What do the repo markets and an Elvis performance have in common? As it turns out, Jeff Kidwell. After a career in repo and securities lending spanning almost three decades in Manhattan, he moved to Florida to join AVM and co-found its direct repo business, where he focuses on connecting his cash provider clients directly with his collateral provider clients. And he still finds time to do Elvis.
SLT: Some of your Repo Commentary followers told me they wanted to know more about you on a personal level and what led you to this point in your career?
Jeffrey Kidwell: My education is actually in communication arts with a degree in English, along with some finance. I intended to be a journalist but instead managed to land a job at Morgan Stanley. Well, luckily I ended up at an investment bank rather than a newspaper, because it has given me the chance to do a lot of other things, like repo and securities lending for 29 years. I also get to write a daily market commentary, which entertains about 2150 people per day, including the Fed, the ECB and most of the State Treasurers. I put in my time in Manhattan at Morgan Stanley and at Cantor Fitzgerald, cultivating sales and trading skills, and building client relationships, which led me to this new gig at AVM. When I left Wall Street in 2008, I wasn’t sure what I wanted to do, and I had covered III Associates, which is the well-known hedge fund affiliate of AVM, and approached them with some ideas I had about a Direct Repo product. It was a way to utilise my client list and relationships with people on both sides of the market without necessarily reinventing myself or continuing to be a typical broker/dealer. I thought this was an exciting challenge and it reinvigorated me to be able to help the market move along its next evolutionary step in which cash providers and collateral providers could speak to each other. That is how I managed to end up in Florida, where I had to embrace the difficult lifestyle: golf, beautiful weather, fishing and boating. There are obviously a lot of things to do in this vacation destination paradise. I have also continued to be an Elvis tribute artist (since 1989) and I continue to travel and sing the National Anthem for major league baseball (since 2003). So, I even find some time to do my singing in Florida too.
SLT: Direct Repo is challenging the standard process in the market, how has this been accepted?
Kidwell: For somebody who had been in the market for a long time managing two huge broker dealer repo desks, you are not sure how a new idea is going to be accepted. After trading and selling for 26 years for a matched book repo desk, intermediating trades with clients on both sides and managing the risk for the broker/dealer, it becomes a very familiar comfort zone. It feels very different and initially unfamiliar, when you are talking about brand new ideas in the market and a new way of thinking, even if it is simply about augmenting the liquidity provided by the existing broker/dealer repo desks. It is not like the cash providers and collateral providers which I am speaking with now weren’t actually trading with each other then, it is just that they had several intermediaries between them, but they have always ultimately been trading with each other.
Because broker-dealers’ balance sheets have shrunk so much, the pipeline is tight - we think of it as a ‘crimped pipeline’ - everybody is under more pressure and there is less liquidity for the actual collateral provider or cash provider at either end of the pipeline. So, people are trying to create other pipelines.
SLT: Why not make the pipeline bigger?
Kidwell: Well, I think they would like to, but with all that has happened since Bear Stearns and Lehman Brothers, senior managers at a lot of broker dealers want to reduce the use of capital and reduce balance sheets, Basel III, Dodd-Frank, Volcker rule, and all these other reforms, financial taxes and so on, are going to actually reduce the pipeline again. Getting back to pre-Lehman levels is probably not going to happen right away, if ever again. But what is happening is that other pipelines are emerging. For instance, there was a pipeline in the news recently, corporate treasurers are now doing triparty repo directly with European banks, which is interesting because it followed an article which came out three months before showing that money funds had stopped doing as much triparty repo with European banks. Corporate treasurers don’t commonly enter the repo market directly, they traditionally go through money funds, but because the money funds pipeline became crimped as they decided to pull back from European banks, a new pipeline emerged with those corporate treasurers who had invested in those money funds deciding to go directly to European banks. Now that new pipeline has gone from $2.5 million to $250 million, jumping 10-fold in one year. And there are other new pipelines forming - like prime custody. Custodians are offering this new product that allows the hedge fund borrower of securities to speak directly to the actual lender of securities, bypassing the traditional prime broker. It is another pipeline that custodians have decided to offer to augment liquidity. Where it used to be just money funds and prime brokers providing a pipeline, other pipelines are emerging.
Another important example is the new Fed pipeline, which they actually referred to as Direct Repo, despite the AVM trademark, in which the Fed chose to expand their cash counterparties. They normally only deal with primary dealers, but now have announced a connection with money market funds and government-sponsored entities (GSEs) such as Fannie Mae, Freddie Mac and Ginnie Mae. The Fed needed to expand their counterparty base to whom they could ultimately sell or repo securities because they recognised that the 21 primary dealers right now do not have sufficient balance sheets to take on all of those securities - ironically the $2.9 trillion of securities moved from the balance sheets of the primary dealers to the Fed’s in the first place in their quantitative easing operations. On top of that, those primary dealers could be more balance sheet and capital constrained going forward, by upcoming regulations, such as Basel III, SEC guidelines, Federal Reserve reporting, new banking regulations, FDIC regulations, etc.
SLT: What support do these pipelines need, technological or otherwise?
Kidwell: The Direct Repo concept would use all the same technology that is already in place. To the extent that a state municipality has been doing repo with a broker dealer or doing cash re- investment with a securities lending agent or custodian, they can still be doing that, but now they will just have more counterparties. So the securities lending agent will show maybe six more counterparties, but the mechanics are the same. For example, if it’s triparty repo, there is no additional technology needed because the securities lending agent already has it in place: If they are doing it for 10 broker dealers, then they can do it for 10 broker dealers and five REITs. To the extent that the cash provider or the beneficial owner are doing their own repo or cash re-investment, then I would be the one who would show them more counterparties.
But beneficial owners, who do their own re-investment or cash providers who do their own repo, may wind up doing some more, or different, counterparty credit work initially. Monitoring might actually be easier for them to check the credit of some of these new counterparties than it has been for checking their current counterparties. REITs, for example, produce quarterly reports and financial reports online. But doing the initial counterparty credit work, that is going to be a little bit more intensive because it is slightly different than what they are used to. They are slightly different animals. When you are studying a lion, you have become familiar with what a lion is – you know it has four paws, teeth, and a tail. Now, you may be analysing a panther, which may have different eating habits and habitat, but is still a similar animal.
SLT: Where is Direct Repo at right now and where is it going?
Kidwell: The nature of the repo market , in my experience over 29 years, despite our advances in technology and electronic trading, begins with people getting comfortable with each other. It starts as an OTC product, over the phone or emails, and then it can move down the road to an electronic form. But when you are talking about a new product, it has to start OTC. People need to get comfortable with new people that they are dealing with. Once they are comfortable with the players that are involved, it can eventually move to an electronic platform and that is probably where things will go down the road for this product, just as it has with derivatives and other OTC markets. You start out OTC, then move to electronic, then move to a centralised clearing counterparty (CCP).
Right now, we have clients on both sides of the fence sitting down at the table and talking to each other, which is a major milestone. We have asset managers sitting down with municipalities. Already the counterparties involved have realised that it makes sense, it is an evolution that could result in significantly better income for both sides, better protections from a haircut standpoint, and more client sector diversification. They are just now working out the mechanics of counterparty credit approval and the questions they should be asking to get their documentation in order.
SLT: Where would you like to be by the end of the year?
Kidwell: I am confident that by the end of the year, many more cash providers will be changing investment policies to include high quality collateral providers as counterparties and taking advantage of this pipeline. I would like them to get more interested in who the counterparties ultimately were that were doing business on the other side with their broker dealers. When you have more intermediaries in a market, you have less information about the other side and I think the market is moving towards more transparency and getting more comfortable with that. I am sure that the Federal Reserve and other regulators probably welcome that too. Clients don’t want surprise headlines and they want to know when they are doing business with a counterparty, who the ultimate counterparty is that they are dealing with. In Direct Repo, we are talking about ultimate counterparties, the owners of the collateral and owners of the cash. In the case of a broker-dealer as a counterparty, clients would like to know where the broker-dealer obtained those securities and how many counterparties are in that repo chain. This leads to the topic of shadow banking and rehypothecation, which is a big discussion for the market right now and regulators are figuring out how they should regulate that. Securities can be rehypothecated countless times, the actual rehypothecation market is some $16 trillion in the US, so securities have been repo’d and repo’d so many times, that the actual owner of the security may be seven clients removed. When there is a default situation and liquidation is necessary, it can be unclear how that path gets unravelled.
SLT: The ECB’s attempts to pump in liquidity have most recently taken the form of the three-year LTRO, can you provide some of your thoughts on the operation?
Kidwell: The LTRO is good for the overall markets’ liquidity for banks, broker dealers and especially European banks. I also think that most of the 523 banks, which took down a total €489 billion in December 2011, are gearing up to try and participate in the second LTRO [On 29 February, figures showed that 800 banks drew €529 billion in the ECB’s second LTRO].
It is inexpensive money at one per cent for three years and the theory is that banks will then be able to use that money in investments, particularly in their sovereign debt, building up their own capital and ultimately their native economies.
SLT: How does it compare to the Fed’s QE programme?
Kidwell: One positive is that the ECB has expanded all of the collateral it will take with the LTRO, all sovereigns, ABS, corporate bonds, a lot more higher-yielding securities than the Fed’s QE took. But it is not that different from the $2.9 trillion balance sheet move by the Fed from broker dealers, which in turn gave the broker dealers and banks all that cash. There is a concern, however. Banks and broker dealers did not in turn necessarily use that money in the US market, but tended to dress up their own balance sheets, improved their own capital position, and went through cost cutting. I don’t think they lent money out to the market or consumers in the way the Federal Reserve expected and there is a risk of the same thing happening with the ECB’s LTROs. In fact, if you look at the first LTRO, almost all of the money that was borrowed by those banks is currently sitting deposited in the ECB in their overnight deposit. It is not being lent out to any other banks or clients. That is a concern, the ECB is trying to get money in the hands of banks to improve the financial conditions of the market and assuming those banks are now going to buy more sovereign debt to prop up those sovereign nations or that they will lend money to consumers or clients to get the market going. But the point of fact from this first LTRO, and from the Fed’s QE programme for that matter, is that this is not happening.
SLT: What might this mean for the securities lending market?
Kidwell: That is another concern. The higher yielding products that the ECB is now vacuuming up in the LTRO will significantly decrease the amount of securities that are available for reinvestment for securities lenders. Securities lenders loan securities out of their portfolios directly or through their securities lending agents to broker dealers who are short the securities. Or, they trade with hedge funds or other clients who are short the securities. Securities lenders then take the proceeds or cash and reinvest or swap into those higher yielding products now moving to the ECB to create incremental income for the portfolio.
So, yes, the LTRO is a good thing from the side of liquidity for the market, but there is no guarantee that banks are going to use the money the way the ECB thinks and then there is this unintended consequence of reducing the amount of securities available for securities lending. On one of the panels I moderated at the IMN Beneficial Owners conference on 1 February 2012, one of the panellists representing a major securities lending firm very specifically noted that this could be a “game changer” for securities lenders.
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