Under pressure
10 January 2017
Experts debate the likely effect of monetary policy on repo markets
Image: Shutterstock
With the European Central Bank committed to continuing its asset purchase programme until December 2017, what is your prognosis for the health of the European repo market over the next 12 months?
Godfried De Vidts
Chairman
ICMA European Repo and Collateral Council
The asset purchase programme is only one of many ingredients that markets need to keep in mind in 2017. Untangling its specific impact is difficult, but the day-to-day strains seen in repo markets make plain the pressure on this product. Another facet of quantitative easing is negative rates, hence the difficulties for banks, and repo markets, to make cash work. Both elements may continue to undermine the repo market’s capacity to prove an automatic stabiliser in future systemic stress situations.
The flood of regulations has certainly created unintended consequences. In recent weeks, the buy side has voiced concerns about the lack of sell-side market making, a function the buy-side will never itself replace.
Positively, the professional repo community has worked diligently through the International Capital Market Association’s European Repo and Collateral Council, providing a pragmatic market response to the spate of new challenges. The participation of buy-side firms, which is expected to increase, will help to find further ways forward in 2017 and beyond.
Discussions with the official sector, whether central banks or regulators, focus on the clear evidence of balance sheet rationing and idiosyncratic pricing that may force policymakers to reconsider some of the new regulation. The capital markets union offers a chance to establish a well-regulated yet dynamic market. Appropriate re-calibration of this DNA of modern financial markets is essential to efficient capital allocation.
David Lewis
Senior vice president
FIS Astec Analytics
By continuing the asset purchase scheme until the end of 2017, and potentially beyond if the inflation requirements have still not been met, the asset purchase programme will continue to starve the repo market of much-coveted high-quality liquid assets. At present, it is said that together, the European Central Bank and the German Federal Bank own more than a quarter of German government debt.
High-quality assets such as these are increasingly sought after as new capital and liquidity regulations make their presence felt, with the potential for costs to rise as supply dwindles. Some data is already showing rates triple those from a year ago. Adjustments to the programme, such as accepting cash collateral, are being made, but they may be too little to make a beneficial impact.
Alternatives may also be under pressure. In the US, investors are said to have moved $1 trillion from credit focused money market funds into government debt funds, further restricting access to high-quality bonds.
Nerin Demir
Head of repo and securities finance
SIX
The continuation of the asset purchase programme until December 2017 will further weaken the European repo market as the scarcity of good collateral will persist the longer the European Central Bank’s asset purchase programme is extended at the same level as before. High-rated bonds will become more expensive and with increased failures to deliver, further pressure is expected in the European repo market.
A widening of the European Central Bank’s collateral policy for securities lending may alleviate some of the pressures on the collateral side but those discussions are ongoing.
Furthermore, US dollar repo versus top-grade high-quality liquid assets may well see some upside with the recent upward interest rate movement in the US by 0.25 percent. This will create a positive effect with further rate rises expected in 2017.
Mick Chadwick
Head of securities finance
Aviva Investors
The market has become accustomed to negative repo rates. The revised terms of the European Central Bank’s securities lending facilities, announced in December, should in theory be an aid to market liquidity, particularly the flexibility to use cash rather than securities as collateral.
Having said this, repo capacity for institutional clients is likely to remain constrained due to the continued pressure on bank balance sheets as a result of regulation. This will likely lead to greater buy-side engagement with alternative routes to market such as central counterparty models and peer-to-peer trading platforms.
Rob Kidman
Vice president, agency trading
State Street
The December announcement from the European Central Bank that quantitative easing would be extended at a lower level of €60 billion to the end of 2017 continues to weigh on the repo market, although some relief to German specials is expected. The European Central Bank also announced that central banks would be able to conduct securities lending versus cash collateral rather than general collateral. This is clearly aimed at alleviating the collateral shortage that has inhibited specials being borrowed from central banks.
Demand for German government bonds is expected to remain strong while some cheapening versus EONIA (Euro OverNight Index Average) is likely given the €50 billion limit on cash borrows set by the European Central Bank. Collateral shortages still remain, however, and the cost of short-dated repo for borrowers is also a hindrance for money market funds that still need to manage short-dated liquidity.
Regulatory requirements for the net stable funding ratio continue to see demand for longer termed repo, but to what extent the new measures will cheapen general collateral out to one year is unclear as other factors, such as balance sheet and the availability of high-quality liquid assets, are still likely to attract a term premium.
Michael Huertas
Associate and solicitor
Allen & Overy
As the asset purchase programme runs its course in 2017, we would imagine that the European Central Bank, and the relevant eurosystem national central banks, may make further amendments to the securities lending programme’s rules to bolster actual and perceived liquidity in bond markets. This might also serve to further discourage any hoarding mentality that had crept into certain parts of eurozone bond markets as a result of perceptions of the asset purchase programme’s distorting impact.
Going forward, the securities lending programme could continue to be tweaked on multiple fronts. In the short-term this might include changes to pricing and haircuts, which are relatively simple but nevertheless may still not be sufficient to fully dispel gripes that European Central Bank pricing is ‘expensive’. Other more longer term changes, such as the European Central Bank and the national central banks accepting broader collateral (beyond what they already do in their other activity), or using a wider set of contractual documentation in securities lending programme activity, may take a longer time to implement.
Consequently, as the asset purchase programme continues to change, we might also see a rebalancing of national central bank-led, ie, decentralised, securities lending programme activity becoming more centrally coordinated by the European Central Bank. As currently one of the largest collateral takers and institutional investors, the European Central Bank is also likely to need to be receptive to solutions that have existed since the onset of the financial crisis to build sustainable collateral pools offering liquidity and transformation services to meet demands driven by regulatory and economic factors.
Given all that 2017 is likely to have in store, we would also imagine that there may be a higher degree of receptiveness to engage with concerns of the market.
Godfried De Vidts
Chairman
ICMA European Repo and Collateral Council
The asset purchase programme is only one of many ingredients that markets need to keep in mind in 2017. Untangling its specific impact is difficult, but the day-to-day strains seen in repo markets make plain the pressure on this product. Another facet of quantitative easing is negative rates, hence the difficulties for banks, and repo markets, to make cash work. Both elements may continue to undermine the repo market’s capacity to prove an automatic stabiliser in future systemic stress situations.
The flood of regulations has certainly created unintended consequences. In recent weeks, the buy side has voiced concerns about the lack of sell-side market making, a function the buy-side will never itself replace.
Positively, the professional repo community has worked diligently through the International Capital Market Association’s European Repo and Collateral Council, providing a pragmatic market response to the spate of new challenges. The participation of buy-side firms, which is expected to increase, will help to find further ways forward in 2017 and beyond.
Discussions with the official sector, whether central banks or regulators, focus on the clear evidence of balance sheet rationing and idiosyncratic pricing that may force policymakers to reconsider some of the new regulation. The capital markets union offers a chance to establish a well-regulated yet dynamic market. Appropriate re-calibration of this DNA of modern financial markets is essential to efficient capital allocation.
David Lewis
Senior vice president
FIS Astec Analytics
By continuing the asset purchase scheme until the end of 2017, and potentially beyond if the inflation requirements have still not been met, the asset purchase programme will continue to starve the repo market of much-coveted high-quality liquid assets. At present, it is said that together, the European Central Bank and the German Federal Bank own more than a quarter of German government debt.
High-quality assets such as these are increasingly sought after as new capital and liquidity regulations make their presence felt, with the potential for costs to rise as supply dwindles. Some data is already showing rates triple those from a year ago. Adjustments to the programme, such as accepting cash collateral, are being made, but they may be too little to make a beneficial impact.
Alternatives may also be under pressure. In the US, investors are said to have moved $1 trillion from credit focused money market funds into government debt funds, further restricting access to high-quality bonds.
Nerin Demir
Head of repo and securities finance
SIX
The continuation of the asset purchase programme until December 2017 will further weaken the European repo market as the scarcity of good collateral will persist the longer the European Central Bank’s asset purchase programme is extended at the same level as before. High-rated bonds will become more expensive and with increased failures to deliver, further pressure is expected in the European repo market.
A widening of the European Central Bank’s collateral policy for securities lending may alleviate some of the pressures on the collateral side but those discussions are ongoing.
Furthermore, US dollar repo versus top-grade high-quality liquid assets may well see some upside with the recent upward interest rate movement in the US by 0.25 percent. This will create a positive effect with further rate rises expected in 2017.
Mick Chadwick
Head of securities finance
Aviva Investors
The market has become accustomed to negative repo rates. The revised terms of the European Central Bank’s securities lending facilities, announced in December, should in theory be an aid to market liquidity, particularly the flexibility to use cash rather than securities as collateral.
Having said this, repo capacity for institutional clients is likely to remain constrained due to the continued pressure on bank balance sheets as a result of regulation. This will likely lead to greater buy-side engagement with alternative routes to market such as central counterparty models and peer-to-peer trading platforms.
Rob Kidman
Vice president, agency trading
State Street
The December announcement from the European Central Bank that quantitative easing would be extended at a lower level of €60 billion to the end of 2017 continues to weigh on the repo market, although some relief to German specials is expected. The European Central Bank also announced that central banks would be able to conduct securities lending versus cash collateral rather than general collateral. This is clearly aimed at alleviating the collateral shortage that has inhibited specials being borrowed from central banks.
Demand for German government bonds is expected to remain strong while some cheapening versus EONIA (Euro OverNight Index Average) is likely given the €50 billion limit on cash borrows set by the European Central Bank. Collateral shortages still remain, however, and the cost of short-dated repo for borrowers is also a hindrance for money market funds that still need to manage short-dated liquidity.
Regulatory requirements for the net stable funding ratio continue to see demand for longer termed repo, but to what extent the new measures will cheapen general collateral out to one year is unclear as other factors, such as balance sheet and the availability of high-quality liquid assets, are still likely to attract a term premium.
Michael Huertas
Associate and solicitor
Allen & Overy
As the asset purchase programme runs its course in 2017, we would imagine that the European Central Bank, and the relevant eurosystem national central banks, may make further amendments to the securities lending programme’s rules to bolster actual and perceived liquidity in bond markets. This might also serve to further discourage any hoarding mentality that had crept into certain parts of eurozone bond markets as a result of perceptions of the asset purchase programme’s distorting impact.
Going forward, the securities lending programme could continue to be tweaked on multiple fronts. In the short-term this might include changes to pricing and haircuts, which are relatively simple but nevertheless may still not be sufficient to fully dispel gripes that European Central Bank pricing is ‘expensive’. Other more longer term changes, such as the European Central Bank and the national central banks accepting broader collateral (beyond what they already do in their other activity), or using a wider set of contractual documentation in securities lending programme activity, may take a longer time to implement.
Consequently, as the asset purchase programme continues to change, we might also see a rebalancing of national central bank-led, ie, decentralised, securities lending programme activity becoming more centrally coordinated by the European Central Bank. As currently one of the largest collateral takers and institutional investors, the European Central Bank is also likely to need to be receptive to solutions that have existed since the onset of the financial crisis to build sustainable collateral pools offering liquidity and transformation services to meet demands driven by regulatory and economic factors.
Given all that 2017 is likely to have in store, we would also imagine that there may be a higher degree of receptiveness to engage with concerns of the market.
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