Keeping repo markets relevant through deeper liquidity and diversification

May 24, 2024

Key Takeaways

Greater liquidity and diversity cuts risk and increases market resilience

Stricter regulatory requirements can drive efficiencies and lower costs

Innovations like P2P and more central clearing can help buy-side prepare for next shock

Having access to deep pools of liquidity and a diverse range of collateral is more important than ever in securities finance transactions as interest rates and tighter regulatory controls continue to create uncertainty.

In the repo market—a critical segment of the capital markets, where central banks and financial intermediaries borrow and lend to each other for short-term funding typically backed by government securities—liquidity is often squeezed in times of volatility, pushing established participants to rely on tried and tested business relationships.

In an increasingly interconnected world, with mandatory central clearing and shorter settlement cycles in trading on the rise, firms must reassess their requirements, prepare for the occasional market dysfunction, and seize opportunities as the industry enters an era driven by innovation.

The benefits of deeper liquidity and diversity

Repo performs a long list of functions, and it is pivotal to the efficient working of almost all financial markets.

When the repo market functions smoothly, it operates in the background, keeping capital flowing. When it malfunctions, as it did with the gilts crisis of September 2022 following the UK government’s mini-budget, it hits the headlines.

External shocks— be they geopolitical tensions or unexpected monetary policy decisions—can create mismatches between collateral and cash. Smaller players or non-bank financial intermediaries, such as pension funds, can find themselves selling assets at a loss.

This underlines the importance of creating deeper pools of liquidity in repo markets and alternative borrowing and lending arrangements. The greater the liquidity and diversification, the greater the market resilience and stability. Diversification reduces systemic risk, allowing traders and investors to convert assets into cash in stressed markets without the disruptive effects of outright sales.

Winds of change – seeking overseas collateral

Collateral is not static. The nexus between interest rates, exchange rates, and risk management can lead to large global movements in search of liquidity and diversification.

For example, European repo markets are net borrowers of APAC-issued collateral, particularly Japanese government bonds (JGBs). According to the Bank of Japan (BOJ), a combination of a persistently weak yen and low borrowing costs has driven overseas demand for JGBs. Foreign investors now hold more than local banks. The use of JGBs as collateral on Euroclear has doubled since 2021 after the BOJ expanded its funds-supplying operation in January 2023 to bring down yields.

There are officials in Tokyo who are concerned about the implications of foreigners’ larger role in the JGB market. On the other hand, there are those who believe their presence could increase liquidity, and the Finance Ministry’s Financial Bureau considers a diverse base of bondholders a stabilizing force.

Investor traffic flows in other directions, too. Cash-rich Japanese investors seeking better returns abroad are some of the biggest investors in US Treasuries and government bonds in the eurozone.

Moreover, other Asia-based investors are shifting from transactions with counterparties in Europe and the US to other international bonds and APAC securities, including JGBs.

Winds of change — seeking technological solutions

Like other corners of the financial world, the repo market is adapting to regulations aimed at reducing systemic risk.

Stricter regulatory requirements can drive efficiencies and lower costs. They also illuminate the differences between repo in Europe and the US and the demand for alternative funding tools.

One such tool is peer-to-peer repo, a relatively new development and useful for the particularities of the European market.

Unlike the US, with its unified monetary policy, each country in the Eurozone has its own central bank responsible for asset purchases and lending, resulting in fragmented markets. There have been frequent high collateral scarcities, causing the repo rate to plunge for high-quality liquid assets.

Peer-to-peer (P2P) opens new opportunities to access balance sheets traditionally off-limits. A hedge fund, for example, may be able to source ‘specials’ from a large asset owner, sovereign wealth fund or insurer directly in a bilateral transaction.

The P2P lending sector has experienced an uptick in activity. According to Andrew Dyson, the CEO of the International Securities Lending Association, this trend is largely driven by a shortfall in available capital within the financial ecosystem. Capital is necessary to fulfill the diverse needs and goals of lenders and borrowers situated at various points along the value chain.

Another example arising from the 2022 gilts crisis is an initiative by Schroders, State Street Global Advisors, and Cardano exploring the use of corporate bond fund units as collateral for emergency borrowing. Such an arrangement would provide a safety net, enabling pension schemes to meet margin calls without having to liquidate their positions hastily.

Preparing for future repo market challenges

Repo, by allowing securities to be sold and repurchased later, is critical for liquidity and short-term financing. However, markets are in flux as participants continue to adapt to closer oversight.

Regulatory pressures to minimize systemic risk have led to tighter capital measures for banks under Basel III, more central clearing and a move away from bilateral transactions.

When COVID-19 hit, buy-side demand for repo soared as funds sought cash, but banks struggled to provide sufficient collateral amid balance-sheet constraints. As debt issuance grows, efficiently connecting security holders and cash lenders will continue to generate challenges.

For buy-side players, including hedge funds and pension funds, it’s imperative they locate more diverse and deeper pools of liquidity, including through greater access to central clearing counterparties and innovations such as P2P, to prepare for the next systemic shock.

ION Markets

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