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Repo gets innovative as regulatory threats recede

Repurchase agreements, or repo for short, were thrust into the spotlight when the product was linked with the shadow banking industry after the global crisis hit. But, far from being financial black magic, the instrument is a useful tool in any bank’s funding kit, finds Craig McGlashan.

The repo industry is emerging with renewed confidence at the end of 2013, after a turbulent few years under regulators’ harsh glare.

On top of the price savings repo offers compared with unsecured funding, market players are finding new ways to innovate using the product.

“Repo is a smart way to mobilise assets on the balance sheet,” says Massimo Grigolin, co-head of solutions group, Europe at Natixis in London. “Banks are now trying to put to work some assets that are not usually eligible for repo transactions.”

Such assets can be used in collateral transformation, an innovation that has emerged over the past few years and is tipped to grow further.

The process involves banks using low quality assets as collateral in repo trades and receiving cash in return — which can then be used as collateral elsewhere.

The issue is becoming increasingly important. New rules like the European Markets Infrastructure Regulation require many products, such as derivatives, to be traded through a central clearing counterparty.

Counterparties sit between the two sides of a transaction but require high quality collateral, placing a burden on banks’ balance sheets — hence the usefulness of collateral transformation.

Tax threat

But while these regulations are leading to repo innovation, another rule has threatened to damage the industry.

A proposed financial transaction tax — to which 11 European Union states signed up earlier this year — would lead to a 66% contraction in short term repo volumes in Europe, according to the International Capital Market Association’s European Repo Council (ICMA ERC), an industry body.

The tax places a 10bp levy on any bond or share transaction between two financial institutions, including market makers. It would apply to any repo using collateral from one of the 11 signatories, which accounted for 51.3% of total outstanding European repo contracts at the end of the year, according to the December 2012 ICMA repo survey.

The levy would wipe out market makers’ profits, leading to a decline in the repo market, according to the ERC.

But the repo industry received welcome news in early September. A leaked document showed that the EU Council Legal Service — effectively the EU’s lawyers — believed the tax would be illegal as it would infringe on the rights of countries that had not signed up.

But the opinion is not binding and market participants remain worried.

“It is only one voice,” says one repo market insider. “There are many other institutions that can have a say on this, but the situation clearly looks better now.”

Cheap and useful

While regulators have lumped repo in with the shadow banking sector — an umbrella term for any credit that is not subject to the same rules as the traditional banking sector — market participants are keen to stress the advantages of the product.

“Repo is a nice way to achieve funding at a cheaper cost than unsecured debt and it’s a very important tool during a liquidity crisis as it could be the only source of funding available,” says Natixis’s Grigolin.

Repo’s usefulness in a crisis is down to its reputation as an ultra-safe product. If the borrower defaults, the lender already owns the collateral and does not have to worry about any legal procedures to claim it, as it might with other types of secured funding.

At times of stress, terms can be set from 18 months up to five or seven years, far beyond the typical tenor of overnight to a month.

But that has led regulators to believe that too much reliance on repo is a sign that a bank is in trouble — and they are now keeping a watchful eye.

“European central banks are asking banks to disclose the repos they have on their books,” says Grigolin. “I would say this is in line with the level of disclosure requested on any other significant transactions.”

Repo’s usefulness during a crisis was made clear in the aftermath of the Lehman Brothers bankruptcy in September 2008, says Grigolin.

“For a lot of frequent issuers funding was not available as before during the crisis,” he says. 

“For the better rated credits it was a matter of price, but that price increase was still important. But for those in the triple-B area it was impossible to get wholesale funding.

“Repo is a very old, vanilla instrument but it was rediscovered during the crisis. Issuers that couldn’t fund looked at their balance sheets to see if they had assets to use in secured funding transactions.”    s

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