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 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.
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.
- 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.
- 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.
- 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.
- 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.
- 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