Thrust into the limelight

  • 14 May 2008
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Repo and money markets have always done the same thing slightly differently, writes Matthew Thomas. Both provide vital short term funding to financial institutions. But the main difference between them — one is secured, the other is not — has opened up into a yawning abyss. As repo market participants prepare for the challenges of increasing efficiency, the challenge facing the interbank market, the father of all money markets, is to regain credibility.

The repurchase agreement and money markets are central to the functioning of the financial system. The money markets — from the interbank market through to the ABCP market — allow borrowers to get short term funds without being forced to provide collateral to protect the lender. The repo market, by having collateral as its name implies, can act as a second option when unsecured lending dries up.

"Suddenly the repo market has become very important," says Godfried de Vidts, head of ICMA’s European repo council. "It’s a key tool for bear markets."

The posting of collateral means more than just a reduction in credit risk for the lenders — it also gives them something to use in repos with the central banks. This is reflected in the numbers. After falling last year, repo volumes rose by 31% in the first three months of 2008, according to data from Xtrakter, while the total number of repo deals rose by 16.8%.

However, all collateral was not created equal. Some was created subprime. Structured finance assets — often difficult to value and the cause of some of the lack of trust in the interbank market — have become much harder to repo.

Changes in the repo market since the beginning of the credit crunch have broadly reflected changes which have taken place in most financial markets. There has been a lack of trust in ratings, with transactions examined on a case-by-case basis. When ratings are used, it is often to tighten up the risk appetite, focusing only on the highest credits.

Repo lenders have also become unwilling to lend for as long as they used to. This has become especially apparent in the triparty market, where a third party manages the collateral. Bilateral repos typically have government bonds as collateral, leaving lower quality assets to be funded in the triparty market.

"The average maturity in the triparty market has contracted a lot," says Stefaan Van de Mosselaer, the head of liquidity and collateral management at Fortis Bank in Brussels. "Whereas it used to be about one month, it’s now one week. Banks are facing shorter and shorter liabilities, so they try and reflect that with their assets."

The triparty and bilateral markets have also diverged in the spreads borrowers are forced to pay to get funds.

"Spreads for bilateral deals reflect Eurepo more or less, whereas trilateral deals are often around Euribor or even above," says Van de Mosselaer. "The spread between Euribor and Eurepo in the one month maturity, for example, is now 35bp. In 2007 and before, it was six or seven basis points."

Eurepo is an average of repo funding levels for general collateral, largely government bonds, from the euro zone.

The repo market has proved itself to be a resilient funding tool as the credit crunch has developed. It has been a useful alternative source of funds for structured investment vehicles such as Sigma Finance Corp, which has seen demand for its commercial paper and medium term notes dry up completely. Nonetheless, there is still room for improvement.

One key point for the European repo market in the future, according to ICMA’s de Vidts, is the expansion of collateral. This can only happen when there is more confidence in mark-to-market levels and in valuing assets. This is an issue affecting all financial markets.

A second area where the repo markets can improve is another market-wide issue: the creation of a truly integrated European financial system, with interoperability between clearing and settlement systems.

"How do we create a central counterparty framework in Europe that is efficient? It’s not enough to have an LCH; it’s not enough to have a Clearnet, CC&G, Eurex CCP: we need to find a way to create an interoperability model, so that it doesn’t matter where the user is," says de Vidts.

"Each market participant selects the central counterparty that best suits his risk profile without any restraints on his ability to work with his usual bilateral counterparties or trading system, wherever they may be."

However, as the European Commission’s code of conduct on clearing and settlement has, so far, only been applied to equities, with the interoperability part of the code still remaining largely ignored, don’t hold your breath.

Libor’s credibility questioned

While the repo market faces challenges to improve, money markets face an uphill struggle simply to return to credibility. Libor rates, increasingly volatile since the credit crunch began (see graph), have come under scrutiny on numerous occasions.

"At the moment, Libor is no longer a near risk-free rate, with banks now more reluctant to lend to each other," says Peter Eisenhardt, chairman of ICMA’s EuroCP committee. "Interestingly, people started saying that Libors were too high, given spreads relative to central bank target rates and OIS. Then some people started to say Libor should actually be even higher, because banks might be cautious about revealing their true cost of funding in case they look too eager to take cash."

Whether or not banks purposefully manipulated Libor levels, unless they are funding in the interbank market at all the maturities at which they post levels, there will always be a certain amount of guesswork involved. The fact that — manipulation or not — these levels have questionable reliability, as well as the huge increase in the credit component in Libor since the credit crunch began, has led many to call for Libor to be replaced.

Some have suggested Libor should be replaced by overnight index swaps (OIS). Others have argued banks should quote levels for secured interbank funding. It seems hard to envisage the market can change to another Libor rate, given the logistical nightmare that would ensue. If Libor stays — which seems likely — then its critics will only be silenced when banks begin to trust one another again, when losses become fully disclosed, and when stability returns to the interbank market.

"Everybody would love to draw a line under this," says Eisenhardt. "Take all of your losses, put them behind you, and move forward. But that’s been hard because you don’t know how to value stuff. It’s difficult to tell how some of these securities will behave or what default rates will be, so it’s going to take some time to play out."

Until that time, banks are being forced to find alternative ways to fund themselves. But they haven’t been entirely deserted by the money markets — the commercial paper market remains a key source of short term funds. And while many banks are paying higher spreads than historical levels, huge volatility in basis swap markets has presented them with a way of reducing these additional costs.

"The FX market wants to be short dollars, so issuers have been able to issue CP at dollar Libor plus 20bp or more and swap to achieve sub-Euribor funding," says Eisenhardt.

Slow times ahead for CP

The commercial paper market, once a stable and oft overlooked subset of the wider money markets, had its importance underlined in bright red marker pen last year.

As the subprime mortgage crisis hit — and liquidity was sucked out of the asset backed and mortgage backed securities markets as investors ran for the hills — structured investment vehicles experienced market value declines in their portfolios.

These vehicles were created with market value triggers — usually referencing the value of the capital notes, which fluctuate directly with the market value of the portfolio — to give early protection for senior investors, who could potentially lose if the assets were not enough to cover the liabilities. Because SIVs — unlike their close cousins, conduits — are not structured with a full liquidity backstop in place, this was a genuine risk for investors.

Soon enough, the SIVs began to fall. What was once a key investor base for ABS and MBS, fuelling the markets’ constant growth, quickly turned into a noose around the collective neck of the securitisation markets: when SIVs fell, liquidity was sucked out of those markets. No one wanted to buy SIV paper anymore so, initially, banks had to fund their vehicles themselves, buying CP when it matured. When those banks realised the market was not going to come back to life, they began — one-by-one, despite early calls for a market-wide initiative — to consolidate the assets back on to their balance sheets.

"There’s a lot of thinking about using short term debt to finance longer term assets, and what is appropriate and what isn’t," says Eisenhardt. "People are thinking about risk and reward in the long term market. The idea of using short term money to finance things like SIVs is no longer appropriate. But it does work with proper backstop liquidity in place."

With the medium term note and commercial paper markets effectively shut for SIVs, the only place they could find funding was in the repo markets. This was always going to be a temporary solution, and the SIV sector is now effectively shut. Some banks, like HSBC, have turned their SIVs into ABCP conduits, with a full backstop liquidity line. Most are leaving the market entirely.

While repo markets have done well since the credit crunch, the money markets have taken a massive hit. The interbank market is a chaotic mess. The commercial paper market has seen its only source of innovation suddenly become frowned upon by investors. The modern financial system is an interconnected whole. All this can only end when the wider market turmoil ends.

"I think we’ll see a slow, gradual grind," says Eisenhardt. "Every piece of bad news that comes out is helpful, in a perverse way.  It moves us closer to the point where we draw a line under all of this and move forward. But that’s been hard because no system of valuing assets could ever be perfect. No one can ever know for sure what default or recovery rates will be, so it’s going to take some time to play out.  In terms of new business, we’re going to be in for a simpler time for a while."

  • 14 May 2008

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3 HSBC 23,853.66 192 7.15%
4 Standard Chartered Bank 18,805.71 138 5.63%
5 Deutsche Bank 13,019.53 76 3.90%

Bookrunners of LatAm Emerging Market DCM

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4 Santander 3,872.61 17 8.95%
5 Morgan Stanley 3,468.80 10 8.02%

Bookrunners of CEEMEA International Bonds

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4 HSBC 6,957.06 34 6.53%
5 BNP Paribas 5,847.14 17 5.49%

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5 JPMorgan 1,110.10 13 9.01%