The European Commission is considering requiring that repo transactions be reported to a trade repository in line with its treatment of OTC derivatives.
Complicating matters is central bank policy, which has seen the Fed and ECB bolster a faltering repo market with liquidity provision – the Fed through its asset purchases and the ECB through its open-market operations.
There is also the risk of undermining financial set-piece regulation including Basel III, EMIR and Dodd-Frank, which seek to reinforce and extend the use of collateralization as a way to hedge credit and liquidity risks.
“The whole regulatory framework is built on collateralization, but regulators have a very ambiguous attitude to collateral,’’ says Richard Comotto, senior visiting fellow at Reading University.
“On the one hand they see it as an important foundation for financial stability. On the other hand they are concerned by what they see as some of the new risks that it introduces. So the overall impact is that there will be greater use of collateral, but it will be more expensive to use collateral.’’
Given regulators’ recognition of the vital role repo markets fulfil, they need to be mindful of distorting the relative pricing advantage of secured over unsecured funding, warns Comotto.
“The question is how much of the risk of another financial crisis can be factored into normal market pricing without having an undesirable impact on the financing of the real economy.’’
Fed chairman Ben Bernanke has repeatedly expressed concerns about a lack of transparency in the repo and secured lending markets generally.
He is worried that without good, comprehensive data, regulators lack the ability to spot the development of asset bubbles.
The FSB hopes its proposals will establish some globally uniform standards for transparency for repo transactions.
However, critics warn that the one-size-fits-all approach is flawed because of differences between the US and European markets.
The majority of the collateral used in the US and European repo markets is government or agency securities, according to figures from the International Capital Market Association. Government securities are higher-quality collateral and therefore subject to smaller haircuts by lenders.
However, the US has prioritized reform of its $2 trillion tri-party repo sector – where collateral is managed by a third party – because of its size and the critical role it plays in creating market liquidity and price transparency for US government and corporate securities. By contrast, tri-party repo only accounts for about 12% of the European market.
As most US repos are one-day, the Fed is keen to reduce tri-party participants’ reliance on massive intraday credit carried entirely by two New York clearing banks.
The US is looking at the European practice in which securities returned to borrowers for use during the trading day are substituted with other securities.
One-day repos, by their nature, render margin maintenance redundant in the US market, but are a practical safeguard in Europe with its broad range of repo maturities.
“Shadow banking regulation is extremely difficult because there are all sorts of different national interests, so it’s going to be difficult to come up with a global regulatory proposal,’’ says Barney Reynolds, partner at Shearman & Sterling.
“I’m not convinced the repo market requires anything beyond the Basel rules and Dodd-Frank. But if there is regulation it needs to be harmonized across the Atlantic – look at all the problems we’re having with derivatives.’’
Reynolds says while it has been five years in the making and some of the momentum has gone, he is convinced there will be reform on shadow banking, but it will take time to reach agreement internationally.
“It’s critical that it’s harmonized because it’s a totally new area of regulation and if you have no regulation in one country and some in another of the same activity, it will be a complete mess.
“With the repo, it’s not clear what consensus there is as to what to do at all and that needs to be sorted out before any rules are drafted.”
He concludes: “Momentum will build. I wouldn’t mistake the silence for inaction. Things are happening but the momentum has slowed in terms of regulatory reform and we’re getting down to the finishing touches, and it’s going to get harder and harder to get major propositions through.”