Sustainable repo: finding the right balance
07 December 2021
After the release of ICMA ERCC’s consultation summary report on the role of repo in green and sustainable finance, leaders in the industry discuss the effects of green collateral on an evolving sector and the possibilities of attaining a truly green repo market. Carmella Haswell reports
Image: stock.adobe.com/3rus
Creating a green and sustainable financial landscape has become a priority for many companies, with the implementation of the Sustainable Finance Disclosure Regulation (SFDR), the International Capital Market Association’s (ICMA) Green and Social Bond Principles (GBP) and deadlines from COP26 pushing every financial firm, bank, insurer and investor to change in order to achieve net zero by 2050.
After months of conversing with 18 different firms, a September summary report by ICMA’s European Repo and Collateral Council (ERCC), titled The Role of Repo in Green and Sustainable Finance, evaluated the sustainability aspects of repo and collateral as well as the potential opportunities and risks in this area.
Alexander Westphal, ICMA director of Market Practice and Regulatory Policy, and secretary to the ICMA ERCC, says the two months following the report have allowed ICMA to start constructing a Task Force to tackle repo market concerns. Combining the forces of the ERCC and GBP, ICMA has invited member firms to select candidates to join the Task Force, with the aim to hold a kick-off meeting by the end of the year.
Westphal comments: “Finding the right balance between promoting sustainability and ensuring the efficiency and safety of the repo market, as well as safeguarding the crucial role it plays for the wider financial market, will certainly be a key objective of the new Task Force. We are very keen to have all the relevant stakeholders represented in the group so we can ensure that the different perspectives are properly taken into account when it comes to the formulation of any definitions or best practices.”
Green collateral repo
The ICMA summary report explored three intersections that it asked stakeholders to consider: “repo with green and sustainable collateral”; “repo with green and sustainable cash proceeds’’; “repo with green and sustainable counterparties”. According to an ERCC committee meeting, the financial landscape is moving towards a green repo market where buyers and sellers will only transfer bonds as collateral that are classified as green. Eurex launched its Green Bond GC Basket in November 2020 and other central counterparties (CCP) and triparty agents report growing demand from clients to support classification and movement of sustainable collateral.
The report also explores the cash leg of repo — where a strict definition of green and sustainable repo might require the cash loaned in a repo transaction to be invested in green projects or activities, thereby boosting the sustainable finance ecosystem. The third dimension to be considered was the classification of the counterparties to the repo transaction, with the borrower’s and lender’s sustainability performance or profile being key in this instance.
Participants listed several important steps to building an efficient market for green and sustainable repo trading. This includes supporting market liquidity, facilitating market making, supporting primary market issuance and fostering price discovery. However, one respondent cautioned that green collateral repo may not provide the necessary transitional environmental benefits if it is strictly limited to green collateral. Furthermore, it was suggested that in the green loan market, non-green assets are often accepted as securities for secured finance that will then be used to produce green assets. A more open approach would enable a better transition compared to “green collateral repo”, where only green assets are used as collateral.
Reinforcing this point, respondents identified a need for the ICMA to assess possible adverse impacts and risks that green repo may have on non-green finance. For example, in ICMA’s April 2021 consultation paper, it questioned “if the pool of eligible collateral is limited by regulators or central banks in the future, and non-ESG investment collateral is deemed less preferable”, then what is the impact of such stricter criteria on the collateral fluidity, liquidity and efficiency in the overall market?. “As noted in the summary report, this is certainly a potential concern and a topic that the new Task Force will probably want to consider in more detail,” says Westphal.
Reflecting on the relationship between green and non-green finance, Marc Poinsignon, expert collateral management at Clearstream says: “Ultimately, what you want to avoid is some sort of cliff edge situation between what is deemed green and non-green. The joint work done by regulators and industry participants as a whole is essential to achieving a smooth transition that supports the objectives to address climate change and social governance.”
Repo and securities finance have a role to play in facilitating growth of environmental, social and governance (ESG) across asset classes, according to Poinsignon. This transition in capital markets may require a phased approach with achievable, scalable and standardised parameters as well as different transitional strategies in different regions and economies, he adds.
Furthering this point, Gerard Denham, senior vice president of fixed income funding and financing at Eurex, emphasises that the “repo market won’t change to fully green on a deadline date set in the future”. He encouraged the repo market, and its associated infrastructure providers, to continue to support issuance and liquidity across all asset classes — green and non-green.
The ICMA report also highlighted the absence of clear standards and how this could lead to claims of greenwashing. 17 respondents agreed greenwashing was a top concern, commenting on risks involving the incorrect classification of products as ‘green’ investment — where no additional green assets are created or no additional funding goes into green activities — and ‘double counting’ of green collateral repo, when both the buyer and the seller of the repo claim the green collateral as their own green investment.
Beyond greenwashing, respondents highlighted the need for clear procedures to ensure that collateral eligibility criteria are applied throughout the lifecycle of the repo transaction — and that the ESG quality of collateral is not compromised through collateral substitution that replaces ‘green’ assets by ‘brown’ assets for example.
To support the functioning of a sustainable repo market several firms have launched products and services to classify and select green collateral. In the coming weeks, Clearstream will introduce ESG bond identifiers which will be implemented as criteria for inclusion in collateral baskets, defining eligibility, concentration limits and haircuts. Available for triparty transactions between clients, the identifiers leverage international standards, principles or guidelines that are available in the market and can be used alongside any liquidity and risk criteria already available, explains Poinsignon.
Revealing Eurex’s process when it comes to selecting green collateral, Denham adds: “We work within existing Eurex Clearing eligibility criteria for all the bonds that we take as collateral for repo transactions. For the green bond general collateral baskets, we added additional criteria, which means they must be classified as a green bond.”
He continues: “They need to be investment grade quality, and a Euro denominated, fixed income security. The green bond must also be issued in line with the ICMA’s Green Bond Principles. Potentially, they could also be aligned to the EU Green Bond standard, which is due to be put into play in regulation within the next three to six months.”
Defining green and sustainable repo
Respondents to the ICMA report highlighted several ways the association could contribute to the development of a green and sustainable repo market, establishing clearer definitions and standard approaches for different types of repo as a starting point. More than half of the respondents suggested the trade association produce a specific framework similar to ICMA’s GBP.
Clearstream’s Poinsignon indicates that there are multiple components to a repo trade that need to be considered when assessing whether the transaction can be classified as “green” or “sustainable” — there’s the collateral element, how the cash is deployed, and counterparty for example. “For sure one of the starting points is the collateral itself,” he says. “Leading international standards and principles, such as those from ICMA or the Climate Bond Initiative, can already be applied on the securities. These bring notably transparent frameworks and detailed information on the ESG characteristics of the bond.”
Eurex’s Denham indicates that there are two main elements to a green or sustainable repo transaction. He says: “One is underlying green collateral, such as Eurex Repo’s Green Bond GC Baskets, which we believe can be classified as a sustainable repo, in reference to the ICMA report. The other area is to do with the cash element of the repo transaction and we believe there’s work to be done on that where you can link that cash, or the cash management of the repo transaction, to sustainable linked investments.” However, this is dependent on the appropriate data being made available by vendors to market participants and market infrastructure providers.
Poinsignon suggests that to provide clarity to the securities finance market, trade associations need to evaluate possible adverse impacts on market stability and pro-cyclical risks on non-green finance. Additionally, they should be supporting sound and transparent operating models that mitigate risk and enable long-term investor engagement on securities that they’re invested in.
After months of conversing with 18 different firms, a September summary report by ICMA’s European Repo and Collateral Council (ERCC), titled The Role of Repo in Green and Sustainable Finance, evaluated the sustainability aspects of repo and collateral as well as the potential opportunities and risks in this area.
Alexander Westphal, ICMA director of Market Practice and Regulatory Policy, and secretary to the ICMA ERCC, says the two months following the report have allowed ICMA to start constructing a Task Force to tackle repo market concerns. Combining the forces of the ERCC and GBP, ICMA has invited member firms to select candidates to join the Task Force, with the aim to hold a kick-off meeting by the end of the year.
Westphal comments: “Finding the right balance between promoting sustainability and ensuring the efficiency and safety of the repo market, as well as safeguarding the crucial role it plays for the wider financial market, will certainly be a key objective of the new Task Force. We are very keen to have all the relevant stakeholders represented in the group so we can ensure that the different perspectives are properly taken into account when it comes to the formulation of any definitions or best practices.”
Green collateral repo
The ICMA summary report explored three intersections that it asked stakeholders to consider: “repo with green and sustainable collateral”; “repo with green and sustainable cash proceeds’’; “repo with green and sustainable counterparties”. According to an ERCC committee meeting, the financial landscape is moving towards a green repo market where buyers and sellers will only transfer bonds as collateral that are classified as green. Eurex launched its Green Bond GC Basket in November 2020 and other central counterparties (CCP) and triparty agents report growing demand from clients to support classification and movement of sustainable collateral.
The report also explores the cash leg of repo — where a strict definition of green and sustainable repo might require the cash loaned in a repo transaction to be invested in green projects or activities, thereby boosting the sustainable finance ecosystem. The third dimension to be considered was the classification of the counterparties to the repo transaction, with the borrower’s and lender’s sustainability performance or profile being key in this instance.
Participants listed several important steps to building an efficient market for green and sustainable repo trading. This includes supporting market liquidity, facilitating market making, supporting primary market issuance and fostering price discovery. However, one respondent cautioned that green collateral repo may not provide the necessary transitional environmental benefits if it is strictly limited to green collateral. Furthermore, it was suggested that in the green loan market, non-green assets are often accepted as securities for secured finance that will then be used to produce green assets. A more open approach would enable a better transition compared to “green collateral repo”, where only green assets are used as collateral.
Reinforcing this point, respondents identified a need for the ICMA to assess possible adverse impacts and risks that green repo may have on non-green finance. For example, in ICMA’s April 2021 consultation paper, it questioned “if the pool of eligible collateral is limited by regulators or central banks in the future, and non-ESG investment collateral is deemed less preferable”, then what is the impact of such stricter criteria on the collateral fluidity, liquidity and efficiency in the overall market?. “As noted in the summary report, this is certainly a potential concern and a topic that the new Task Force will probably want to consider in more detail,” says Westphal.
Reflecting on the relationship between green and non-green finance, Marc Poinsignon, expert collateral management at Clearstream says: “Ultimately, what you want to avoid is some sort of cliff edge situation between what is deemed green and non-green. The joint work done by regulators and industry participants as a whole is essential to achieving a smooth transition that supports the objectives to address climate change and social governance.”
Repo and securities finance have a role to play in facilitating growth of environmental, social and governance (ESG) across asset classes, according to Poinsignon. This transition in capital markets may require a phased approach with achievable, scalable and standardised parameters as well as different transitional strategies in different regions and economies, he adds.
Furthering this point, Gerard Denham, senior vice president of fixed income funding and financing at Eurex, emphasises that the “repo market won’t change to fully green on a deadline date set in the future”. He encouraged the repo market, and its associated infrastructure providers, to continue to support issuance and liquidity across all asset classes — green and non-green.
The ICMA report also highlighted the absence of clear standards and how this could lead to claims of greenwashing. 17 respondents agreed greenwashing was a top concern, commenting on risks involving the incorrect classification of products as ‘green’ investment — where no additional green assets are created or no additional funding goes into green activities — and ‘double counting’ of green collateral repo, when both the buyer and the seller of the repo claim the green collateral as their own green investment.
Beyond greenwashing, respondents highlighted the need for clear procedures to ensure that collateral eligibility criteria are applied throughout the lifecycle of the repo transaction — and that the ESG quality of collateral is not compromised through collateral substitution that replaces ‘green’ assets by ‘brown’ assets for example.
To support the functioning of a sustainable repo market several firms have launched products and services to classify and select green collateral. In the coming weeks, Clearstream will introduce ESG bond identifiers which will be implemented as criteria for inclusion in collateral baskets, defining eligibility, concentration limits and haircuts. Available for triparty transactions between clients, the identifiers leverage international standards, principles or guidelines that are available in the market and can be used alongside any liquidity and risk criteria already available, explains Poinsignon.
Revealing Eurex’s process when it comes to selecting green collateral, Denham adds: “We work within existing Eurex Clearing eligibility criteria for all the bonds that we take as collateral for repo transactions. For the green bond general collateral baskets, we added additional criteria, which means they must be classified as a green bond.”
He continues: “They need to be investment grade quality, and a Euro denominated, fixed income security. The green bond must also be issued in line with the ICMA’s Green Bond Principles. Potentially, they could also be aligned to the EU Green Bond standard, which is due to be put into play in regulation within the next three to six months.”
Defining green and sustainable repo
Respondents to the ICMA report highlighted several ways the association could contribute to the development of a green and sustainable repo market, establishing clearer definitions and standard approaches for different types of repo as a starting point. More than half of the respondents suggested the trade association produce a specific framework similar to ICMA’s GBP.
Clearstream’s Poinsignon indicates that there are multiple components to a repo trade that need to be considered when assessing whether the transaction can be classified as “green” or “sustainable” — there’s the collateral element, how the cash is deployed, and counterparty for example. “For sure one of the starting points is the collateral itself,” he says. “Leading international standards and principles, such as those from ICMA or the Climate Bond Initiative, can already be applied on the securities. These bring notably transparent frameworks and detailed information on the ESG characteristics of the bond.”
Eurex’s Denham indicates that there are two main elements to a green or sustainable repo transaction. He says: “One is underlying green collateral, such as Eurex Repo’s Green Bond GC Baskets, which we believe can be classified as a sustainable repo, in reference to the ICMA report. The other area is to do with the cash element of the repo transaction and we believe there’s work to be done on that where you can link that cash, or the cash management of the repo transaction, to sustainable linked investments.” However, this is dependent on the appropriate data being made available by vendors to market participants and market infrastructure providers.
Poinsignon suggests that to provide clarity to the securities finance market, trade associations need to evaluate possible adverse impacts on market stability and pro-cyclical risks on non-green finance. Additionally, they should be supporting sound and transparent operating models that mitigate risk and enable long-term investor engagement on securities that they’re invested in.
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