Fitch: fire sale could burn repo
18 June 2015 New York
Image: Shutterstock
The repo market could be at risk if a ‘fire sale’ of assets hits financial markets, Fitch Ratings has warned in a new report.
The rating agency’s study of corporate bond liquidity focused on the characteristics of corporate bonds pledged as collateral in the triparty repo market.
Corporate bond collateral characteristics such as long-dated maturities, low trading frequency and wrong way risk could raise risks of a forced unwinding of repo-funded trades in a scenario where risk aversion increases sharply, said Fitch in a statement.
“Such risk aversion could limit the ability of dealers to finance securities in the repo market. Cash investors such as money market funds could also be forced to sell collateral in the event of a dealer default.”
On top of this, maturity mismatches between short-term repos and the long-term corporate bond collateral that they finance could exacerbate fire sale risk if trades are unwound quickly, argued Fitch.
“Over 90 percent of the bonds in our collateral sample have maturities of one year or more. These bonds carry greater interest rate risk, and could be more difficult to sell in a period of market dislocation.”
The effects that a fire sale could have on repo have long been mooted, with the Financial Stability Oversight Council commenting in its latest annual report on financial markets: “Previous annual reports have highlighted structural vulnerabilities in the triparty repo market.”
“Significant progress has been made in this market in recent years, in particular reducing market participants’ reliance on intra-day credit from clearing banks. The risk of fire sales of collateral deployed in repo transactions remains an important financial stability concern.”
According to the Federal Reserve, up to $250 million per day in corporate bonds can be liquidated without negatively affecting bond prices.
But total corporate bond triparty repo collateral averaged approximately $75 billion in 2014. “Forced selling of even a small fraction of that amount could accelerate price pressure during periods of market stress,” added Fitch.
Fitch’s study, Corporate Bonds and Fire Sale Risk: Repo Collateral Pools Highlight Liquidity Issues, is based on a broad survey of corporate bonds pledged as collateral by dealers in the triparty repo market as of 31 December 2014.
The rating agency’s study of corporate bond liquidity focused on the characteristics of corporate bonds pledged as collateral in the triparty repo market.
Corporate bond collateral characteristics such as long-dated maturities, low trading frequency and wrong way risk could raise risks of a forced unwinding of repo-funded trades in a scenario where risk aversion increases sharply, said Fitch in a statement.
“Such risk aversion could limit the ability of dealers to finance securities in the repo market. Cash investors such as money market funds could also be forced to sell collateral in the event of a dealer default.”
On top of this, maturity mismatches between short-term repos and the long-term corporate bond collateral that they finance could exacerbate fire sale risk if trades are unwound quickly, argued Fitch.
“Over 90 percent of the bonds in our collateral sample have maturities of one year or more. These bonds carry greater interest rate risk, and could be more difficult to sell in a period of market dislocation.”
The effects that a fire sale could have on repo have long been mooted, with the Financial Stability Oversight Council commenting in its latest annual report on financial markets: “Previous annual reports have highlighted structural vulnerabilities in the triparty repo market.”
“Significant progress has been made in this market in recent years, in particular reducing market participants’ reliance on intra-day credit from clearing banks. The risk of fire sales of collateral deployed in repo transactions remains an important financial stability concern.”
According to the Federal Reserve, up to $250 million per day in corporate bonds can be liquidated without negatively affecting bond prices.
But total corporate bond triparty repo collateral averaged approximately $75 billion in 2014. “Forced selling of even a small fraction of that amount could accelerate price pressure during periods of market stress,” added Fitch.
Fitch’s study, Corporate Bonds and Fire Sale Risk: Repo Collateral Pools Highlight Liquidity Issues, is based on a broad survey of corporate bonds pledged as collateral by dealers in the triparty repo market as of 31 December 2014.
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