Regulation and extraordinary monetary policies are affecting the ability of the European repo market to function efficiently and effectively in what could have major effects on broader capital markets and the real economy, according to a study by the European Repo Council (ERC) at the International Capital Markets Association (ICMA).
The study, which is based on interviews with bank repo desks, fund managers, inter-dealer brokers, electronic platform providers, agency lenders and triparty agents, said Basel III was single biggest regulatory driver for changes in the repo market. Basel III Leverage Ratios have resulted in repo activity becoming a high-cost transaction.
“When the Leverage Ratio is applied to a repo book, the cost of capital required to support on-balance sheet repo activity increases dramatically. A number of respondents suggested that the effective break-even rate for a repo after Leverage Ratio is in the region of 40 basis points (bps) to 45bps. One respondent bank estimated their overall cost of transacting a repo, including other Basel measures to be in the region of 70bps to 75bps,” read the study – “Perspectives from the eye of the storm: the current state and future evolution of the European repo market.”
As such, the cost of capital to run a repo trading book is now making repo an unprofitable exercise for some financial institutions. Many survey respondents believe the repo market is likely to shrink significantly going forward as a result of this.
The paper also identifies post-crisis European Central Bank (ECB) monetary policy as having played a role in the dampening of the repo market. The ECB monetary policy has resulted in excess bank reserves and negative interest rates, which have hurt repo activity. Furthermore, it has led to a reduction in availability of high quality collateral, added the paper.
Firms are reforming their businesses to deal with these changes. Most banks have already restructured or are restructuring their business models, for example. They have done this through de-risking, deleveraging, reducing headcount and merging repo desks with other funding functions to create centralized liquidity and collateral management hubs. The paper highlighted numerous banks now provide repo liquidity to preferred clients as a loss-leader to support other, more lucrative businesses and services.
The survey also found unsurprisingly that market participants questioned whether regulators properly understood the repo market. “This latest study clearly shows that uncoordinated measures by legislators, regulators and prudential authorities are radically altering the short term secured financing market and may even compromise the success of regulatory measures such as the European Market Infrastructure Regulation (EMIR) which depend on the fluidity and availability of collateral,” said Godfried De Vidts, chair of the ICMA ERC.
Regulations hampering ability of repo market to function – report
Regulation and extraordinary monetary policies are affecting the ability of the European repo market to function efficiently and effectively in what could have major effects on broader capital markets and the real economy, according to a study by the European Repo Council (ERC) at the International Capital Markets Association (ICMA).