Banks Can't Make Money Out of Repo Market, Lobby Group Says

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  • Survey suggests Europe's market will shrink `significantly'
  • Basel III rules seen by respondents as having biggest impact

Europe’s market for borrowing and lending securities including government bonds, a vital part of the world’s financial plumbing, will shrink “significantly” in coming years as regulation makes the practice uneconomical for banks.

That’s the verdict of respondents to an International Capital Market Association survey on the future of the repurchase -- or repo -- market, where bonds are used as collateral for short-term loans. Those contributing to the lobby group’s report, published Wednesday, warned this may thwart other capital markets and, in turn, the real economy.

Repos are relied upon by the biggest banks for their day-to-day funding needs. The Basel III regulations, which include rules on leverage ratios and capital requirements, are having the greatest impact and are prompting banks to constrain the use of their balance sheets for securities lending, according to ICMA’s report.

“If you impair the market that puts collateral in the right place, you can’t even fulfill the basic requirements of recent regulation,” Godfried De Vidts, the London-based chairman of ICMA’s European Repo Council, said in an interview. “The uncoordinated measures are really starting to bite now. The practical impact will be jeopardizing systemic resilience. When collateral doesn’t flow, central counterparties are at risk.”

Privileged Clients

As banks adjust to the new rules, repo has increasingly become a privileged service for preferred clients whose business generates revenue for the banks in a number of areas. The cost of taking part looks set to rise in tandem to the market changes, with survey respondents saying they saw current bid-ask spreads as unsustainably narrow.

The total value of outstanding repurchase contracts was 5.6 trillion euros ($6 trillion) in June, barely growing from 18 months earlier, according to ICMA. So far, the repo market has been dominated by banks but this may change as more buy-side clients step in to trade directly between themselves, according to the report. Banks may also continue to merge their funding and collateral management functions, ICMA said.

“One of the most striking changes for repo businesses has been the significant decline in their profitability,” Andy Hill, ICMA’s director of market practice and regulatory policy, wrote in the report. For some banks, “providing repo liquidity to their client base is very much a loss-leading strategy, and more a service provided in return for clients’ more profitable business,” he wrote.

Official Comprehension

Traders were most concerned policy makers don’t understand the changes to the repo market and that loose monetary policy, such as the European Central Bank’s bond-buying program, may be disguising the true impact of regulation on the cost of capital, according to the report. Since new rules are implemented at different times, repo market volumes and pricing have yet to reflect such changes, ICMA said.

The survey is compiled from the results of 45 interviews with repo-market participants from June to September, most of whom were from banks or broker-dealers.

The efficient functioning of the repo market has become more imperative as regulation and central bank activities encourage more trading and lending backed by collateral. Yet some of the biggest users of repos globally, including Deutsche Asset & Wealth Management and Fidelity Investments, have said the contraction in the market is manageable.

“How it will look after the storm remains to be seen,” according to the report. “But it is safe to assume that it will be a very different market to the one we have known. The fear, however, is that it may no longer be able to function as well as previously, particularly when most needed.”