The rise of repo

Saheed Awan

Despite the progress in automation in the tri-party repo market, says Saheed Awan, work still needs to be done to manage valuable collateral inventory on a global and holistic basis

Saheed Awan recalls the start of the repo market in the late 1980s. At the time he was with General Electric and was introduced to the world of securities finance by a venture with DML, a mainframe securities lending system. Previously Awan had been trading futures and bonds at brokerage firm E.F. Hutton. He describes the birth of the market as an innovation forced by regulation, costs and taxes.

“The U.S. investment banks had moved into the City of London after the ‘Big Bang.’ Back then, those American banks didn’t have access to the retail client deposits to borrow in the same way as their U.K peer banks. Consequently, they started repo activities.”

In addition, the supply of bonds to cover shorts and fails was mainly done through Euroclear. As the lender of last resort and used for fails lending, the investment banks found this to be a very expensive option. Hence the inter-dealer repo market was born. “Euroclear is attributable for creating the modern repo market,” notes Awan.

Regulations also led to the creation of Euroclear itself in the late 1960s and the birth of the Eurobond market as a result of the U.S. imposed 30% interest withholding tax on foreign investors holding U.S. paper. Eurobonds were an attractive way for foreign holders to own U.S. dollar (USD)-denominated debt without paying the tax.

When the repo market began, says Awan, its issues were fundamental. “I started European tri-party with a PC and two operations people. We learned on the job as there was no blueprint to follow,” he says.

The early adopters of tri-party repo were the large American banks, Swiss Bank Corporation and Barclays Capital. Volumes then were limited and cash providers grappled with what it meant to place cash in the secure money markets, like repo.

Balance sheet relief was key. “Before Basel, we had the Cooke ratios which set out how much capital a bank should have as a percentage of its total risk-adjusted assets on its balance sheet,” says Awan. “Less regulatory capital was required and most banks only cared about yield. The Cooke ratios forced cash-rich European banks to start looking at managing their balance sheets in a new way—and that is why a number of them entered the repo market. I set about moving from a small PC set up to building a more robust and automated service. This was timely, because tri-party volumes started growing. We were not quite there in terms of getting the new system with automatic selection and allocation of collateral. So, while waiting for the new technology to be delivered, I was forced to use five bond settlement experts to handle the increasing volumes manually. ‘Manual’ is invaluable if you need to get to market quickly.”

In the late 1990s, collateral was also being explored at granular levels. The recent financial crisis has seen a further explosion of new rules concerning eligibility and concentration limits.

Awan notes what automation did for managing the new risk management ethos: “In 2008, Euroclear tri-party had less than 80 eligibility and concentration limit rule sets. Today, we have close to 220 such rules. I know the functionalities in most tri-party systems, but what Euroclear has is simply unprecedented. I stand back in amazement at how what we call AutoSelect goes through those complex rule sets, makes its selections or substitutions in the most optimal way and delivers the securities accordingly. Tens of thousands of selections and allocations occur in less than fifteen minutes; repeated throughout the day.”

Despite the progress in automation, Awan is still surprised by the siloes that exist today in most banks and broker-dealers, given there is an unprecedented need to manage valuable collateral inventory on a global and holistic basis. “The issue is primarily in the OTC derivatives area of most banks,” says Awan. “What they mistakenly call collateral management is anything but. Over 80% of margin is still delivered as cash—it is akin to giving away the firm’s liquidity. The best place for them to optimize is to go to their repo or securities lending desks and ask them what collateral management is really about. Securities financing people are the ultimate collateral management and financing professionals.”

Going forward, says Awan, the challenge will be in helping Western banks meet the acute capacity issues they are facing due to a shortage of capital and the leverage ratio requirements. “How do we increase balance sheet capacity? The obvious place is to put more transactions through a CCP (central counterparty),” he says. “But, to maximize netting, dealers and banks will have to open infrastructures like CCPs to the buy-side. Such CCPs with new models that give direct access are close to springing up.”