Liquidity Management in a volatile interest rate environment

What accounts for the recent uptick in cleared repo activity?

One factor has been collateral scarcity in the bank-to-bank market, which is driving the specials segment massively. Interventions from finance agencies to supply the market with collateral are now pushing repo activity up quite substantially. Also, as funding driven measures like TLTRO are gradually phased out of the market, participants are looking for more market driven secured funding again.

More broadly, in past crises market participants have always complained about the availability of liquidity. Pension funds and other buy-side participants that have bilateral relationships always report that if volatility increases, banks lock up their balance sheets.

In these market conditions, we see the complete opposite happening in cleared repo. One reason is trust, which is becoming an issue during stressed times in bilateral markets.

But in this scenario, market participants trust the CCP. Whoever they execute with, they are facing that CCP from a credit perspective. That makes people comfortable with providing more liquidity into cleared repo in particular during time of stress.

Next to trust, economic benefits are equally important: For banks, bilateral repo sits quite heavily on their balance sheets. But if they deal through a cleared repo system and bring the interbank and dealer-to-client markets together into a single ecosystem, they can apply multilateral netting. That massively reduces the capital footprint they need to have to service the repo markets.

How can cleared repo markets be more competitive with uncleared repo during more benign market conditions?

During times of no stress, the bilateral repo markets are less expensive. Not from a CCP fee perspective, but because clients sometimes do not have to pay a haircut on the collateral. The banks are also happy to provide balance sheet for repo in exchange for derivatives business, which they sell as an economically attractive bundle. But they are less willing to do this during stressed scenarios.

This means that the motivation for clients to move into cleared repo during times of low stress, to prepare for these stress events, is very limited.

There are a number of options to increased adoption of cleared repo: One option is that if central banks join the European cleared repo environment and actively use that channel to interact with the market, that could be a mechanism to drive adoption.

Another mechanism could be applying mandatory haircuts for the bilateral repo markets. That would put uncleared markets on a level footing with cleared, because CCPs have to apply haircuts as part of our risk management. Banks currently have a greater degree of freedom to manage that.

A clearing obligation for repo of Treasuries is being discussed in the US, do you think that similar measures might be necessary in Europe?

I think Europe is somewhat behind the curve in the framework it uses to encourage repo clearing. 

Improving this would not only make repo markets more efficient and robust, it will also help central banks to make their monetary policy decisions much more effective in impacting the market.

That is because their presence would reduce banks’ need for balance sheet. Those banks would get money from the central bank via the cleared repo environment. So, they would face the CCP and if they passed that money on to someone else in the market, who was also facing the CCP, it would incur no material balance sheet cost for that bank. They would just need to execute the transaction.

So that transmission mechanism, of providing liquidity sent by the central bank into the market, would function much more effectively. Banks wouldn’t need to add significant additional costs on when they pass this kind of liquidity into the market.