Weathering the storm
22 August 2017
The repo market has a chance to sculpt the EU Money Market Fund Regulation to relieve some of the stress that it would put reverse repo under as proposed. Drew Nicol examines the responses to ESMA’s consultation
Image: Shutterstock
The European repo market is struggling against major market forces beyond its control. The stresses and strains that these are causing are easily observable from both sides of the transactions and multiple industry associations and notable figures have spoken of their deep concern about the market’s future.
Repo’s woes can be boiled down to a lack of accessible but much coveted high-quality liquid assets (HQLA) to be leveraged as collateral. HQLA has been siphoned off bit by bit by firms to comply with new collateral requirements, while also being hoovered up in significant quantities by central banks as part of their ongoing asset purchase programmes.
Now, however, the EU has a chance to avoid tightening the screws still further if it makes the right choices going into the final phase of its drafting of the money market fund (MMF) reverse repo rules.
The European Securities and Markets Authority (ESMA) has closed its consultation on the first draft of regulatory standards to manage the liquidity and credit quality risks associated with collateral received as part of MMF reverse repo activities. Thirteen industry stakeholders made up of major global banks and industry associations responded, with largely positive feedback on ESMA’s proposals.
For the repo world, the incoming MMF Regulation (MMFR) presents an opportunity, rather than another burden to be avoided.
The Irish Funds Industry Association (IFIA) said it best in its response letter to EMSA: “[F]ollowing the implementation of the MMFR, MMFs will become more reliant on short-term reverse repos. This fact underscores the importance of ensuring that the conditions for reverse repos falling under Article 15(6) are appropriately calibrated and future-proofed.”
“This is particularly the case in light of the capital conditions being imposed on banks under the fourth Capital Requirements Directive, which mean that banks are increasingly constrained in the level of short-term repo in which they can engage.”
As part of ESMA’s consultation, stakeholders were offered five options on how best to manage liquidity and credit risk, and the industry was almost totally united in its response.
On liquidity, 10 of the 13 respondents favoured option A, which focused the measurement of risk on the counterparty of the trade, as opposed to the theoretical liquidity of the collateral itself, or piggybacking of other existing regulatory collateral standards.
Two respondents declined to choose a prefered option and one highlighted significant issues with option A and B (the main two choices) without choosing a favourite.
Option A is based on an approach whereby liquidity requirements applying to the collateral depend on the risk of default of the counterparties to the reverse repo agreement and the applicable counterparty risk diversification limit.
Under option A, ESMA stated: “An MMF may only be forced to liquidate those assets following the default of the counterparty to the reverse repurchase transaction. As a consequence, should the risk of default of the counterparty be limited, based on applicable regulation, no specific liquidity requirements may apply, since as long as the counterparty to the MMF does not default, the assets received as collateral shall not and will not be liquidated by the MMF.”
“However, when counterparties to the MMF may default, the MMF may be forced to liquidate assets received as collateral. Under such circumstance, the liquidity profile of the MMF may be endangered. To avoid so, additional liquidity requirements shall apply to address that potential risk.”
As part of option A’s exempted counterparties, ESMA included European credit institutions, investment firms, central banks, and regulated central counterparties (CCPs), among others.
Of the rejected options, Option B focuses on the overall market liquidity value of the assets used as collateral. Option C has an emphasis on using Basel III’s HQLA definitions to supplement Option B’s framework. Option D has an emphasis on European Market Infrastructure Regulation terminology and Option E offered a variation of Basel III rules.
In its response to ESMA’s regulation draft, BlackRock stated: “We note that option A is the most appropriate, and fits with how we would undertake risk management for our reverse repo activity: with risk management (including haircuts) set based on an assessment first of the counterparty, and then the collateral.”
“However, it is important to note that repo markets are changing: banks are the main counterparties today, but increasingly, the market may move more towards a less dealer-driven market structure where, for example, MMFs deal directly with insurers or pension funds (who, because of clearing rules, will see an increase in demand for the asset side of repo).”
BlackRock also noted that “other developments could see MMFs looking at direct access to cleared repo (and hence CCPs as counterparties) or indeed, even seeing central banks provide reverse repo facilities (as with the New York Federal Reserve reverse repurchase programme in the US)”.
“The rules need to recognise not just what the market looks like today, but allow for how the market is expected to evolve in the near future. The proposed measures recognise CCPs and central banks alongside credit institutions and investment firms. We recommend including insurers and pension funds rather than treating them as ‘unregulated’ for the purpose of the liquidity assessment criteria.”
Given the work that ESMA has put in to shining a spotlight on and limiting this type of alternative financing, commonly known as shadow banking, it’s unclear how well suggestions to include pension funds and insurers will be received.
In terms of further credit requirements on reverse repo transactions, BlackRock simply stated that, due to collateral being of HQLA standard, “we [BlackRock] do not believe further prescriptive rules on credit quality are necessary”.
Asset management firm Amundi, a subsidiary jointly created by Credit Agricole and Societe Generale, emphasised BlackRock’s views. It said: “Amundi clearly supports option A. Option A is intellectually strong and practically efficient.”
“First, it rightly considers that the primary risk in a reverse repo lies with the counterparty and that collateral comes only after; as bankers use to say ‘good guarantees do not produce good credits’. Option A is correct when it focuses on the capacity for the MMF to enforce its rights in case of default of the counterparty.”
BVI, which represents the interests of the German investment fund and asset management industry, reinforced what over-stringent rules could mean for the market.
“Further limitations would prohibit continuing reverse repos as the collateral is very limited. Moreover, reverse repos are an important tool to manage short dated liquidity in the negative interest/excess cash environment.”
“Further limitation with regard to credit quality and liquidity requirements would lead to a reduced market capacity for MMFs.”
From the point of view of the securities financing market, raising the bar on collateral requirements for MMFs would damage the overall market twice over. First, by potentially bringing down the overall number of transactions being conducted while also tying up yet more HQLA at a time when the EU market is crying out for more high-quality liquidity. On the other hand, an active MMF demographic in reverse repo market could be a boon to the liquidity of the market, much to the relief of all involved.
Repo’s woes can be boiled down to a lack of accessible but much coveted high-quality liquid assets (HQLA) to be leveraged as collateral. HQLA has been siphoned off bit by bit by firms to comply with new collateral requirements, while also being hoovered up in significant quantities by central banks as part of their ongoing asset purchase programmes.
Now, however, the EU has a chance to avoid tightening the screws still further if it makes the right choices going into the final phase of its drafting of the money market fund (MMF) reverse repo rules.
The European Securities and Markets Authority (ESMA) has closed its consultation on the first draft of regulatory standards to manage the liquidity and credit quality risks associated with collateral received as part of MMF reverse repo activities. Thirteen industry stakeholders made up of major global banks and industry associations responded, with largely positive feedback on ESMA’s proposals.
For the repo world, the incoming MMF Regulation (MMFR) presents an opportunity, rather than another burden to be avoided.
The Irish Funds Industry Association (IFIA) said it best in its response letter to EMSA: “[F]ollowing the implementation of the MMFR, MMFs will become more reliant on short-term reverse repos. This fact underscores the importance of ensuring that the conditions for reverse repos falling under Article 15(6) are appropriately calibrated and future-proofed.”
“This is particularly the case in light of the capital conditions being imposed on banks under the fourth Capital Requirements Directive, which mean that banks are increasingly constrained in the level of short-term repo in which they can engage.”
As part of ESMA’s consultation, stakeholders were offered five options on how best to manage liquidity and credit risk, and the industry was almost totally united in its response.
On liquidity, 10 of the 13 respondents favoured option A, which focused the measurement of risk on the counterparty of the trade, as opposed to the theoretical liquidity of the collateral itself, or piggybacking of other existing regulatory collateral standards.
Two respondents declined to choose a prefered option and one highlighted significant issues with option A and B (the main two choices) without choosing a favourite.
Option A is based on an approach whereby liquidity requirements applying to the collateral depend on the risk of default of the counterparties to the reverse repo agreement and the applicable counterparty risk diversification limit.
Under option A, ESMA stated: “An MMF may only be forced to liquidate those assets following the default of the counterparty to the reverse repurchase transaction. As a consequence, should the risk of default of the counterparty be limited, based on applicable regulation, no specific liquidity requirements may apply, since as long as the counterparty to the MMF does not default, the assets received as collateral shall not and will not be liquidated by the MMF.”
“However, when counterparties to the MMF may default, the MMF may be forced to liquidate assets received as collateral. Under such circumstance, the liquidity profile of the MMF may be endangered. To avoid so, additional liquidity requirements shall apply to address that potential risk.”
As part of option A’s exempted counterparties, ESMA included European credit institutions, investment firms, central banks, and regulated central counterparties (CCPs), among others.
Of the rejected options, Option B focuses on the overall market liquidity value of the assets used as collateral. Option C has an emphasis on using Basel III’s HQLA definitions to supplement Option B’s framework. Option D has an emphasis on European Market Infrastructure Regulation terminology and Option E offered a variation of Basel III rules.
In its response to ESMA’s regulation draft, BlackRock stated: “We note that option A is the most appropriate, and fits with how we would undertake risk management for our reverse repo activity: with risk management (including haircuts) set based on an assessment first of the counterparty, and then the collateral.”
“However, it is important to note that repo markets are changing: banks are the main counterparties today, but increasingly, the market may move more towards a less dealer-driven market structure where, for example, MMFs deal directly with insurers or pension funds (who, because of clearing rules, will see an increase in demand for the asset side of repo).”
BlackRock also noted that “other developments could see MMFs looking at direct access to cleared repo (and hence CCPs as counterparties) or indeed, even seeing central banks provide reverse repo facilities (as with the New York Federal Reserve reverse repurchase programme in the US)”.
“The rules need to recognise not just what the market looks like today, but allow for how the market is expected to evolve in the near future. The proposed measures recognise CCPs and central banks alongside credit institutions and investment firms. We recommend including insurers and pension funds rather than treating them as ‘unregulated’ for the purpose of the liquidity assessment criteria.”
Given the work that ESMA has put in to shining a spotlight on and limiting this type of alternative financing, commonly known as shadow banking, it’s unclear how well suggestions to include pension funds and insurers will be received.
In terms of further credit requirements on reverse repo transactions, BlackRock simply stated that, due to collateral being of HQLA standard, “we [BlackRock] do not believe further prescriptive rules on credit quality are necessary”.
Asset management firm Amundi, a subsidiary jointly created by Credit Agricole and Societe Generale, emphasised BlackRock’s views. It said: “Amundi clearly supports option A. Option A is intellectually strong and practically efficient.”
“First, it rightly considers that the primary risk in a reverse repo lies with the counterparty and that collateral comes only after; as bankers use to say ‘good guarantees do not produce good credits’. Option A is correct when it focuses on the capacity for the MMF to enforce its rights in case of default of the counterparty.”
BVI, which represents the interests of the German investment fund and asset management industry, reinforced what over-stringent rules could mean for the market.
“Further limitations would prohibit continuing reverse repos as the collateral is very limited. Moreover, reverse repos are an important tool to manage short dated liquidity in the negative interest/excess cash environment.”
“Further limitation with regard to credit quality and liquidity requirements would lead to a reduced market capacity for MMFs.”
From the point of view of the securities financing market, raising the bar on collateral requirements for MMFs would damage the overall market twice over. First, by potentially bringing down the overall number of transactions being conducted while also tying up yet more HQLA at a time when the EU market is crying out for more high-quality liquidity. On the other hand, an active MMF demographic in reverse repo market could be a boon to the liquidity of the market, much to the relief of all involved.
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