Bilateral repo in the spotlight as new rule intensifies scrutiny

Key Takeaways

• New rule shines light on largest segment of repo market
• Flexibility of bilateral repo attractive to investors like hedge funds
• Market events have brought greater transparency to the fore

It has been a long time coming but earlier this month, the Office of Financial Research (OFR), a US Treasury Department-based research firm, adopted a final rule that will allow for the collection of data on non-centrally cleared bilateral repurchase or repo agreements (NCBBR).

The repo market enables banks and other firms to borrow cash for short periods in exchange for collateral, such as high-quality government securities. The aim of the legislation is to pry open the door on NCBBR transactions which have remained a relatively closed book despite being the largest segment of the repo market. Latest figures show that daily outstanding commitments are estimated at over USD 2 trillion.

Attributes of the four US repo markets

View full image

This product type has proven popular with investors, especially hedge funds, because of the greater flexibility in contract terms such as haircuts and margining. Haircuts are an important element when determining the pricing of a repo transaction because they specify how much leverage can be taken on an individual trade.

According to the OFR, “permanent data collection will shine a spotlight into this opaque corner of the financial market, provide high-quality data on NCBBR transactions, and remove a significant blind spot for financial regulators.”

By contrast, the other sections – centrally cleared and tri-party repo – are already covered by various regulations in the US and Europe. The OFR established a data collection for the US market five years ago while firms offering tri-party services are subject to national and regional rules. It involves an independent institution such as a clearing bank, international or national central securities depository (CSD) acting an as an intermediary, handling the nitty gritty administration between the two parties in the repo transaction.

Different finishing lines

The OFR’s data collection requirement came into effect on 05 July 2024 and covers roughly 32 data fields. It applies to two categories of firms but the deadline for full compliance differs due to the size and scope of each. The first group, which is the largest with around 40 firms, has 150 days or until 02 December 2024 to get their reporting houses in order. They comprise brokers and dealers and their government counterparts with outstanding commitments to borrow cash and extend guarantees in NCCBR transactions with counterparties every business day during the prior quarter of USD 10 billion.

The second cohort is much smaller and covers any other financial company that falls outside the broker and dealer realm. As a result, they do not have to be at the starting gate until 01 April 2025, followed by an additional three months to fully cross the implantation line.

As with most regulation, though, it has taken a long time to come to fruition. The groundwork was originally laid in 2022 but the OFR did not submit a concrete proposal until early 2023 after urging from the Financial Stability Oversight Council, among others, to consider the most effective ways to obtain better data. A consultation was launched in March 2023 and, while many market participants had hoped to see a final edict later that year, it was not published until May this year.

Crunch time

Although the lack of transparency had been a topic of debate and discussion for years, the turning point was in September 2019 when increased government borrowing exacerbated a shortage of bank reserves. This caused interest rates on repos, as measured by the Secured Overnight Financing Rate, to increase from 2.43% to 5.25%, hitting a lofty peak of more than 10% at one point.

Fears that an ensuing surge on rates for unsecured loans between banks could trigger a full-blown financial crisis, forced the Federal Reserve to intervene and inject roughly USD 350 billion into the market to restore calm. Money markets had not seen so much cash being pumped in since the financial crisis and the resulting quantitative easing programmes.

The intervening years had been relatively calm with banks and fund managers locking in funding at the end of each month, quarter and year, until December 2023. This is when the impact of quantitative tightening to curb inflation took its toll causing significant oscillations in the market for short-term loans collateralised by Treasuries. The DTCC GCF Treasury Repo Index, which tracks the average daily interest rate paid for the most-traded general collateral finance (GFC) Repo contracts for US Treasuries, jumped to 5.45% in the last week of the month from 5.395% the week before.

Push for repo clearing and transparency

Although this was the highest level since September 2019, the furore soon died down as the volatility triggered was much smaller than five years ago. It did however serve as a strong reminder of the important function that repo market plays in oiling the wheels of the wider global capital system and the transparency that is needed to identify the spikes behind market movements.

Financial crises have pushed regulators to act. Indeed, coming into effect in phases by June 2026, new rules will require cash and repo transactions in US Treasury securities to be centrally cleared.

While it is widely accepted that regulators must get a handle on market data to gauge potential systemic risk, a critical question market participants must ask themselves under the OFR’s final NCBBR rule is how prepared are they for more intense, daily reporting of transactions?