On one hand, corporates are having difficulties finding places to put their cash. On the other, hedge funds needing liquidity are being turned away by banks. It seems logical to cut out the middleman and let buy-side firms provide liquidity to other buy-siders.
Elixium is one platform recently launched in the UK seeking to do just that, by fostering peer-to-peer repo trading and collateral transformation. The platform, run by Swiss interdealer broker Tradition, says it has talked to more than a thousand institutions and all but five have shown interest in its offering.
Its roll-out is ongoing – it is nearly ready to switch on its central limit order book (Clob) – but it aims to host daily European trading volumes of £10 billion ($12.3 billion) by the end of January and £20 billion a day by the end of March.
Asset managers are keenly looking into the possibilities of peer-to-peer trading, but doubts remain. First is the mismatch of demand for repo with differing time horizons. Pension funds, for example, have high demand for repo over three to 12 months, but corporates and investment funds may not want to lock up their cash for so long.
Second is the number of counterparties peer-to-peer traders will engage with. The amount of documentation required is bulky – but asset managers will also have to face the default risks of many counterparties, including small money-market funds. Do buy-side firms have the appetite to take on the operational complexity and risks that banks do?
Some in the market think the first of these problems is insoluble, and will prevent peer-to-peer trading from ever making up for the decline in European repo caused by banks withdrawing from the market.
Nevertheless Tradition has enrolled 14 members to Elixium – including banks, agency lenders, clearing house CME, pension funds and a corporate. The Local Pensions Partnership, pooling assets of Lancashire County Pension Fund and London Pensions Fund Authority, has signed up to beta-test the platform, alongside Deutsche Bank, Societe Generale, State Street, Nomura and Aviva. Around 60 others have its documentation.
Buy-side firms are beginning to understand peer-to-peer platforms and are in the evaluation phase
Mark Higgins, BNY Mellon Markets
Its electronic Clob platform is to go live in mid-January, allowing traders of all sorts to repo or exchange collateral with each other. At the moment all trades are executed by a fixed price auction. Participants are able to sign either an Elixium master agreement (but being able to choose not to trade with certain members) or use existing bilateral global master repurchase agreement docs.
Roberto Verrillo, London-based head of strategy and markets at Elixium, sees the need for repo on both flanks of the buy side – cash-rich asset managers, and pension funds and hedge funds seeking new financing routes – while banks' balance sheets are constrained and they are held back from acting as go-betweens.
"To the extent that collateral providers needed a level of comfort with banks stepping in the middle of [repo transactions], there is now a cost to that. We've got corporates pulling their cash out of overnight deposits. Surely a collateralised loan is better than an uncollateralised loan. It's transparent and ticks the right regulatory boxes. It makes sense for those with liquidity issues to look at these platforms now," he says.
Bound by Basel
Basel III's net stable funding ratio effectively penalises banks for holding excess cash, leading some banks to charge a fee for deposits or turn depositors away. At the same time, bound by Basel III's caps on bank leverage, the repurchase agreement (repo) market has become stricter, pricier and smaller. Investment funds are needing to grow less reliant on a steady flow of repo.
Several ways to ameliorate the pressures have been proposed including enabling buy-siders to gain direct access to cleared repo, but are thought not to have taken off among buy-side firms.
Other regulatory developments are adding to the need for peer-to-peer repo, thinks Verrillo. Buy-siders are increasingly keen to hold high-quality liquid assets suitable to post as collateral to banks, which creates the need to trade those assets.
He sees a more pressing industry-wide need for repo after March, when firms are required to put up daily variation margin on over-the-counter derivative trades under the European Market Infrastructure Regulation (Emir).
"Buy-side firms are beginning to understand peer-to-peer platforms and are in the evaluation phase. They are asking the right questions so they can go back to their clients and say 'we know we have a challenge here and these are the options'," says Mark Higgins, business development manager at BNY Mellon Markets.
BNY Mellon is in the process of acquiring DBV-X, a peer-to-peer platform formerly owned by Tradition. DBV-X has yet to successfully launch, having originally cited a 2016 launch date when part of Tradition. BNY Mellon declined to comment on the takeover.
Buy-side firms are concerned about the risk associated with unwinding a trade should they need to change a position if they are dealing with another end-user
Bruce Kellaway, LCH's RepoClear
Higgins is upbeat about the potential for peer-to-peer repo, saying many asset managers are comfortable with unsecured lending, so they ought to be fine with secured lending. It is simply a matter of adjusting operations.
"Some on the buy side will never have transacted using these documents before. Agency repo managers have a great opportunity here to help manage liquidity for those firms without an existing repo desk. When operating via an agent, there is no need for buy-side institutions to sign multiple separate legal agreements as they will already have agency agreements with the usual banking counterparties," he says.
Verrillo says: "There's no reason why small insurers and small corporates shouldn't come to us. At some point in time, it's a matter of pricing and cost. If you can save a particular amount of money with the same risk parameters and see competitors doing it, the question will be why aren't you doing it?"
Aviva Investors is looking at P2P repo platforms with interest, says Mick Chadwick, its head of securities finance. "We need to find a secure liquid outlet for surplus cashflow and the banks increasingly don't have the appetite or the capacity to provide that. It can sometimes be a struggle finding that liquidity outlet at a suitably competitive price," he says.
"We're staying close to all of these peer-to-peer initiatives and hopefully we've got the flexibility and mandate to move quickly if it looks like they're starting to gain some traction, which I suspect at least one may well do over the next 12–18 months," he adds.
The buy side's need for repo has not yet exceeded banks' capacity to provide it, Chadwick says, at least not for Aviva Investors; but it is important to look into P2P alternatives to ensure best execution.
Max Verheijen, head of financial markets at Cardano, a Dutch pension fund, says his firm is investigating P2P platforms. "I like the idea, and in theory it should work: cash-rich companies coming together with those that need liquidity on a collateralised basis," he says. "Documentation can be an issue and proof of technology of the new platforms is holding them back. Pension funds typically are not the first movers in financial innovation."
He thinks the March deadline for variation margin will increase interest in P2P, but says repo is only one option. Buy-siders needing cash can sell assets and get similar exposure using total return swaps; others can arrange bank financing.
Boosting bank-facilitated repo, meanwhile, are rivals such as Icap's EBS BrokerTec, an interdealer platform that dominates European repo markets. It has offered European government bond repo since 2000 and its daily trading volumes reach up to €200 billion ($213 billion). Around 95% is transacted via a central counterparty (CCP), where banks predominate.
"There has been increasing interest in [CCP] membership from non-banks over the past 12 months but this hasn't progressed significantly in so far as reshaping the way repos are traded in the secondary market," says John Edwards, managing director at EBS BrokerTec.
"Our current business model, as a major liquidity venue for dealer-to-dealer repo trading, is to provide connectivity to multiple clearing houses but the evolution for P2P repo is not an obvious next step at this juncture," he says.
Bank-to-bank repo is the backbone of LCH's European repo clearing, says Bruce Kellaway, global head of LCH's RepoClear. "The share of centrally cleared repo is increasing as banks seek to optimise netting and risk management," he says.
Another hope for the flourishing of peer-to-peer lending came when LCH announced it was to offer direct repo lines to pension funds in need of liquidity. But Kellaway says that as an end-user, matching buy-siders' needs in a peer-to-peer format will be hard.
"We are a lender of cash and we use reverse repos all the time. So actually we face the same challenges that a lot of end-users face. We are lending directly to some pension funds and I can tell you from experience, when you put two fussy end-users together with a bank in the middle, that's difficult practically speaking," he says.
Kellaway says the repo transactions with pension funds represent only a small percentage of LCH's portfolio, but declined to give further details.
Timing is everything
Two problems are thought to bedevil plans to match up buy-side firms' repo needs. First is the time horizon mismatch. Pension funds may want to raise cash over several months, but repoing securities for that length of time may be tricky for other buy-side counterparties. Ucits funds in particular are prohibited from repo agreements lasting more than seven days.
Aviva's Chadwick thinks this is the "toughest nut" for P2P platforms to crack. "Generally speaking, the funds that have surplus liquidity need to keep that repo trade relatively short-term. Conversely the entities that are natural liquidity takers tend to want that liquidity further out along the curve," he says.
Kellaway says: "From anecdotal evidence we hear, buy-side firms are concerned about the risk associated with unwinding a trade should they need to change a position if they are dealing with another end-user. A bank would have more flexibility to do this, for a fee, whereas many end-investors would be unwilling or unable to unwind at another's request."
Second is the complexity of switching to P2P, which may put off smaller buy-side firms.
"Will the buy-side feel they have the expertise, in particular the credit expertise, to do this?" says Erik Vynckier, non-executive director at UK insurer Foresters Friendly Society. "I think large firms can indeed do this but for smaller firms there is a significant risk that they step into the wrong sort of trades, accepting poor collateral unknowingly or lending to companies that are in too bad a shape."
As a result, he argues that new platforms will not make up the shortfall from previous levels of repo. "I think the bulk will still go through the repo market but we will have an alternative to push the banks towards best price," he says.
Buy-siders would be faced with the default risk of many counterparties, rather than one bank – some more opaque and less regulated than others. For peer-to-peer, Kellaway says, "you need to get the appropriate documents in place, and then conduct credit due diligence on each counterparty. Banks are typically more straightforward for an end-user to credit score than a money market fund or hedge fund."
Alongside quantifying the default risk, there is the sheer number of counterparties the buy-side firm is exposed to. "Both sides will need to have the ability to do credit due diligence on each other in order to have some view of the market, and any end-user would have to do due diligence with hundreds of counterparties," says Kellaway.
Allocating that responsibility to banks is not risk-free, counters Stephen Malekian, head of US business development at Elixium. "On the Elixium platform, you're only trading with institutions you have a signed document with, that you have a credit line with. You have clearly defined risk parameters. We don't provide indemnification, these are bilateral transactions. But indemnification isn't free: those that provide indemnification get paid for it," he says.
Perhaps a bigger problem, suggests Kellaway, is how to calculate haircuts to account for counterparty risk. "End-users have typically required credit protection against a bank in the form of a haircut but in a peer-to-peer model, each party needs a haircut on the other," he says.
Many requirements for haircuts on end-users are regulatory. "Ucits funds are not able to under-collateralise their lending transactions. They have to be fully funded at all times, which means they cannot pass haircuts to anybody else," says Paul Elkins, head of product for LCH's RepoClear.
While there may be a wealth of cash out there, providing channels to hedge funds and pension funds that need it may be harder than it seems.
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