Derivatives funding: Smart solutions for a complex environment

Of all the factors of interest to derivatives market participants, the funding environment is one that warrants careful attention. It defines balance sheet capability, collateral pricing, trading risk appetite and more. 

Funding has remained top of mind as we move further into a year characterised by geopolitical uncertainty and macro-economic fluidity. And market players keep watch for central bank moves to lower base rates. 

The funding environment appears to have settled after a two-year period of inflationary intensity that roiled markets globally. Market participants also had to grapple with significant credit events, notably the collapse of Credit Suisse in Europe and, in the US, of regional banks including Silicon Valley Bank.

Even before then, banks and other counterparties in Europe were dealing with a significant transition in the funding environment, whereby the liquidity support and access to funding provided by the ECB since pre-Covid days has been gradually unwound. As a result, banks sought funding in the market instead. 

"There has been a big transition in the funding markets," says Arne Theia, head of short-term funding, interest rate and cross-asset management at UniCredit in Milan. "We came from more than a decade of low and negative interest rates in Europe." 

Theia describes the unwinding of the ECB’s asset purchase and reinvestment programmes as an additional “paradigm shift” for the short-term funding markets.

Banks have weathered this transition well, say market participants. The main issues affecting funding now are regulatory capital – in particular Basel III and the upcoming Securities and Exchange Commission US Treasury clearing mandate – and a weakening macro-economic outlook. In December, the ECB’s outgoing head of supervision said that while banks in the Eurozone had “solid” capital positions, they should nonetheless prepare themselves for “more volatile funding sources” amid a weak macro-economic outlook (see under Further Information).

Cosmin Lupea, treasurer at Capstone Investment Advisors, says that while there is not much funding pressure now, the environment looks set to change once more. “Balance sheet availability is not an issue at the moment, but it could become a problem in the near future because banks are having to manage multiple constraints,” he says.

One reason is an increase in the supply of government bonds coming at a time when broker-dealers’ balance sheet capacity has not changed significantly for some years. “The market needs more capacity, more intermediation,” Lupea says. 

Regulatory capital issues are likely to further constrain the funding environment, and margin funding costs have increased for banks due to the interest rate environment. In short, regulatory capital requirements are driving banks to carefully ration scarce balance sheet capacity, with repo markets most significantly impacted, since they consume substantial balance sheet capacity under the Basel III Leverage Ratio measure and the Global Systemically Important Bank (GSIB) framework.

Strategic solutions

In response to these challenges, market participants are reducing their exposures through netting and trade compression services, while dealing with margin cost pressures by using collateral optimisation options. 

Diversification of collateral is another strategy, says Roelof van der Struik, investment manager at Dutch co-operative fund manager, PGGM. “It’s about diversification into T-bills, commercial paper, commercial, debt, money market funds, all kinds of repos with a wide range of counterparties in as many jurisdictions as possible,” he says.

Geographical diversification is a common theme, in fact. “This allows greater capacity around reporting days and more flexibility to move balances and get the best liquidity from wherever can support your financing needs,” Lupea explains. 

Market participants are also taking advantage of services, including those from central counterparties, to manage liquidity and funding through cleared repo. “Clearing houses such as Eurex Clearing are offering certain tools, which is helpful to address challenges faced by the market,” says Theia at UniCredit.   

Sponsored clearing models – allowing transactions to be netted off between banks and other clearing members – are also well-received by market participants. “Opening up the clearing service to more and more customer groups is a big part of the Eurex model,” explains Theia. “This is interesting for banks, because the more trades there are in a clearing house, the more netting opportunities you have, and the more you can net off your balance sheet.”

Eurex offers a broad range of cleared repo services via its F7 trading venue – an integrated market for electronic trading, CCP clearing, collateral management and settlement of repo transactions. Its GC Pooling repo service is the European benchmark for standardised secured funding with central clearing.

While historically Eurex’s repo offering was focused on the inter-bank financing and funding business, Eurex Clearing's repo clearing access models now offer direct access to CCP cleared repo for buy-side firms. This allows banks to maintain the repo trading service offering for their buy-side clients without disproportionately high leverage capital costs and depressed returns on equity. 

Buy-side firms benefit from improved access to funding and a large liquidity pool through Eurex’s cleared repo services. Compared with bilateral trading, operational efficiencies can also be achieved through settlement netting and reduced documentation. Buy-side firms also benefit from better protection of assets and improved portability in a default scenario.

Collateral optimisation

By increasing the range of participants and collateral types accessible via cleared repo, Eurex is bringing greater capacity and intermediation, helping to increase the efficiency of the European repo markets. 

Eurex already has more than 160 market participants active in its repo markets, with more to come, according to Matthias Graulich, member of the executive board at Eurex Clearing. “With innovative access models we have successfully connected pension fund and insurance firms to the cleared repo offering and aim to have the first hedge funds going live in 2024,” he says. 
 
Cleared repo is proving itself as a useful tool for managing today’s funding and financing challenges. It also has two distinct and unique benefits over other liquidity management tools. 

Margin efficiencies

The first is the superior transaction terms that buy-side firms enjoy, by way of a better repo rate enabled by greater netting efficiencies and lower capital costs for banks’ repo counterparts. 

The second is that it has proved more resilient in stressed market conditions than other tools. As market participants witnessed in previous periods of stress, worrying about bilateral credit risk was a constant issue in the non-cleared market. 

“That’s why cleared repo should also be in the toolbox of buy-side participants,” says Graulich, “creating a virtuous cycle of higher efficiencies, better terms and strengthened market resilience in stressed conditions.”