European Repo Council chief fears ‘meltdown of G20 dream’

Concerns heard as repo industry considers voluntary adoption of clearing


Fears were expressed at the Euroclear Collateral Conference in Brussels in May that, given the extreme pressure on bank balance sheets, the advantage of being a clearing member is being eroded as the role is so capital and risk intensive.

Godfried De Vidts, chairman of the International Capital Market Association European Repo Council, told the conference: “At a meeting last week, to my shock and horror but not unpredictably, somebody said we are not going to have general clearing members (GCMs), anymore, because these GCMs are banks who can no longer afford to offer enough balance sheet to provide for client clearing [from derivatives to repos to fixed income]. The whole set up of the G20 – that everything has to be centrally cleared including the buy side – will not happen if that proves to be the case. So, is this the meltdown of the G20 dream?”

For derivatives under the European Market Infrastructure Regulation, mandatory clearing for big dealers starts six months after regulatory technical standards enter into force, potentially meaning a start date in 2016.

Clearing members stand between central counterparties (CCPs) and clients; holding margins, facing capital charges, stumping up default fund contributions and facing overnight funding obligations if they are not able to collect margin from clients in time to meet calls from CCPs. But Basel III’s leverage ratio fails to recognise the benefit of offsetting collateral, so the accumulation of operational and counterparty risk is burdensome for a business not well remunerated enough for the risks taken by banks, panellists agreed. Bank clients of clearing members, meanwhile, will also have to hold capital against trades.

In 2009, the G20 mandated clearing as one element to control systemic risk in over-the-counter derivatives and the concept is being gradually rolled out to apply to a whole range of instruments. Industries such as repo and securities lending are examining the voluntary adoption of clearing.

Greg Markouizos, London-based global head of fixed income at Citigroup Global Markets, says clearing members are taking a close look at their models, quantifying their resource requirements and finding that with clearing businesses often the returns don’t justify the means.

“So people exit or scale back,” says Markouizos.

Goldman Sachs has hiked its clearing fees while Nomura is exiting OTC clearing offering in the US and Europe, joining BNY Mellon, RBS and State Street in bowing out.

Talk at the conference recalled instances in which bank clients have been told by “second-tier” clearing members, “we will not clear for you any more, given the risk of your institution”. No specifics were offered, however.

The presumption has always been that a clearing member would receive a healthy proportion of its clients’ execution business, but that is not necessarily the case any longer, said Markouizos. Capital and liquidity requirements have become increasingly onerous and this has only been appreciated fully in the last few months. “It has gone beyond a tipping point,” he says.

Concerns were expressed at the conference around what this means for the buy side; if there is a move by some clearing members to withdraw from the business and the buy side is denied the opportunity to link directly to CCPs due to the cost and operational burden involved. In addition, CCPs are choosy about who they accept as clients, although some are exploring membership models that would allow the buy side to face them directly. Clearing members could offer their services at a higher premium but this still does not remove the risk they assume.

The conference also discussed whether moving repos in the direction of mandatory clearing was desirable. In a panel titled ‘Collateral Optimisation: Securities Financing – Uncharted Territory’, industry experts considered whether cleared repos might lead to more effective use of collateral.

The question was tackled against the backdrop of regulatory reform squeezing balance sheet capacity and banks’ securities financing business contracting. Panellists also noted negative interest rates impacting depositors as banks no longer absorb the costs.

In an audience poll, three-quarters thought the ratio of cleared industry-wide general collateral repo baskets would comprise 50–75% of the total traded by 2020. In the US, nearly all such trades are cleared while in Europe the number stands at around 10%. The overwhelming majority of interbank repo market trades are already cleared.

But Citi’s Markouizos believes clearing repos will cause problems if participants do not understand how they differ fundamentally from bilateral transactions. He says: “I have rung the alarm bell about such a development because I think it produces far more complexity than some repo market participants are used to dealing with.” He says that, in particular, collateral upgrade trades will not be suited to clearing: “Collateral transformation has been very important in the smooth functioning of markets and in the settlement of derivatives transactions among other things, but I don’t think it will be possible to clear those transactions. OTC bilateral markets are needed for managing that.”

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