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New Repo Regulation And What It Means For The Future

September 03, 2013
by Scott E.D. Skyrm
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10 Comments

The Repo market is being bombarded from all different regulatory angles these days. Most banks have Repo businesses across many geographies, so it leaves them with different regulation for the same Repo transaction. Dodd-Frank affects the largest U.S. banks, foreign banks through Section 165, U.S. broker-dealers with assets above $50 billion, and perhaps even challenges the bankruptcy treatment of Repo. The Financial Transaction Tax affects Repo activity at some European banks, Basel III affects all banks at all levels, and just recently, the Financial Stability Board in the U.K. joined in on the action.

Dodd-Frank

Dodd-Frank Section 165 applies to foreign bank subsidiaries in the U.S. and specifies that capital held at the parent level cannot be assumed to support a U.S. subsidiary. In practice, it means that 26 foreign banks will establish Intermediate Holding Companies (IHC) and hold more capital to support their U.S. bank and broker-dealer. More capital means more expense for foreign banks to hold assets in the U.S., and that will naturally affect their Repo market activity. It was estimated the IHCs will create a $330 billion reduction in the size of the U.S. Repo market, equal to about 7% of the entire market.

Automatic Stay Exemption – Partially Chipped Away

Since 1985, the Repo market has been exempt from the “automatic stay” provisions of the U.S. bankruptcy code. This means is that Repo transactions can be immediately liquidated once a counterparty is in default. It has been the heart and soul of the Repo market, and it now appears that Dodd-Frank has chipped away at it. A report from the Securities and Exchange Commission (SEC) in July 2013* put the “automatic stay” exemption for Repo in doubt. A footnote in the report stated that certain exemptions for Qualified Financial Contracts (which Repo is included) are now subject to automatic stay. A entity, which is a party to a Repo transaction, with a “covered financial company may not exercise any termination rights …. ” until 5:00 pm the day after the FDIC appoints a receiver.

My reading is that Repo is no longer exempt from the automatic stay once FDIC takes over a failing institution.** In the event of a default, a counterparty must move fast to liquidate because they only have until 5:00 pm on the following day before they’re stuck in bankruptcy court for months or years waiting to get their cash or securities back.

Leverage Ratio

There’s talk about a Leverage Ratio being imposed on banks. That, of course, is a way of limiting the size of banks through a backdoor capital requirement. It’s not finalized, but so far there’s speculation it will apply to Dodd-Frank SIFIs (Significantly Important Financial Institutions), which will be required to hold a minimum of 5% capital on all of their assets. Naturally, there are so many ways to take leveraged risk these days that limiting assets doesn’t necessarily reduce bank risk overall.

The principal take-away from this possible new rule is that a minimum amount of capital will be required on all assets. It will hit the Repo market the hardest. Soberlook did a piece using Barclays calculations that shows that Repo now uses about 1% in bank regulatory capital, and that capital usage will bump up to 5% for SIFIs under the Leverage Ratio.

Basel III – Additional Capital Required For Repo Or Not?

The amount of capital needed to support the global Repo market under Basel III is still unclear. A couple of months ago, the Financial Times estimated that $180 billion in additional capital was needed moving from Basel II to Basel III, estimating the average capital set aside for Repo trades was about 2.5% of the entire market. That seems high to me, especially since Basel II had relatively high charges for Repo trades to begin with.

Then, some analysts at JP Morgan came up with a similar number. According to them, all Repo transactions in the U.S., Europe, and Japan make up a $6.8 trillion*** market. Under their study, Repo assets are about 10% of the $77 trillion assets of commercial banks in those countries. They say, under current accounting rules, much of the $6.8 trillion in Repo assets do not show up currently in banks’ Risk Weighted Assets. The J.P. Morgan analysts argue that the new Basel III rules will create an additional capital requirement of $180 billion, assuming a 3% capital requirement is applied.

Financial Transaction Tax (FTT) – Putting Some European Banks Out of The Repo Business

There’s been no new news on the FTT over the past couple of months. The European Commission failed to persuade all 27 EU member countries to implement the tax and there are 11 EU member countries, led by Germany and France, who have pledged to move forward with it anyway. If all goes well, the 11 member tax will be launched around the middle of 2014.

There’s been an important discussion as to how the 10 basis point tax is applied to Repo. If it’s 10 basis points as a rate of interest, then adding .10% on Repo trades makes being an intermediary in the Repo market impossible. If it’s charged as “fee,” then it’s 10 basis points at an annual rate and the equivalent of 36.50% for an overnight trade – making all overnight and short-dated Repo trades impossible.

FSB – Mandatory Repo Haircuts

And just when you thought all avenues of new regulation were already on the table, a new one pops up! This time, there’s a fear by regulators, mostly in Europe, of repeated lending of the same security, re-hypothication as it’s called in the Repo market. Basically, it’s the same securities being loaned from one counterparty to another over and over. Now, my first reaction is to question why there’s anything wrong with that in the first place. Could you imagine limiting how many time a security could be bought and sold?

In August, 2013, the Financial Stability Board (FSB) in the U.K. released a study on securities re-hypothication and what they planned to do about it. They joined the European Commission, which has been looking at an outright ban on how many times an asset can be transferred through financing. The FSB solution, however, is to require mandatory haircuts on securities financing, and so far from what I’ve read, the proposed haircuts do not exceed those already imposed by the market. I have two points to add: First, if the market is already policing itself, why add further burdens? Second, I can’t recall one instance during the financial crisis when re-hypothication was an issue or added to market contagion in any way.

Here’s What It All Means

These are my long-term projections on the the effects of new regulation and increased capital requirements on the Repo market. Note, these projections apply to those entities affected by new regulation and capital requirements.

  1. Repo Matched-Books Eliminated – No more “market making” in Repo, securities finance, and/or stock loan for customers. The costs will become too high for customers who only trade Repo with a bank. The matched-book businesses will disappear at the large banks. One might argue that spreads will widen to reflect the additional costs, but I believe other players will fill the vacated space.
  2. Re-Engineering The Finance Business – There will be significantly more trades with central counterparties (CCPs) and exchanges. Salespeople covering central banks and quasi-government entities (e.g. IADB, World Bank) will suddenly become best-friends with the Repo desk. These entities are mostly exempt from regulatory capital charges and taxes. Large banks will be in the Repo business to finance bank positions and multi-product clients only.
  3. Trading Repo Direct – Repo business will evolve between end-buyers (e.g. money funds) and end-sellers (e.g. hedge funds) – effectively eliminating the middle-men in the Repo market. Not because the end-buyers and end-sellers want to eliminate the middle-man, large banks will just find the cost of standing between two counterparties too costly. The entire market will evolve away from the dealer-to-customer model that’s existed since the dawn of finance. Instead, “customers” of the Street will join the CCPs like FICC and LCH.Clearnet.
  4. Regulatory Arbitrage – Wherever there’s a regulation, there’s a loophole or an exemption somewhere, and where there’s a business need, firms will find a way to make money. There will be increased Repo market-making activity from entities that can compete in the securities financing markets. Perhaps the pendulum will swing back to favor the large U.S. broker-dealer, or some kind of off-shore entity.
  5. Shrinking Repo Market – Many pundits have projected that the Repo market will shrink drastically from its current $4.6 trillion in the U.S. and $7.5 trillion in Europe. Added regulation and capital requirements will certainly mean a smaller market, in general, but claims of a major hit to the Repo market are deceiving. As more Repo business is done direct, it will appear the Repo market is shrinking when fundamentally it is not. Say currently a German bank borrows from a securities lending bank, and then lends those securities to a hedge fund. Suppose with new regulations that transaction becomes too expensive and the German bank middle-man is priced out of the market. The hedge fund still needs to borrow the securities and the securities lending group still has those securities to lend. Those transactions will happen, just not through a large bank middle-man anymore. On paper, the volume of that Repo transaction was just cut in half, but in reality there was really no fundamental change in the size of the Repo market.

* Detailed in a Bloomberg News Article, “Automatic Stay May Harm Repo More Than Liquidity Rules:  Skyrm”; by Alex Harris; August 5, 2013.

**If someone with a legal background understands this new rule, please feel free to contact me. Everything will naturally remain confidential.

*** That number is low compared to most Repo market size estimates

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Scott E.D. Skyrm
About the Author
I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I am the author of the books "The Money Noose - Jon Corzine and the Collapse of MF Global" and "Rogue Traders"

© 2022, Scott Skyrm, LLC, All Rights Reserved

Disclaimer: The information and data in these reports were obtained from sources considered reliable. Opinions, market data, and recommendations are subject to change at any time without notice. Their accuracy and completeness are not guaranteed and nothing herein shall be deemed an offer or solicitation on our part with respect to the purchase or sale of any financial products. Contributors may, in the normal course of business, have position(s) which may or may not agree with the opinions expressed herein.
  • Jon Skinner

    Scott,

    Interesting interpretation. I was looking for a quantification of the leverage ratio stuff on repo so thanks for passing that on. Still looking for similar on Repo Basel III though I heard that the calculation imposes the greater of reg haircuts and market haircuts where today it just uses market haircuts so would expect some increase in capital usage in theory but I’ve no feel for the magnitude.

    On the FSB stuff the minimum haircut (as well as basel III capital) would amount to an incentive to trade cleared repo instead of bilateral. It’s probably hard to estimate the effective haircut impact if everything moves to CCP in Europe because IM is done on a portfolio risk model rather than a flat percentage in Repoclear. What will definitely be true though is that if a dealer does a matched overnight flow trade i.e. repo to a client and a reverse from another dealer on the same security and both trades clear in the same CCP the impact on the flow dealer will be zero risk / funding cost / cRWA.

    I’m wondering whether this becomes the market making norm for govies and more liquid corporates / agencies / MBS repos?

    What do you think?

    Jon

    • David Brosnahan

      Fed prints QE money. Fed gives free QE money to Fed banks. Fed Banks buy US bonds and CDS. Fed Banks exchange bonds and CDS on Repo Market for cash. Fed Banks use cash to invest in inflated stock market. CEO’s cash out stock options (sterilization, false recovery, record US billionaires). Bank of Intn Settlement decrees Basel 3. Dodd-Fank implements Basel 3. Dodd-Frank crushes Repo Market. Inflated Stock Market goes bust. Question: When do Dodd-Frank Repo rules go into affect???

  • Thomas Michl

    Scott,

    Didn’t the train wreck in Lehman’s London subsidiary with rehypothecated securities contribute to financial contagion?

  • scottskyrm

    @jonskinner:disqus Let me know if you find any specific analysis on Basel3 repo, I’m interested.I expect a lot of repo volume moving to exchanges and CCPs, clearly that’s the incentive.
    @thomasmichl:disqus Do you have data/research/articles on Lehman London’s re-hypothication problems? I’d like to see whatever is out there.
    Scott

    • Thomas Michl

      Scott,

      My main source is just FT reportage, such as http://www.ft.com/intl/cms/s/0/88abb51a-160b-11e3-a57d-00144feabdc0.html#axzz2eOgo4yjb

      Also, Darrell Duffie’s book “How big banks fail and what to do about it” which puts runs by hedge funds on prime brokerages on the short list of problems.

      Tom

  • scottskyrm

    Thomas, I’m adding an update on repo re-hypothication in next week’s Repo Roundup
    Scott

  • Pingback: Fair Game: After a Financial Flood, Pipes Are Still Broken | Brians Big Deals()

  • David Brosnahan

    Fed prints QE money. Fed gives free QE money to Fed banks. Fed Banks buy US bonds and CDS. Fed Banks exchange bonds and CDS on Repo Market for cash. Fed Banks use cash to invest in inflated stock market. CEO’s cash out stock options (sterilization, false recovery, record US billionaires). Bank of Intn Settlement decrees Basel 3. Dodd-Fank implements Basel 3. Dodd-Frank crushes Repo Market. Inflated Stock Market goes bust. Question: When do Dodd-Frank Repo rules go into affect???

    • Jon Skinner

      Don’t think DFA / CFTC have direct bearing on Basel 3 / repo. In fact banks put the QE cash in reserves at the rather than investing to limit capital burden of invested assets.

  • Naresh Patel

    Very interesting article –
    thanks. How do you think things have developed since you wrote this article ?
    Do you think there has been any significant shrinkage in the repo market ? If
    so, do you think this has been a contributory factor in the recent volatility
    in the 10Y German bonds ?

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