ICMA-ERC: regulations are radically altering repo
18 November 2015 Zurich
Image: Shutterstock
Uncoordinated regulations are radically altering the short-term secured financing market, argues a new study.
The new study from the European Repo Council (ERC) of the International Capital Market Association (ICMA) shows increasing concerns that the cumulative impact of various prudential and market regulations, along with extraordinary monetary policy, could be affecting the ability of the European repo market to function efficiently and effectively.
The qualitative assessment of the current state and future evolution of the European repo market is based on interviews with bank repo desks, fund managers, inter-dealer brokers, electronic trading platform providers, agency lenders and triparty agents,
Basel III, which mandates risk capital requirements and ratios for leverage, liquidity and net stable funding, is the single greatest regulatory driver of change, according to the study.
Each of its four components impact the repo market in different, yet cumulative ways, significantly adding to the cost of capital required to run a repo trading book.
The leverage ratio, with the supplementary leverage ratio for larger US banks, is having the most profound impact on the repo market, “to the point where repo is becoming unprofitable as a traded product”, explained the ICMA-ERC in a briefing document summarising the results of the study.
Adding to the regulatory pressuring on the repo market are European Central Bank monetary policy, which has resulted in excess bank reserves, negative interest rates and a reduction in the stock of high quality collateral, and upcoming changes, including the Central Securities Depository Regulation’s mandatory buy-ins and the provision under the Bank Recovery and Resolution Directive for resolution stays.
Most banks have already restructured or are restructuring their business models, according to the study, through de-risking, deleveraging, changing from a profit-centre to a cost-centre, reducing head-count, and the merging of repo desks with other funding functions to create centralised liquidity and collateral management hubs.
Many banks now even provide repo liquidity to preferred clients as a loss-leader to support other, more profitable businesses and services, according to the study.
The ICMA-ERC interviews discovered a sense among repo market stakeholders that regulators do not fully appreciate how the repo market operates, and that this is apparent in a number of regulatory initiatives, both directly and indirectly related to the repo market.
There is also concern about the cumulative burden of regulation and the cost of its implementation.
“There are still many unknowns arising from both regulation and monetary policy making predicting the future evolution of the European market difficult. The consensus views are: an expected reduction in the size of the market; an increase in the diversity of participants; a general widening of bid-ask spreads; and the ongoing merging of banks funding and collateral management functions,” the ICMA-ERC summarised in its briefing document.
“The overriding concern among market participants is that in future, although they expect the repo market to continue in some form, it may be unable to function as effectively and efficiently as it has in the past in providing liquidity and collateral fluidity to the financial system, with potential negative consequences both for markets and the broader global economy.”
Godfried De Vidts, chair of the ICMA-ERC, said: “The ERC has highlighted the value of the repo market for decades and was swift to recognise the need for regulatory reform in the aftermath of the financial crisis, but this latest study clearly shows that uncoordinated measures by legislators, regulators and prudential authorities are radically altering the short-term secured financing market and may even compromise the success of regulatory measures such as EMIR, which depend on the fluidity and availability of collateral.”
The new study from the European Repo Council (ERC) of the International Capital Market Association (ICMA) shows increasing concerns that the cumulative impact of various prudential and market regulations, along with extraordinary monetary policy, could be affecting the ability of the European repo market to function efficiently and effectively.
The qualitative assessment of the current state and future evolution of the European repo market is based on interviews with bank repo desks, fund managers, inter-dealer brokers, electronic trading platform providers, agency lenders and triparty agents,
Basel III, which mandates risk capital requirements and ratios for leverage, liquidity and net stable funding, is the single greatest regulatory driver of change, according to the study.
Each of its four components impact the repo market in different, yet cumulative ways, significantly adding to the cost of capital required to run a repo trading book.
The leverage ratio, with the supplementary leverage ratio for larger US banks, is having the most profound impact on the repo market, “to the point where repo is becoming unprofitable as a traded product”, explained the ICMA-ERC in a briefing document summarising the results of the study.
Adding to the regulatory pressuring on the repo market are European Central Bank monetary policy, which has resulted in excess bank reserves, negative interest rates and a reduction in the stock of high quality collateral, and upcoming changes, including the Central Securities Depository Regulation’s mandatory buy-ins and the provision under the Bank Recovery and Resolution Directive for resolution stays.
Most banks have already restructured or are restructuring their business models, according to the study, through de-risking, deleveraging, changing from a profit-centre to a cost-centre, reducing head-count, and the merging of repo desks with other funding functions to create centralised liquidity and collateral management hubs.
Many banks now even provide repo liquidity to preferred clients as a loss-leader to support other, more profitable businesses and services, according to the study.
The ICMA-ERC interviews discovered a sense among repo market stakeholders that regulators do not fully appreciate how the repo market operates, and that this is apparent in a number of regulatory initiatives, both directly and indirectly related to the repo market.
There is also concern about the cumulative burden of regulation and the cost of its implementation.
“There are still many unknowns arising from both regulation and monetary policy making predicting the future evolution of the European market difficult. The consensus views are: an expected reduction in the size of the market; an increase in the diversity of participants; a general widening of bid-ask spreads; and the ongoing merging of banks funding and collateral management functions,” the ICMA-ERC summarised in its briefing document.
“The overriding concern among market participants is that in future, although they expect the repo market to continue in some form, it may be unable to function as effectively and efficiently as it has in the past in providing liquidity and collateral fluidity to the financial system, with potential negative consequences both for markets and the broader global economy.”
Godfried De Vidts, chair of the ICMA-ERC, said: “The ERC has highlighted the value of the repo market for decades and was swift to recognise the need for regulatory reform in the aftermath of the financial crisis, but this latest study clearly shows that uncoordinated measures by legislators, regulators and prudential authorities are radically altering the short-term secured financing market and may even compromise the success of regulatory measures such as EMIR, which depend on the fluidity and availability of collateral.”
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