The broken mechanics of the repo market have been exposed creating demand for change says Roberto Verrillo, Head of Strategy and Markets at Elixium.
“Those that say it can’t be done should stand aside of those doing it” – Chinese Proverb
Repo provides for smooth functioning of ALL financial markets. It allows for the safe transmission of cash and collateral from buyer to seller. As a result, it lowers the cost of issuance, thereby supporting the real economy. Furthermore, it supports efficient collateral management, facilitates market-making in underlying instruments, contributes to derivative market liquidity and plays an important role in the implementation of monetary policy.
Any breakdown in this transmission mechanism affects liquidity and pricing. Repo is far more fundamental to markets than is generally realised and has been largely ignored, until now…
For many years the esoteric world of repo existed inside a well-crafted and well-oiled ecosystem where beneficial owners willingly ceded the responsibility of collateral and liquidity management to their custodian or asset manager. Many of the proceeds gleaned from securities lending and repo were used to offset fees charged for custody, settlement, clearing, etc. The sell-side intermediaries on these transactions and their buy-side customers had a mutual self-interest in maintaining the status quo: the buy-side did not have to commit resource to the network and connectivity required to enable their business, and the sell-side got to leverage and enhance their returns via hypothecation and the leverage of collateral and cash into lower quality assets with the incremental return sitting in the intermediaries’ P&L.
Some intermediaries still offer revised versions of these services and can provide a scalable way to direct participation into repo and collateral optimisation going forward. The issue is capital usage and balance sheet.
Major alterations to the regulatory environment that have already taken place, and those that will occur over the next few years, have put us on a path that will change the industry forever. The impact on how the industry executes its business has been fundamentally changed.
Balance sheet availability in the current, bank- centric, market structure has been significantly reduced and the cost has risen. Repo market activity has become more concentrated on matched maturity bilateral transactions.
Whilst the repo market may not appear to have shrunk that dramatically from a gross- notional perspective, non-matched maturity transactions which utilise balance sheet are becoming increasingly scarce and the cost of non-netting transactions has risen dramatically.
Buy-side firms are feeling increasingly disenfranchised by the additional cost burden directly imposed on them by traditional intermediaries. Dysfunctional and illiquid secured financing markets globally are increasingly becoming the norm rather than being a month/quarter end phenomenon. Daily average reporting of the leverage ratio (LCR), rather than just on reporting dates, is due to be enacted from the end of 2017 in Europe. This and the Net Stable Funding Requirement (NSFR) rules under Basel III increase the regulatory burden on traditional intermediaries. The associated costs are being passed onto their existing clients in the form of wider bid/offer spreads.
Mandatory margining of uncleared over-the- counter (OTC) derivatives is upon us: buy-side firms which have previously given collateral as variation margin may now be required to post cash (will be required to if they join a CCP). If repo markets, already show signs of being stressed for capacity, have this additional requirement for collateral/cash transformation, this will almost certainly exaggerate the issues surrounding balance sheet capacity and increasing bid/offer spreads.
MiFID II will be introduced with a view to de-restricting market access on a non-discriminatory basis. There is a requirement for Multilateral Trading Facilities (MTFs) to implement non-discriminatory rules regarding access to its facility. MiFID II introduces additional pre- and post-trade transparency requirements for a number of financial instruments, the aim of which is to create a level playing field for the regulation of all organised trading.
The Fundamental Review of the Trading Book (FRTB), due to be implemented in local regulation by 2019, is a supervisory framework for the next generation of market risk regulatory capital rules for international banks.
The cost of transacting repo has risen and will continue to rise as regulation is implemented.
Looking at this issue in its entirety, we can ascertain quite clearly that:
- Illiquidity in secured and unsecured markets is reported across the spectrum, be it buy-side, sell-side or brokers.
- Current intermediated capacity is stretched and is causing fragmented pricing.
- Intermediated capacity is only likely to deteriorate further.
- There is more than ample liquidity in the form of cash as a result of global quantitative easing.
- Collateral providers have significant reserves of previously un-lent and unencumbered (HQLA) inventory.
- There is an increasing need for capacity on the back of new margining rules for OTC products.
- The transmission mechanism for collateral transformation to be executed is severely impaired.
The potential for more serious market dislocations, where collateral provision/transformation can be severely affected in stressed environments, is set out more comprehensively in a Bank of England staff working paper (No.609).*
Fundamental change is essential
Intermediaries have responded by reducing the size of their net balance sheet to the tune of 80%, while netting 90% of their trades and severely rationalising/cutting their client base. They have systematically backed away from high volume/ low margin business and are are increasingly reticent to provide the balance sheet intermediation to fill that demand. Banks are rationalising their business models, a long overdue overhaul of client base and product offering, they will find their niches and reverse the ‘one-stop-shop’ approach seen until now. Allocation of scarce resource to profitable product and clients is fundamental to this approach.
The financial crisis, fines and resulting regulation have forced the issue – the result, if we focus on the positives rather than the immediate issues for existing business models, is the opportunity to re-think this space and create a financial market ecosystem where everybody has the same opportunity to access liquid markets, impartially, through transparent execution methodology.
The buy side realises that it needs to take ownership of its own destiny.
Even those clients who could rely on the ‘diamond client’ status afforded them in the past are experiencing increasing difficulties. The sell- side can benefit from NSFR and LCR benefits and true exposure to a diverse, multi-faceted and global counterparty list.
We are facing a “democratisation” in financial markets, a sort of anti-big-bang if you like – the opportunity to re-engineer and create a better marketplace for all, is now.
Elixium’s response to fractured liquidity
By facilitating the flow of cash to collateral, and vice-versa, Elixium seeks to ‘release’ liquidity from counterparties that previously may or may not have been engaged in secured financing activity. Elixium is a global all-to-all electronic marketplace that has been designed to address the impact of regulation, balance sheet pressures and deteriorating levels of liquidity in the repo market by providing participants with collateralised liquidity on a fair, transparent, inexpensive and equitable basis.
It is a regulated, MiFID II-compliant, MTF for collateral and secured deposits, targeted at firms of various size and constituencies, including corporate treasurers, CCPs, asset managers, hedge funds, banks, government issuers, central banks, insurers, local authorities and agencies. As an MTF, Elixium is characterised by the non- discretionary execution of transactions and is therefore subject to pre-determined rules which ensure transparency and equanimity for all.
Costs of some investment strategies, such as liability-driven investment, which is sensitive to the provision and pricing/tenor of finance have been driven sharply higher by this balance sheet deficiency and intermediary capacity. Elixium has plans to introduce specific solutions in order to increase liquidity for these strategies going forward. Whilst the demand and client benefits are clear, many new counterparties are continuing to face high barriers to entry when seeking to access collateralised liquidity.
Elixium has addressed this by adopting a user-friendly modular approach to documentation with the option of subscribing to Elixium’s bespoke Global Master Repurchase Agreement (GMRA), which allows for rapid all-to-all connectivity, or utilising existing GMRA documentation between counterparties. Elixium can also help solve know-your-customer (KYC) issues and facilitate credit benchmarking and risk-management.
Elixium provides a full credit limit framework where the participant retains full control over the credit line, products and firms with which it is willing to trade. Via intelligent trading tools and analytics, Elixium enables institutions to qualify for credit slippage, view depth and liquidity across tenors and collateral baskets, and offer varied execution functionality.
Elixium uses standardised products and processes where beneficial. Firms will have access to a range of maturities, currencies and collateral baskets and will be able to facilitate collateral upgrades and new trading strategies via cleared, tri-party and domestic settlement. Following mandatory margining of un-cleared OTC products, demand for efficient initial and variation margin collateral transformation, is set to increase dramatically.
Elixium facilitates this process and will provide a marketplace through which cash or collateral can be sourced from a much more diverse counterparty base and therefore at mutually beneficial rates compared to traditional liquidity mediums.
Over the coming months, Elixium will expand its initial offering to a range of collateral offerings and currencies covering fixed income and equities in GBP, EUR, USD, CAD, JPY and EMs.
The system is being launched in various stages:
- Auction, using standard collateral baskets and a fixed (independently derived) rate.
- Central limit order book enabling transparent and unbiased price discovery.
- Collateral Transformation, which will enable participants to swap collateral credit in exchange for a fee.
- Request for Quote (RFQ) will enable users to RFQ liquidity providers based on ISIN and maturity.
- Elixium also supports evergreen transactions and interest rate risk neutral transactions.