Since the financial crisis, regulators have pushed the notion of central clearing as a bulwark to financial market stability, but tensions between banks and asset managers over who will provide those big liquidity backstops is a reminder that central clearing counterparties themselves are becoming concentrated centres of systemic risk. Keeping them well-capitalized, funded and secure is not cost free.
The row also highlights escalating tensions specific to the repo market. Regulators have had this market in their sights ever since the sudden withdrawal of secured financing, on which many large financial firms had become excessively dependent in the run-up to 2008, became the new bank deposit runs that tipped them over the edge.
The repo market has been hit from several sides, with the 6% supplementary leverage ratio imposed on large US banks making them much less inclined to extend balance sheet, even in low-risk activities such as lending or borrowing short-term against high-quality collateral. Extraordinary monetary policy measures designed to pump cash into the banks in an effort to promote lending to the real economy have also left high-quality collateral scarcer.
So as the DTCC, pressed by the SEC and the Fed, seeks industry support for its backstop lines, participants in the repo market face an uncertain future.
Many banks have yet to reflect in the pricing and volume of repo transactions the full capital costs of complying even with the 3% leverage ratio and with the net stable funding ratio. When they do, expect already shrunken volumes to fall further and bid-offer spreads to widen more.
Fully costed, on-balance-sheet repo is now deeply unprofitable for banks. In the past, they might have absorbed this unwelcome drag on their margins as a hit worth taking to maintain the FICC market infrastructure from which they could reap plentiful profits. But as earnings fall across FICC, so shareholder pressure mounts to remove such internal cross subsidies.
Since 2012, US money centre banks have cut repo assets by around 10%, while the leading European banks have cut them by 25%.
What if this is just the start? You hardly have to search far in any market to find self-interested sources claiming that uncoordinated regulators have damaged their businesses. But in repo the tone is particularly acute. One industry veteran tells Euromoney a meltdown is coming. Netting may help but he warns that it will be too little too late and that the damage is already done.
Who ultimately will pay the price? Governments fund in bond markets where primary dealers that sell their paper habitually go short in the process. The often-overlooked mechanism that allows them to go long and short is a liquid repo market. If that is damaged, illiquid and expensive to operate in, then so is the cash bond market.