Repos in the post-regulated world: What can we expect?
Posted by Val Srinivas, Banking & Securities research leader, Deloitte Services LP, on October 8, 2013
The repo market is not likely to be described as an exciting place, except of course when it doesn’t work the way it’s supposed to. Some might contend that it’s a pretty staid business. When a financial institution needs money – be it a big broker-dealer or a small investment shop – it can sell securities it owns to another institution for cash, with the commitment to repurchase at a later date. In other words, repos, or repurchase agreements, are just another type of collateralized loan, with the lender making money through the “haircut” – i.e., the difference between the initial sale price and the repurchase price.
Such activities, boring as they may seem, are a critical underpinning of the modern financial system. Trillions of dollars are exchanged in repo transactions every day, accounting for a significant source of short-term funding for banks and broker-dealers. The total value of outstanding repo contracts in the United States alone is more than $4 trillion.1
And when such an important part of capital markets has even a slight hiccup, as witnessed during the economic turmoil in 2008, it can lead to serious systemic problems.
According to some observers, among them Professor Gary Gorton of Yale University, the most potent roots of the crisis flourished in the repo world.2 As fear gripped the markets and trust became scarce, counterparties demanded higher haircuts or didn’t accept certain types of collateral at all and, in more serious instances, simply refused to lend money to some, fearing they might never see their cash again.
It is precisely for this reason that regulators wishing to prevent another such market failure have been looking to bolster industry practices. For instance, in 2012, the Tri-Party Repo Infrastructure Task Force sponsored by the Federal Reserve Bank of New York made a few recommendations, including “steps to reduce the risk that a dealer's default could prompt destabilizing fire sales of its collateral by its lenders.”3
And more recently, the Financial Stability Board (FSB), under the broader initiative to strengthen oversight and regulation of the shadow banking system, published policy frameworks to address risks in the securities-lending and repo markets.4 Both these markets are considered by many to be part of the shadow banking world because they perform bank-like functions – converting short-dated liabilities into longer-term assets through maturity and risk transformation – without the protection of insurance or access to central-bank liquidity.
In its latest document released on August 29, 2013, the FSB recommends a number of policy frameworks, covering transparency, data collection, rehypothecation, cash collateral reinvestment, bankruptcy treatment and even minimum haircuts for non-centrally-cleared transactions. In other words, the FSB is trying to change a number of things in the securities financing world. Suffice it to say there is a fair bit of uncertainty as to how all this might play out.
But this is not all the repo market has to contend with. New leverage ratios proposed by U.S. banking regulators, changes to capital structure required of foreign banking organizations (FBOs) in the USA, Basel III capital requirements and the new Financial Transaction Tax proposed by the EU, are the other major issues clouding the regulatory path in the repo world.
All these changes, if implemented, have the potential to reshape the repo market. And what’s more, they are likely to have consequences for short-term funding and the broader financial system. You might say the repo world has suddenly become an interesting place!
Determining exactly how new regulations will influence the repo market is, of course, not possible. What is possible is the fact that at least some of these may have a dampening effect. The lessons of history suggest that applying too many brakes to any financial vehicle is likely to result in a slow-down in demand. And slowing things down too much in the repo market might not be a good idea, as repos are just too critical for the smooth functioning of the financial system. It’s not to say that risks in repo world should not be controlled, but going too far in the other direction should likely be a very real concern to regulators and to the broader industry as well.
What do you think? How will the proposed regulations affect the functioning of the repo market? And how should market participants prepare to respond?
1Jim Brunsden and John Glover, “EU Said to Weigh Curbs on Collateral Asset Reuse in Repos”, Bloomberg, August 22, 2013.
2Cardiff Garcia, “Misunderstanding financial crises, a Q&A with Gary Gorton”, FT Alphaville, October 25, 2012.
3Federal Reserve Bank of New York, “Statement on the Release of the Tri-party Repo Infrastructure Reform Taskforce’s Final Report”, February 15, 2012.
4Financial Stability Board, “Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos”, August 29, 2013.