Liberating liquidity
14 July 2017
Roberto Verrillo of Elixium explores the harsh landscape of liquidity management following the arrival of post-financial crisis regulation
Image: Shutterstock
Changes to the regulatory environment that have already taken place, and those that will occur over the next few years, have put us on a path that will change the industry forever. The impact on how the industry executes its business has been fundamentally changed. Regulatory changes aimed squarely at improving the resilience of financial markets, and their participants as an unintended consequence, have had a direct impact on the pricing and liquidity provided by traditional intermediaries (banks).
Balance sheet costs have risen substantially as significantly more capital is now required to support outstanding transactions. These changes have had a disproportionate effect on low-margin, high-volume businesses, such as repo, which are balance sheet-intensive. As a result, balance sheets have been scaled back dramatically and, consequently, banks have reduced their trading operations and risk appetite. A clear consequence of the reduction and pricing of balance sheets has been a pronounced pass-through of this additional cost from banks to their customers, and a knock-on effect on the pricing and liquidity of the underlying assets.
More specifically, spreads offered to clients for balance-sheet intensive repo transactions have increased to reflect the additional costs incurred by banks by virtue of regulation—increasing the overall cost of trading. This has also affected dealers’ ability to act as maket makers because the cost of holding and funding inventory has risen. Looking at this issue in its entirety, we can ascertain that:
• Illiquidity in secured and unsecured markets is reported across the spectrum, be it buy-side, sell-side or brokers
• Current intermediated capacity is stretched and is causing fragmented pricing
• Intermediated capacity is only likely to deteriorate further
• There is more than ample liquidity in the form of cash as a result of global quantitative easing
• Collateral providers have significant reserves of previously un-lent and unencumbered inventory
• There is an increasing need for capacity on the back of new margining rules for over-the-counter (OTC) products
• The transmission mechanism for collateral transformation to be executed is severely impaired
The potential for more serious market dislocations where collateral provision/transformation can be severely affected in stressed environments is set out more comprehensively in a Bank of England staff working paper (No 609).
Liquidity in anything other than short-dated, balance sheet-neutral trades has dried up substantially, with brokers and market professionals all reporting a lack of activity and interest in price making across the inter-dealer community.
The more balance sheet-intensive a particular business area is, the higher the hurdle rate for returns should be. In this regard, market-making (via capital costs for holding positions) and repo stand out.
We believe that as this process of re-pricing and charging business areas for the regulatory cost of partaking in certain businesses (and transactions) progresses, the market will find many more institutions cutting back and re-structuring their current business models, or simply pulling out of certain markets or product lines altogether—clearly, this will exacerbate the problem.
Evidence of the liquidity situation in the market suggests the need for a platform such as Elixium is becoming even more compelling. The most recent UK DMO T-bill auction yielded negative rates for UK one-month bills, implying -4 percent rates for this quarter-end. A study by the International Capital Markets Association, Closed for Business: A Post-Mortem of the European Repo Market Break-Down Over the 2016 Year-End, found that the weighted average rate for German TomNext general collateral was close to -8 percent, with a low point of -9 percent. French general collateral also averaged around -8 percent.
Mandatory margining for OTC derivatives, which began on 1 March 2017, has already highlighted the dwindling capacity in the repo market. Forthcoming regulation will contribute further to this situation. Daily averaging for liquidity coverage ratio and the implementation of net stable funding ratio are both due in January 2018, just nine months away. The requirements of the fundamental review of the trading book take effect a year later (January 2019).
All will further increase the cost of balance sheet for banks, which, in turn, will have to charge ever wider spreads for financing transactions, be they secured or unsecured.
Liberating capacity
By facilitating the flow of cash to collateral, and vice-versa, Elixium releases liquidity from counterparties that previously may not have been actively engaged in secured financing.
Elixium is a global all-to-all electronic marketplace, designed to provide an unbiased venue for the trading and financing of collateral, which addresses the growing issues around liquidity that have been affected by ongoing market evolution.
The platform has been designed to address the impact of regulation, balance sheet pressures and deteriorating levels of liquidity in the repo market by providing participants with collateralised liquidity on a fair, transparent, inexpensive and equitable basis within a regulated multilateral trading facility environment.
Elixium can help reduce the heavy lifting traditionally associated with access to the repo market. Elixiums’s bespoke, inclusive, all-to-all global master repurchase agreement (GMRA) addresses the issues of cumbersome documentation.
The marketplace can also help solve know-your-customer (KYC) latency and facilitate credit benchmarking and risk-management.
Our purpose has been to design and build an effective, all-to-all electronic trading medium that meets the following criteria:
• Transparent, unbiased, free-to-join, regulated all-to-all marketplace
• Flexible, client-driven trading interface
• Multiple execution options
• Pre-trade anonymity
• Credit framework where participants control credit and counterparty limits
• Connectivity (accommodates and agnostic to all settlement and clearing mediums)
• Secure, cloud-based technology with industry-standard governance controls and audits
• Single-sign documentation (flexible and simplified onboarding, KYC, credit and bespoke GMRA)
• Meet current and future regulatory requirements
Balance sheet costs have risen substantially as significantly more capital is now required to support outstanding transactions. These changes have had a disproportionate effect on low-margin, high-volume businesses, such as repo, which are balance sheet-intensive. As a result, balance sheets have been scaled back dramatically and, consequently, banks have reduced their trading operations and risk appetite. A clear consequence of the reduction and pricing of balance sheets has been a pronounced pass-through of this additional cost from banks to their customers, and a knock-on effect on the pricing and liquidity of the underlying assets.
More specifically, spreads offered to clients for balance-sheet intensive repo transactions have increased to reflect the additional costs incurred by banks by virtue of regulation—increasing the overall cost of trading. This has also affected dealers’ ability to act as maket makers because the cost of holding and funding inventory has risen. Looking at this issue in its entirety, we can ascertain that:
• Illiquidity in secured and unsecured markets is reported across the spectrum, be it buy-side, sell-side or brokers
• Current intermediated capacity is stretched and is causing fragmented pricing
• Intermediated capacity is only likely to deteriorate further
• There is more than ample liquidity in the form of cash as a result of global quantitative easing
• Collateral providers have significant reserves of previously un-lent and unencumbered inventory
• There is an increasing need for capacity on the back of new margining rules for over-the-counter (OTC) products
• The transmission mechanism for collateral transformation to be executed is severely impaired
The potential for more serious market dislocations where collateral provision/transformation can be severely affected in stressed environments is set out more comprehensively in a Bank of England staff working paper (No 609).
Liquidity in anything other than short-dated, balance sheet-neutral trades has dried up substantially, with brokers and market professionals all reporting a lack of activity and interest in price making across the inter-dealer community.
The more balance sheet-intensive a particular business area is, the higher the hurdle rate for returns should be. In this regard, market-making (via capital costs for holding positions) and repo stand out.
We believe that as this process of re-pricing and charging business areas for the regulatory cost of partaking in certain businesses (and transactions) progresses, the market will find many more institutions cutting back and re-structuring their current business models, or simply pulling out of certain markets or product lines altogether—clearly, this will exacerbate the problem.
Evidence of the liquidity situation in the market suggests the need for a platform such as Elixium is becoming even more compelling. The most recent UK DMO T-bill auction yielded negative rates for UK one-month bills, implying -4 percent rates for this quarter-end. A study by the International Capital Markets Association, Closed for Business: A Post-Mortem of the European Repo Market Break-Down Over the 2016 Year-End, found that the weighted average rate for German TomNext general collateral was close to -8 percent, with a low point of -9 percent. French general collateral also averaged around -8 percent.
Mandatory margining for OTC derivatives, which began on 1 March 2017, has already highlighted the dwindling capacity in the repo market. Forthcoming regulation will contribute further to this situation. Daily averaging for liquidity coverage ratio and the implementation of net stable funding ratio are both due in January 2018, just nine months away. The requirements of the fundamental review of the trading book take effect a year later (January 2019).
All will further increase the cost of balance sheet for banks, which, in turn, will have to charge ever wider spreads for financing transactions, be they secured or unsecured.
Liberating capacity
By facilitating the flow of cash to collateral, and vice-versa, Elixium releases liquidity from counterparties that previously may not have been actively engaged in secured financing.
Elixium is a global all-to-all electronic marketplace, designed to provide an unbiased venue for the trading and financing of collateral, which addresses the growing issues around liquidity that have been affected by ongoing market evolution.
The platform has been designed to address the impact of regulation, balance sheet pressures and deteriorating levels of liquidity in the repo market by providing participants with collateralised liquidity on a fair, transparent, inexpensive and equitable basis within a regulated multilateral trading facility environment.
Elixium can help reduce the heavy lifting traditionally associated with access to the repo market. Elixiums’s bespoke, inclusive, all-to-all global master repurchase agreement (GMRA) addresses the issues of cumbersome documentation.
The marketplace can also help solve know-your-customer (KYC) latency and facilitate credit benchmarking and risk-management.
Our purpose has been to design and build an effective, all-to-all electronic trading medium that meets the following criteria:
• Transparent, unbiased, free-to-join, regulated all-to-all marketplace
• Flexible, client-driven trading interface
• Multiple execution options
• Pre-trade anonymity
• Credit framework where participants control credit and counterparty limits
• Connectivity (accommodates and agnostic to all settlement and clearing mediums)
• Secure, cloud-based technology with industry-standard governance controls and audits
• Single-sign documentation (flexible and simplified onboarding, KYC, credit and bespoke GMRA)
• Meet current and future regulatory requirements
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