Post-crisis financial regulation is changing the way banks and financial institutions do business. As a vital part in the operation of banks and the functioning of financial markets, the bank repo desk will have to evolve and adapt to the new regulatory environment. While much of the eventual impact of the regulation remains uncertain, some is predictable: repo will become more expensive and more transparent; some disintermediation of banks is likely, though not inevitable; creativity and innovation in how banks fund themselves and their clients will be critical; as will a growing focus on collateral management. Despite these challenges, the neo-regulatory landscape will also provide opportunities. The key is to spot these, and to start positioning now.
The ‘Repo Desk’ has traditionally been at the heart of the capital markets divisions of investment and commercial banks, providing the main source of funding for the bank’s trading activities, while also making markets to finance the bank’s diverse client base. Furthermore, repo desks tend to be the focal point for taking short-term interest-rate risk; are a vital component in the pricing of a whole range of securities and derivatives; and are the primary interface between the bank and central bank monetary operations. Yet despite these important, and even critical, roles, repo desks are often perhaps the least understood corner of the trading floor. Partly this could be because of the diversity of functions they serve, but also it is due to the intricate (and all too often ignored) ways in which repo markets can influence the pricing and liquidity of a whole range of underlying securities and derivatives. In this paper, I attempt to identify the probable trends and significant changes in how repo desks are likely to operate in light of the rapidly evolving regulatory environment.
The raft of local and global regulatory initiatives following the financial crisis of 2007-10, which is designed to reduce systemic risk in the banking and financial sectors, is already having huge repercussions for the trading and market-making activities of banks. Yet anticipating the full impact of this regulation on repo desks is not straightforward. Many of the initiatives tend to be sweeping rather than product or market segment focused, and in many instances, it would seem reasonable to assume that those driving the regulation have given little or no thought to the repo market. In some cases, such as the drive for greater transparency in trade reporting, the likely impact for the repo market is indirect, and may prove to be relatively nuanced. Whereas proposals such as the European Financial Transaction Tax (FTT), or the accounting treatment of repos in the calculation of leverage ratios, would be far more direct, even having an existential resonance. The fact that much of the regulation is work in progress, and (quite rightly) being scrutinized, challenged, and modified, also makes it difficult to predict the long-term effects on repo. However, there are a number of consistent themes and impetuses underlying the regulatory changes that will almost certainly mean that repo desks will need to review the way they do business and evolve accordingly. I will try to highlight some of these key forces.
Repo just got more expensive…
One thing we can be fairly certain of is that the cost of trading repo for banks will increase. The only question is by how much? Underlying this is the requirement of Basel III that all banks hold more and better quality reserve capital, which in effect will make all trading and financing activities more expensive. It would seem inevitable that there will be far more focus on the return on capital of various trading functions within banks, including repo, as desks and business units fight for their share of a decreasing and more expensive balance sheet. Low margin, capital intensive trades will become harder to justify, or will need to be more prudently priced. For some repo desks, this may come as a culture shock, but for many, particularly those at banks that are already used to fighting over smaller balance sheets, and where return on capital is engrained, this may not be such a challenge.
However, as banks that already treat balance sheet as a limited resource are well-aware, much of their repo activity is made possible through the ability to net counterparty exposure. That is, the offsetting of repos and reverse-repos with the same counterparty, in similar securities and matching maturities. Given that by its very nature much of the repo market is high volume and low margin, this accounting provision is critical, since it effectively takes the lion’s share of repo activity off the balance sheet. For many banks, this provision could be under-threat. Basel III introduces a Leverage Ratio, a non-risk weighted ratio of total exposure to capital. The purpose is to prevent an excessive build-up of leverage on banks’ balance sheets, and it is intended to be a ‘back-stop’ for risk weighted asset (RWA) based capital ratios. In the US, this has been taken further with a proposal that bank holding companies (BHCs) adhere to an even higher Supplementary Leverage Ratio (SLR). Whether by accident or design, neither of these proposals allow for the netting of repo exposure, suggesting that exposure be measured purely on a gross basis. A report by JP Morgan suggests that the current size of the global repo market that is currently treated off-balance sheet (estimated at more than $7tn) would require major banks in the US, Japan, and Europe to hold additional capital of around $180bn. In reality, the effect is more likely to be a huge deleveraging of these banks and a significant contraction of the repo market. Somewhat ironically (and perhaps counterintuitively to the intent of the regulation), it would be the high volume, low-RWA segment of the market (namely high quality government bonds such as US Treasuries) that would be hardest hit, as the Leverage Ratio supersedes other capital ratios as the primary limit on assets. This could precipitate a shift in the focus of repo desks away from high-volume, low risk, low margin, bread-and-butter activity, to more selective, high-risk, high-margin trades.
The proposed European Financial Transaction Tax (FTT), were it ever to happen, would have an even more direct and even seismic impact on the cost of trading repo. Affecting all EU financial institutions, it would effectively place a flat levy on all secondary market trades, including a 0.10% charge on the value of all repo and securities financing transactions (SFTs). The impact of a flat fee would have a disproportionate impact the shorter the maturity of the transaction, to the point of absurdity. On an overnight trade, for instance, it would equate to an additional cost of 36.5%. Given that the tax is levied on all sides of a transaction, this would mean a 73% charge for an over-night match-funded trade. Analyses suggest that this could effectively close the European repo market for all transactions of under six months’ maturity, and reduce the size of the market by as much as 66%. The knock-on effect of the FTT in contracting secondary and derivatives markets would only further reduce repo activity. If the FTT is implemented as planned, then any discussion on the future of repo desks, at least in the Eurozone, is irrelevant, and you can stop reading now.
However, while the FTT, at least in its proposed form, should never happen, it is still very possible that some form of levy on repo and SFTs could be imposed by the EU. Further sources of rising costs are also likely to come from regulation pushing for the greater use of central counterparties (CCPs) for repo transactions, which will demand more stringent margin requirements, and the possible introduction of mandatory hair-cuts for some trades.
All of this will mean that repo desks will need to become even more discerning in the repo trades and activities they select, and more savvy in the allocation and pricing of balance sheet.
…and more transparent
Both Dodd-Frank and MiFID II call for greater market transparency and reporting of trades, which would include all repo and SFT activity. From an operational perspective, given the size and turnover of the global repo markets, this is a gargantuan challenge, for both those doing the reporting and those doing the monitoring. Automation and technology will clearly play a role, and this could significantly increase the appeal of trading repo through electronic platforms, not only for repo desks but also for their clients. Where CCPs take on the onus of trade reporting, this should also help to make them a more attractive proposition.
Other than these operational considerations, this should have little impact on the activities of repo desks. What may, however, is the reporting of positions and risk. Repo matched-books (the positions repo traders hold on their books that ensue from market-making in repo) can be horribly complex, and while most banks should be adept at monitoring and managing the imbedded interest-rate, credit, and counterparty exposures, some may not be.
A further sense of scrutiny could also arise from regulations designed to restrict high frequency trading (an interesting proposition for a high frequency market), as well as the much contested Volker Rule, which seeks to prohibit banking entities from engaging in proprietary trading, and which could encroach on the gray-area between matched-book related positioning and proprietary speculation.
But what will almost certainly arise out of the demand for greater transparency and reporting is the need for repo desks to think more carefully about the trades they take on, the positions they run, and the way they manage their risk.
Collateral is king
One aspect of the new regulations that has filled up the columns of the financial press more than any other is undoubtedly related to the expected surge in the demand for collateral. Both Dodd-Frank and EMIR require that most derivatives trades be cleared through CCPs, with far more stringent initial margin requirements than counterparties are willing to accept through bilateral trades. While nobody is quite sure of the exact impact this will have when fully implemented, the OCC estimates that initial margin requirements, globally, could reach $2tn. Furthermore, the collateral that is pledged as margin will need to be of relatively high quality (primarily major currency government bonds). This has led commentators to predict an unprecedented increase in demand for such collateral to meet margin requirements. Furthermore, Liquidity Coverage Ratio (LCR) requirements under Basel III should add to the demand for high quality liquid assets (HQLAs), which include reverse-repos in high-grade government bonds. Rules limiting the rehypothecation of certain assets could add further pressure.
The question that is writing headlines is will there be enough good quality, unencumbered collateral to meet the demand? And where will this collateral come from? Accordingly, ‘collateral management’ has become the newest game in town, and with it a range of concepts such as ‘collateral mining’ (the sourcing of securities to borrow) and ‘collateral transformation’ (the simultaneous lending and borrowing of securities with different credit ratings). For many users of OTC derivatives, who are beginning to adjust to the realities of the new regulations, collateral management is an exciting and mysterious new world awaiting discovery, a land of treasure hunters and financial alchemists. Yet for repo desks, collateral management, by any other name, is as old as the ark and what they do best. This would suggest an opportunity.
But first, we should perhaps not get too carried away by the anticipated shortfall in rehypothecatable quality assets. The demand for margin, in all reality, is likely to be less extreme than predicted (as trading derivatives becomes more expensive, volumes should decrease). There may be more accessible collateral out there than we think, and already there is some talk of central banks recycling government debt purchased through their QE programs. And then there is always cash, which for many may be much easier to manage and post than collateral.
But it is reasonable to assume that certain collateral types will see an increase in demand and value, and being able to source, price, and manage these securities, as well as the ability to fund and recycle lower quality assets, could provide an even sharper edge for the bank repo desk. The full potential for repo and securities lending has not yet been tapped, and repo desks and their emissaries should be sharing the wonder that is collateral management far and wide; before somebody else does.
Cutting out the middle-man
Given the general increase in the cost of trading repo, with banks being hardest hit, it would not be surprising if some repo and SFT activity moved out of the banks, and became the dominion of other, less onerously regulated entities. Some business could be taken on by alternative investment funds with capital to spare, and already a number of larger hedge funds operate their own repo desks, some in competition with the banks. Meanwhile, the regulatory push toward using CCPs could create an environment where buy-side counterparties could easily trade directly with each other, negating the need for an intermediary bank. Buy-side to buy-side platforms for repo and securities lending are already being built, and are likely to garner popular support. Some even question the necessity for the bank repo desk in the neo-regulatory world.
However, while some disintermediation is likely, and, in the case of low margin, capital intensive business, may even be welcomed by some banks, we should not be too quick to write the obituary of the bank repo desk. What is often overlooked is the market-making service that repo desks provide. Were they simply standing between counterparty-A and counterparty-B, and taking a spread, then indeed their role could be questionable. But this is rarely the case. Repo desks are usually required to provide pricing to a whole range of clients, with different funding and investment requirements, in a raft of different securities and credits, whenever they require it. Accordingly, their trading books (somewhat confusingly known as the ’matched-book’) are invariably a complex portfolio of assorted repos and reverses, in a multitude of securities, covering a whole range of periods, and loaded with interest-rate and credit risk, which the repo trader must adroitly manage. It is this liquidity and pricing repo desks provide that give them their value.
While some of the repo market could possibly function without the bank repo desks, at least some of the time, there is an inherent risk in completely disintermediating their role. If repo desks are unable or unwilling to make markets, this could leave a huge hole, particularly for more bespoke or less vanilla financing requirements. There could also be a lack of immediacy for counterparties in filling their trades, as borrowers and lenders wait to find complimentary interests. And in times of market stress, without the liquidity back-stop that repo desks provide, funding markets could freeze. Unless there are non-bank institutions ready to take on the role of market-making in repo and SFTs, the bank repo desk will be around for a while longer.
One thing we learn from history is not to underestimate the ability of markets and participants to adapt to and survive new regulatory initiatives. The same should be true for the repo market, particularly given the engrained culture of resourcefulness and creativity of repo desks. In the neo-regulatory landscape, this aptitude for flair and ingenuity will be even more imperative. Balance sheet management (and more importantly, off-balance sheet management) will be critical, and we should expect new products and funding vehicles to accommodate this. Relocating businesses to less arduously regulated centers or entities seems inevitable. As already discussed, repo desks will need to hunt down more sources of cash and collateral, as well as finding ways to fund and recycle low quality assets. They will also need to become more innovative in creating new instruments and funding tools, such as the recent promotion of repo-backed commercial paper. In many respects, this all points to the survival of the most creative.
Whether one views this as regulatory arbitrage, or market efficiency, we can be confident that it is going to happen, with the smartest banks leading the way.
Cooperation makes it happen
Perhaps the most visible change in the structure and functioning of the traditional repo desk will be in its need to better cooperate and coordinate with other funding functions of the bank. As already highlighted, the ability to optimize the management and financing of the bank and clients’ assets will be critical. This will require the ‘de-silofication’ of funding centers and with it the possible centralization of collateral and liquidity management. This will involve repo desks working more closely with their equity finance and stock-loan desks, as the definition of collateral is broadened to all cash funded securities. They will also need to coordinate closely with their prime brokerage division to ensure consistency and efficiency in the pricing of client financing and the rehypothecation of client assets. Greater interaction with the bank’s treasury and cooperation in liquidity management (particularly in meeting LCR requirements), also makes eminent sense. Operations, too, need to be part of this equation, supporting the smooth movement of collateral and the efficient posting of margin.
Figure: A model for an integrated collateral management function
What we are likely to see is the creation of a formalized, centralized, integrated collateral management function, connecting all these various desks and business units. However, collateral management will not be an optimization algorithm (although clever technology will certainly be involved), nor will it be an operations function (even though the ability to efficiently allocate and move collateral between centers and systems will be critical). Rather, it will be structured around the ability to source, price, fund, allocate, and recycle collateral effectively and efficiently, and to manage the inherent interest-rate, credit, and counterparty risks that go with it. It will be market and client facing, as well as connecting to the bank’s internal business units. Essentially, it will look a lot like a repo desk, only with a far broader mandate.
It is almost impossible to predict how the various ongoing regulatory initiatives will pan out, their eventual impact on global capital markets, and with that the repo market. In some respects, this makes it difficult to plan for every eventuality, not least when some of the proposals, such as the accounting treatment of repo in leverage ratios or the FTT, are such potential game changers. But in light of some of the themes and objectives underlying the regulation, there are some identifiable certainties for the neo-regulatory environment, for which bank repo desks can and should be preparing themselves.
Repo will become more expensive to trade, and more transparent in terms of the risks and returns. Repo desks will need to think more carefully about the businesses that make sense, how they manage their risk, and how they utilize limited balance sheet. Disintermediation will pose a threat, but so long as repo desks can offer high levels of service and pricing, their franchises should remain intact. Repo desks have often been a force for innovation in the financial markets, and never will this have been more pertinent. Creativity will be key as they find new and more efficient ways to finance their bank and their clients. Collateral management will become ever more of a focus, and no function should be better suited than the bank repo desk when it comes to the sourcing, pricing, and recycling of collateral. Greater cooperation between the repo desk and other funding businesses, and even the creation of integrated financing and collateral management functions, will make more sense as banks look to optimize their business advantages.
In some respects, and despite all the challenges, the new regulatory environment may offer a number of opportunities for the bank repo desk. Of course, some will fare better than others. The key will be to spot those opportunities early, and to position for them now. Waiting until the regulatory dust has settled could be too late.
 Repo desks have traditionally almost exclusively focused on fixed income products and their financing, while Stock Loan or Equity Finance desks serve a similar function for equity-type securities
 I used to give a presentation at Goldman Sachs entitled ‘r is not a constant’ (where ‘r’ is the repo rate), illustrating exactly this point in the context of government bond futures.
 It is currently proposed that the Leverage Ratio be 3%, to become binding from 2018
 The FDIC, OCC, and FRB are proposing an SLR of 5% for BHCs, and 6% for the largest BHCs. This would be enforceable from 2018.
 i.e. the total value of either reverse-repos or repos
 Financial Times, 2013, Why new leverage ratio rules could stifle repo markets, July 22 2013
 See Comotto R, 2013, Collateral damage: the impact of the Financial Transaction tax on the European Repo Market and its consequences on financial markets and the real economy, ICMA-ERC, April 8 2013
 Currently scheduled for implementation in January 2014, but likely to be put back to mid-2014
 Both recommendations of the FSB; see FSB, 2013, Strengthening Oversight and Regulation of Shadow Banking: Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August 29 2013
 Proposed under MiFID II
 Currently proposed under Title VI of Dodd-Frank; implementation has been delayed until mid-2014
 One possible explanation for this extremely misleading name might be the fact that to ‘balance their book’, the repo trader needs to ensure that every long position is funded, while every short position is borrowed, at least for that day. So on an ‘overnight’ basis, one could argue that the repo-book is indeed ‘matched’.
 One could even argue that by restricting or disintermediating the market-making activity of bank repo desks, this is creating a procyclicality risk, which is somewhat counterintuitive to the objective of the regulation.
 Perhaps with the notable exception of the introduction of a Financial Transaction Tax in Sweden in 1984, where secondary market trading in Swedish securities dropped by 80% (what survived migrated to London), while derivatives trading fell almost to zero. Unsurprisingly, the tax was abolished two years later.
 Traditionally, repo desks and the prime brokerage divisions have been kept at arm’s length, primarily due to the legal separation of client services and capital markets. However, where client confidentiality is ensured, there is no reason to prevent closer coordination in their financing and collateral management functions.