As we warned here most recently [12], the shadow-banking system remains the most crisis-catalyzing part of the markets currently as collateral shortages (and capital inadequacy) continue to grow as concerns. In recent weeks, between The Fed, Basel III, and the FDIC, regulators have signalled the possible intent to change risk, netting, and capital rules that could have dramatic implications on the repo markets and now, it seems, the SEC has begun to recognize just how big a concern that could be. As Reuters reports [13], the SEC urged funds and advisers last week to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance.
A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities. Most repos, around 80%-90%, are against government-related collateral and it is the repo market which makes government securities relatively more liquid by allowing fast and efficient financing and short covering. It is not accidental that trading volumes in bond markets are so closely related to the outstanding amount of repos.
Via Reuters [13],
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The U.S. Securities and Exchange Commission on July 17 quietly issued new guidance to money funds that spells out the risks they could face if borrowers in the tri-party repurchase market collapse.
"There are a variety of ways in which a money fund and its adviser may be able to prepare for handling a default of a tri-party repo held in the fund's portfolio," the SEC wrote. "Such advance preparation could be part of broader efforts by the money market fund and its adviser to follow best practices in risk management."
In a four-page document, the SEC urges funds and advisers to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance.
It also calls for funds to consider the operational aspects of managing a repo, and to contemplate whether there are any legal issues that could arise in the event of a repo default.
The SEC's guidance comes at a crucial time for the money fund industry. The SEC is weighing controversial new rules that seek to reduce the risk of runs on money funds by panicked investors - a scenario that took place during the financial crisis.
The Federal Reserve is separately eyeing a new rule that would force investment banks that rely on risky short-term funding such as found in the repo markets to hold more capital.
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And as JPMorgan explains,
...Regulators have introduced a simple non risk-based leverage ratio framework, i.e. capital over un-weighted assets, as a complement to the risk-based capital framework. The Basel Committee’s revisions to the framework in the 26th of June release relate primarily to the denominator of the leverage ratio, the Exposure Measure.
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The most significant impact is likely to be on repo markets. As with derivatives, the proposals do not allow netting of collateral, i.e. repos are accounted for on a gross basis in the calculations of the Exposure Measure. Effectively both derivatives and repos are accounted for as loans on a gross basis rather than a securitized net product. In fact the revised guidance is even more punitive for repo transactions as it not only forbids netting of collateral but it does not allow netting of exposure either, i.e. repos and reverse repos cannot be offset against each other.
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Repos are a $7tr universe approximately across the US, Europe and Japan. This is equal to close to 10% of the $77tr of the reported assets of G4 commercial banks including US broker-dealers. However, off-balance repos as well as accounting reporting which allows for netting between repos and reverse repos under both IFRS and US GAAP as well as collateral netting under US GAAP, means that most of this $7tr of repos is not captured in reported balance sheets, i.e. it is not included in the above $77tr figure of commercial bank assets.
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If we apply the same 10% to the whole of the $7tr of G4 repos, i.e. we assume that around $700bn is accounted via existing reporting of net repos in banks’ balance sheets, then under the revised Basle proposal which forces reporting of total gross rather than net exposures, the Exposure Measure would increase by more than $6tr.
Applying the 3% minimum capital requirement to this $6tr potentially results to additional capital of $180bn across the whole of the G4.
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These new regulations are hitting repo markets at a time when they are struggling to recover from their post-Lehman slump.
[14]
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A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities. Most repos, around 80%-90% are against government-related collateral and it is the repo market which makes government securities relatively more liquid by allowing fast and efficient financing and short covering. It is not accidental that trading volumes in bond markets are so closely related to the outstanding amount of repos.
[15]
Figure 4 shows that US repo amounts and overall bond trading volumes have been following a flattish pattern in recent years with no signs of a return to pre Lehman levels.
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While we see a bigger on repo markets, the impact on derivatives markets should not be underestimated. Similar to repos, banks will have to reassess their derivative portfolios and businesses against higher leverage buffer.
At a time of rising 'fails', rising leveraged-carry-trades, and no real end in sight for Fed intervention, a repo default contagion could indeed be the self-inflicted wound to bring down the risk-markets in spite of Fed liquidity.