Contributing factors to the current situation in repo market Let me now review some medium to long-term trends contributing to the current situation in the repo market, affecting both the supply and demand of collateral. It should first be noted that the repo market has seen a reduction in its role for funding, also due to the excess liquidity injected and the securities absorption implied by APP. On the supply side, the availability of high-quality collateral is inevitably pro-cyclical. From a pure economic view point, the financial crisis, its length, rising debt levels and rating downgrades to sovereigns reduced the amount of available assets that are considered ‘safe’, particularly for non-banks (although regulators treat all sovereigns as risk-free). This is most easily visible in the current clustering of GC collateral rates by country of issuer, which was largely absent prior to the crisis. On the demand side, the evolution of prudential regulation has affected the repo market. A number of features, which have in principle been known since the reform of Basel III in 2010, are still being phased in and directly affect banks’ participation in the repo markets, particularly the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). A third measure – the leverage ratio – is now subject to reporting requirements, but there is not as yet an agreed international regulatory standard. The LCR requires banks to hold sufficient high-quality liquid assets (HQLA) to cover projected net cash outflows.
Given the higher relative penalty given to holding sovereign bonds under the leverage ratio as opposed to the capital ratio, it is expected to increase the cost of banks’ repo, and reduce incentives for money market arbitrage and market making.2 Reduced incentives for arbitrage and market making in turn affect market liquidity and can lead to greater periods of uncertainty. Furthermore, since European banks are required to report average month-end positions, there are increasing signs of market stress at month-end dates. The leverage ratio contains provisions for netting of offsetting cash positions when they are with the same counterparty and settled through the same system. This has resulted in a much greater use of central counterparties (CCPs). The use of CCPs has been strongly supported by authorities and brings benefits in terms of smooth market functioning, as well as for individual institutions. Eurosystem contacts report a wide difference in the pricing of trades cleared bilaterally and those cleared through CCPs – sometimes in the tens of basis points. CCPs, however, are also important for repo markets for a different reason. The increased volume of derivative trades centrally cleared at CCPs due to new regulations such as EMIR, as well as sporadic bouts of volatility, means that those institutions tend to hold significant quantities of cash. Placing that cash as unsecured deposits would represent wrong-way risk for CCPs as the collapse of a significant financial institution would create significant market volatility at the same time as potentially the loss of some of the unsecured deposits.