A strange phenomenon has been prevalent recently in the US repo market. At the start of every quarter, a handful of foreign dealers – led by the three big French banks – begin to massively expand their repo books, with outstanding balances reaching a peak about midway through the cycle. As quarter-end approaches, these firms shed up to 80% of their repo balances to finish the reporting period roughly where they started.
A quirk in the leverage ratio rules explains these undulating repo balances. While US banks are required to calculate their leverage exposures on a daily basis, French banks do so at quarter-end. This allows them to run vast overnight repo books, at least until the end of the quarter, when their regulatory filings come due.
French banks have taken advantage of the discrepancy in the leverage ratio rules to fill the void left by US banks, which cut back their repo matched-books following the implementation of the US supplementary leverage ratio (SLR).
Data from the US Treasury's Office of Financial Research (OFR) shows four big US firms – Bank of America, Citi, Goldman Sachs and JP Morgan – have slashed the amount of US Treasury repos they do with money market funds (MMFs) by half since the start of 2013, from $51.5 billion to $26.4 billion. Over the same period, three big French banks – BNP Paribas, Credit Agricole and Societe Generale – have more than doubled the amount of US Treasury repo trades they do with MMFs, from $51.6 billion in January 2013 to $104 billion in July this year.
Repo trading has been lucrative for the French banks of late. Repo spreads – the difference in the rates at which banks borrow and lend cash in the wholesale funding market – widened out as US dealers retreated from the business. Currently, dealers can borrow from MMFs at less than 30 basis points and re-lend that cash in the cleared general collateral finance (GCF) repo market at around 50bp – a spread of at least 20bp. The three French banks could have generated profits of more than $200 million by re-lending all the cash they borrowed from MMFs in July in this way.
For repo market participants, the additional liquidity provided by the French banks is a welcome development. There is a downside, however. Cash lenders and borrowers alike must scramble to find alternative sources of liquidity when the French banks step out of the market at quarter-end. For now, MMFs can turn to the US Federal Reserve's temporary reverse repo program (RRP), where they earn 25bp on overnight loans collateralised with US Treasuries. Meanwhile, cash borrowers, such as broker/dealers and hedge funds, see their funding options evaporate at quarter-end.
"I expect [the] year-end to potentially be a real mess," says a trader at a New York-based broker/dealer that relies on the repo market for funding.
The bigger question is what happens at the end of 2018 when the US SLR rules will be applied to big foreign banks with more than $50 billion in US assets. That would make it costlier for French banks to run outsized repo books, potentially flushing them out of the market entirely.
"Everyone is concerned by this, but we really need to keep the liquidity going, and to do that, we will have to adapt the way we trade," says a source at one of the big French banks.
Repo market participants should take note: the liquidity provided by the French banks will not last forever, at least not in its current form.