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Euro repos soar to record heights

Repo market | Euro repos soar to record heights Anthony Harrington

In mid-September the Zurich-based International Capital Market Association (ICMA) issued a very significant press release that went almost unnoticed by the mainstream press. According to the latest ICMA-European Repo Council (ERC) survey, the European repo market has bounced back from the lows that followed the collapse of Lehman Brothers, and has now surpassed peak pre-crisis levels.

Repo lending in the European repo market hit almost 6 trillion euros (6,979 billion), an increase of over 25% on the ICMA-ERC survey figure for December 2009, which was 5,582 billion. The previous record figure for the sector was 6,775 billion euros achieved in June 2007 before the financial crisis blew up.

Why is this important? Because one chunk of the repo market is all about banks lending to each other with the borrower bank putting up collateral to indemnify the lender bank in case of a default. Since the credit crisis was all about banks refusing to lend to each other, the return of robust activity in the repo arena should be excellent news for the global economy.  

Repo is also a major way of funding securities purchases. In a classic repo, a dealer buys a government bond outright for cash, then “repo’s” that bond to a lender who advances the dealer the equivalent in cash in exchange for the (temporary) possession of the bond. What makes this different from a sale by the dealer to the lender, is that the dealer agrees at the time of the repo to repurchase (hence the name) that bond from the lender for an agreed sum on a set date.

Since the deal is fully collateralised (the lender has title to the asset while it is in their custody and can sell it immediately if the dealer fails to honour the repo), repo is a much less risky form of lending than an unsecured loan. This has huge regulatory implications since under Basel II, and even Basel III, lenders are assumed to be taking on lower credit risk in a repo deal and therefore they need to hold less regulatory risk capital. As the ERC points out in its “primer” on repo these features have increasingly favoured repo – and fully collateralised lending – over deposit markets, and consequently the last decade saw a huge shift in liquidity from deposit markets to the repo market. 

Precisely because the repo market is such an important source of liquidity to the global debt and derivatives markets, it is critical that the repo market functions smoothly. And this is where things get interesting. In July, ICMA released a working paper on the operation of the European repo market and its weaknesses. The paper addresses the twin issues of short selling and the danger of unintended consequences following from the ham-fisted imposition of new regulations. Basically, anything that interferes with the effective clearing and settlement of repo transactions damages the market.

The authors of the white paper point out that regulators like well collateralised transactions (which is what repos are all about) and governments and corporates all round the world want to be able to make more and more demands on financial markets. But politicians and regulators need to understand that the repo market sometimes offers negative rates of return for perfectly sound reasons (for example, when there is high demand for a particular security and interest rates generally are unusually low). The negative rates, in other words, are not a sign of a dysfunctional market (where it looks like lenders are paying borrowers to borrow cash!) but occur because the repo rate incorporates the fees required to borrow scarce securities.

Because strong demand in the repo market for a particular security often means that a number of hedge funds, for example, are shorting the stock and so need to borrow it, politicians in particular are apt to start shooting at the repo market as somehow blameworthy. The author's response should be educational, if politicians ever paused to be educated:

“Shortselling is a fundamental trading technique which performs an essential function in the financial markets, among other things, supporting market-making in government securities. It is also key to price discovery and the prevention of asset bubbles. The suggestion is periodically made that short-selling is intrinsically destabilising in that it allegedly (more than any other trading activity) exacerbates financial crises by amplifying price falls, fuelling volatility and causing settlement failures, thereby contributing to disorderly markets and threatening financial stability. However, the evidence tends to point the other way. Studies in the equity market have shown that bans on short-selling have been followed by steeper price falls, increased volatility and wider bid-offer spreads."

In other words, markets need shorting to keep stocks honest and to expose flawed business models by betting that an allegedly flawed stock’s current price is unsustainable. If shorters are wrong, they lose their shirts and that is defence enough. Where shorting is deployed as palpable market abuse, there are existing market abuse mechanisms for dealing with this. If this argument is right, then shorting is indeed a proper market tool and it needs the repo market to function. Here again, regulators need to do their homework, understand the markets they are trying to regulate, and they need to proceed with caution…

Further reading on shorting, financial regulation and the repo market:

Tags: derivatives , ICMA , liquidity , negative rates , regulation , repo transactions , repurchase agreements , short selling
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