Repo Market Contracts as Dealers Face More Capital Requirements

The market for borrowing and lending U.S. government debt, after shrinking 31 percent in the past five years, risks contracting further as global regulators consider raising capital and leverage standards for banks.

The 21 primary dealers that trade with the Federal Reserve averaged $2.71 trillion a day in repurchase agreements last month, down from a peak of $4.28 trillion in the first quarter of 2008, according to Fed data compiled by the Securities Industry and Financial Markets Association. Combined with reverse repurchase agreements, the average was $4.82 trillion, down from $7.02 trillion in the first three months of 2008.

U.S. regulators on July 7 proposed ordering eight of the largest lenders to hold capital equivalent to 5 percent of assets at their parent companies and 6 percent at their banking units, surpassing the 3 percent global minimum that the Basel Committee on Banking Supervision approved to help prevent another financial crisis. In a repo, a dealer provides securities as collateral to another in exchange for cash; in a reverse repo, the opposite takes place.

“‘The proposals for higher capital and lower leverage won’t eliminate repo, but are factors that will squeeze it,” Alex Roever, head of short-term fixed-income strategy at JPMorgan Chase & Co. in Chicago, said in a July 23 telephone interview. “If you are thinking about dealers providing liquidity to the bond market, then anything that weighs on repo market is another limiting factor. We already have dealers who are constrained as far as using their balance sheet to provide liquidity to the market.”

Leverage Ratios

The push for larger capital cushions and less leverage for U.S. lenders was followed last week by a proposal from European regulators for an enhanced leverage ratio to measure equity to total assets, eschewing formulas that let banks hold less capital for assets deemed less risky. If the proposals are incorporated into U.S. regulations, it could cause derivatives, securities financing transactions and other off-balance-sheet items to be counted as assets in the leverage ratios, making repo activity less appealing.

The Basel Committee proposals would disallow the current practice of banks netting repos against reverse repos, causing banks’ leverage exposure levels to rise and triggering needs to cut repo activity. The Basel III requirements for securities financing transaction would cause repos, reverse repos, margin and securities lending and borrowing transaction to be reported on a gross basis, with no provision to net exposure.

Average Rate

Reduced dealer activity in the repurchase-agreement market has been a contributing factor in driving repo rates down over the past year, according to Roever.

The average rate for borrowing and lending Treasuries for one day in the repo market was 0.046 percent yesterday and has averaged 0.12 percent this year, according to a GCF repo index provided on a one-day lag by the Depository Trust & Clearing Corp. That compares with a 0.157 percent average over the past three years. The overnight Treasury general collateral repurchase agreement rate opened yesterday at 0.07 percent, according to ICAP Plc, the world’s largest inter-dealer broker.

In a general collateral repo transaction, the lender of funds is willing to accept a variety of Treasury, mortgage-backed securities or agency collateral.

Market Volatility

“Liquidity in fixed-income markets could be impaired and trading volumes would likely fall, particularly for Treasuries and other low-return-on-asset businesses” if the stronger Basel III rules are implemented in the U.S., wrote Brian Smedley, an interest-rate strategist in New York at Bank of America Corp., in a note published on July 19. “Market volatility would likely be amplified by the new rules, if and when they take effect, as the reduced elasticity of bank balance sheets will constrain their ability to provide liquidity to clients during periods of financial stress. We would also expect bid-ask spreads to widen and hedging costs to rise,” he wrote.

In a repurchase agreement, one party provides cash to another in exchange for a security, and vice versa. Repos are typically used to finance holdings, meaning movements in the rates affect the cost of holding the securities in inventory. The Fed uses the agreements to meet its target interest rate for overnight loans between banks.

Collateral Netting

Volatility in Treasuries as measured by the Merrill Lynch Option Volatility Move index surged to 117.89 on July 5, the highest since December 2010. The gauge, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, has averaged 64.8 over the last year.

Banks have been focused on increasing their highest-quality capital since 2007 to shore up balance sheets after the global financial crisis and to meet tougher rules. The focus on leverage is the latest effort by financial watchdogs to prevent a repeat of the taxpayer-funded bank rescues of 2008.

The most significant impact if the enhanced Basel III regulations are implemented by U.S. regulators would to the repo markets, according to JPMorgan, due to the provision disallow the netting of collateral.

All of “these regulations will affect the repo market as it essentially changes the entire perspective that you approach your bank balance sheet,” Andrew Hollenhorst, fixed-income strategist at Citigroup Inc. in New York, said in a July 23 telephone interview. “With the new supplementary leverage ratio is doing is forcing you to look at our balance sheet from the perspective of return on total assets given it doesn’t apply any risk weighting. So some of the assets that might have made sense before, such as repo, might not make sense anymore.”

-With assistance from Nicholas Comfort in Frankfurt and Elisa Martinuzzi in Milan. Editors: Dave Liedtka, Paul Cox

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