Libor’s sunset sees US repo market cast a longer shadow

Concern over structural deficiencies as SOFR chosen to replace key benchmark

Image of dollar

  • The US’s decision to replace Libor with the Secured Overnight Financing Rate (SOFR) – based on US repo trading – is likely to spur debate about the strength of the underlying market.
  • Using the SOFR benchmark “would expand repo’s influence even further and increase the connectivity” between derivatives and repo, says BNY Mellon’s Edward Fisher.
  • While repo volumes are up in the past six months, the underlying market structure is far from perfect.
  • The volume was driven largely by a change in regulation for money market funds, and the Federal Reserve has become the largest counterparty for these entities. 
  • This worries some market participants who believe it could distort the market in a stressed scenario. These trades also don’t count toward the SOFR.
  • Bilateral dealer-to-client trading is on the rise and isn’t part of the SOFR either. The volume of general collateral finance repo, which is included in the rate, is down 84% since 2011.
  • Cleared interdealer trades are part of the SOFR, but dealers have threatened to walk from the industry clearing house due to concerns about a new liquidity facility.
  • Clearing of dealer-to-client repo trades could help stabilise the market, but the structure has turned off some potential users, while banks are not incentivised to clear.

Like an occasionally off-key understudy for a big Broadway show, the US repo market is set to take Libor’s starring role in the financial markets while some fear it is not ready for the limelight.

The choice of the repo-backed Secured Overnight Financing Rate (SOFR) as Libor’s replacement was taken in June by an industry working group, following a turbulent 12 months for the market: interbank trading between JP Morgan and BNY Mellon broke down, and there were repeated dislocations at quarter-ends thanks to up-and-down trading activity from foreign banks. Money market fund (MMF) reform in October 2016 added to the drama.

Repo volumes this year have been booming, but that follows years of post-crisis decline, and fears for the market’s longevity.

Now, in addition to its role as a vital funding market for banks, hedge funds and others, the repo market is preparing to take on the mantle of reference rate for roughly $70 trillion notional of US dollar interest rate swaps.

“Repo is already the most important building block of the financial market, but if swaps were to trade tomorrow using the new SOFR benchmark, it would expand repo’s influence even further and increase the connectivity between the two markets,” says Edward Fisher, head of fixed income and equities at BNY Mellon in New York.

Broadly, market participants feel it was the right choice – possibly the only choice – but the decision is already producing a closer appraisal of the repo market’s complex structure and occasionally-weird practices. Some worry about the fact that the Federal Reserve is still the largest counterparty to MMFs that are qualified to use its reverse repo programme (RRP) – and these trades don’t count towards the SOFR rate. Not only does this reduce the total volumes on which SOFR is based, some feel the Fed’s involvement could imperil repo market liquidity during a crisis.

“If there was a bank default, MMFs would go straight to the Fed. So if the Fed has all the cash and the dealers have all the collateral, when they put up collateral on the broker screens, there will be no bids. In that situation you would have a non-functioning repo market because of the Fed’s RRP,” says a head repo trader at a dealer in New York.

Bilateral transactions executed between dealers and clients are also excluded from SOFR. Anecdotally, this opaque part of the market is said to be growing, reducing the volumes underpinning the new benchmark. At the same time, volumes of GCF repo, which is included in the SOFR, have collapsed by 84% in the last six years.

The proportion of bilateral trading could increase thanks to a decision by the only US Treasury repo clearing house, the Fixed Income Clearing Corporation (FICC), to implement a so-called capped contingent liquidity facility, which has riled members and seen some threaten to leave.

Repo is already the most important building block of the financial market, but if swaps were to trade tomorrow using the new SOFR benchmark, it would expand repo’s influence even further
Edward Fisher, BNY Mellon

Market participants say market stability would be improved by a move to central clearing, which could bridge the liquidity gap between counterparties and lessen fire-sale risk in a default scenario.

“While the US repo market is functioning adequately, introducing a broader-based clearing solution would strengthen its resiliency,” says Mark Wendland, head of global repo at Citadel, a hedge fund and trading firm. “This could not only facilitate balance sheet netting, but also increase transparency and reduce fire-sale risk, helping ensure a functioning market at all times.”

SOFR reference rate
The Boy Fitz Hammond,
Rickety foundations: is repo market strong enough to underpin new reference rate?

However, many question whether mooted clearing structures for the buy side are viable, as the current proposals are unworkable for a number of clients. The US Treasury’s plan to exclude Treasuries from the bank leverage ratio, and the chunky spreads banks are currently able to capture in the bilateral market, could also disincentivise banks from moving these trades to clearing.

While volumes in the tri-party market are growing, some fear a lack of stability in the overall repo market could be detrimental for the SOFR rate – and by extension, the swaps market.

“It is paramount that any security utilised as a base or benchmark holds a strong and structured foundation. If there is confidence with the process, the broader market will continue to function in a healthy manner. But if there’s not, the wider markets, including the swap market, will be negatively impacted,” says Sean Simko, head of fixed-income portfolio management in the investment management unit at SEI Investments.

Repo’s revival

The US repo market is complicated. It operates similarly to other over-the-counter markets in that there is an interdealer and dealer-to-client structure, but that is split between how trades are settled, either on a tri-party or bilateral basis. For interdealer transactions between FICC members, trades executed and settled tri-party via a clearing bank – BNY Mellon or JP Morgan – are executed in GCF Repo, a service of the Depository Trust & Clearing Corporation. Trades executed without a clearing bank are settled bilaterally. Both types of trades clear at the FICC.

The same concept applies in the dealer-to-client market. Asset managers can use a custodian bank such as BNY Mellon to manage the valuation and sending of cash and collateral between their dealer counterparties, or they can do this bilaterally themselves. Aside from a few exceptions, these trades are not cleared at the FICC.

The underlying structural difficulties facing the market betray what, on the surface, has been a resurgent time for repo.

Tri-party repo has boomed this year. Data from the Federal Reserve Bank of New York shows daily average volume in the dealer-to-client tri-party repo market for US Treasuries exceeded $1 trillion in June – the highest level since regulators began collecting this data in 2010, and up from $771 billion a year ago.


“The contraction of the US repo marketplace has stopped,” says Deborah Cunningham, chief investment officer at Federated Investors, one of the largest managers of MMFs in the US. “[The repo market] is no longer just stagnant but is starting to grow in size and depth. That’s all good for liquidity.”

The turnaround was fuelled in large part by government MMFs, which entered into $647 billion of US Treasury repo transactions in July, compared with $370 billion for the same month in 2016. This was thanks to MMF reform that required prime funds investing in commercial paper and floating rate debt to establish gates and fees to stem outflows during periods of financial stress. This drove investors into government MMFs, which are more reliant on repo markets.

A big chunk of those trades was done with foreign dealers such as BNP Paribas, Crédit Agricole and HSBC, which have massively expanded their US repo trading books over the past couple of years.


MMF reform has helped improve the robustness of the market because it forced more and more buyers of collateral into the market. You had a transition of $1.5 trillion that migrated from prime to government funds, so suddenly there has been a new buyer and pool of assets seeking US Treasury-backed repo that you didn’t have before,” says Joe Lynagh, a portfolio manager in the fixed-income division and head of the cash management team at asset manager T Rowe Price.

Anatomy of the SOFR

The resurgence in repo activity could not have been timed better. On June 22, the Alternative Reference Rates Committee (Arrc), which was convened by the Federal Reserve Bank of New York in 2014 and consists of 15 large banks, selected the SOFR – a broad index of repo rates including tri-party repo, general collateral finance (GCF) repo, and bilateral interdealer trades cleared at the FICC – to replace Libor as the preferred reference rate for derivatives contracts.

This rate is set for official publication in the first half of 2018. But in July, Andrew Bailey, chief executive of the UK’s Financial Conduct Authority, which oversees the Libor-setting panels in London, said the regulator would no longer compel banks to submit quotes after 2021. The prospect of the end of US dollar Libor as a swaps reference rate emphasises the importance of a stable repo market for derivatives users.

“A sound, well-functioning Treasury repo market will be critical to facilitate a smooth transition for interest rate swaps users and other market participants from using Libor to the industry’s recommended broad Treasuries repo rate,” says Isaac Chang, managing director at AQR Capital Management.

However, the rapidly changing structure of the repo market thanks to regulatory reform has forced the Federal Reserve to reshuffle the deck on what would be included within the SOFR.

The Fed initially proposed that cleared bilateral data be excluded from SOFR, as “robust data on the bilateral repo market” was not available at that time. That was changed in an updated notice to the market on May 24, mainly due to the deterioration in market liquidity in the tri-party settled GCF market, which has seen average daily volume collapse from $540 billion in December 2011 to $84.3 billion in July 2017, according to data from the Fed. Cleared bilateral data, however, has shown a steady increase in volume.

SOFR component volume NEW

According to the US Treasury’s Office of Financial Research (OFR), bilateral transactions – including cleared interdealer trades settled bilaterally – make up roughly 50% of the US repo market. In a report published in January 2016, the OFR also concluded that “comprehensive data is still lacking” in the bilateral market, and is one of the reasons it has been difficult to measure.

But non-cleared, dealer-to-client bilateral repo is also a significant part of the market and it isn’t included in the SOFR rate. MMFs, which have traditionally traded repo with banks via a tri-party clearing bank, are increasingly doing more bilateral repo, while other participants are also branching out to trade bilaterally.

“We have accessed more repo in the past two years than we have ever had in both tri-party and bilateral. We have interacted with non-traditional counterparties, and seen bank treasuries that have only done tri-party traditionally now do bilateral,” says Marques Mercier, a senior portfolio manager at Invesco, which has done between 15–30% of its repo trades bilaterally in the year to date.

Even if regulators wanted to collect this data to include within the SOFR, doing so would be difficult given the way the market trades, says Scott Berman, portfolio manager on the short-term desk at Pimco. “It might be useful to begin reporting transactions, but it could be difficult to ever get to that point given the way bilateral repos trade,” he says. “There is some aspect of electronic trading in repo, but that doesn’t really exist for non-FICC bilateral transactions. It does for GCF, but non-FICC bilateral is almost all via phone or some kind of non-screen-based execution method, so it would be extremely difficult to trace those transactions.”

FICC cleared volume (bilateral and tri-party) NEW

As the GCF market itself continues to shrink, it is not known how long this will continue to be included within the SOFR as banks continue to reduce the amount of liquidity they supply into that market.

“The GCF market used to do a lot of volume, but the theme of optimising the balance sheet means there is more bilateral repo traded and more specific security interaction. Gone are the days of carrying excess inventory or capacity – it’s more about being as efficient as you can,” says Peter Diminich, global co-head of global securities finance fixed-income repo at ING.

At the same time, over the past year and a half banks have been avoiding repo trading at quarter-ends to make their leverage exposure numbers more palatable. This forces certain government MMFs to turn to the Federal Reserve’s RRP programme. At the end of the second quarter, when liquidity typically becomes constrained, the Fed was counterparty to $365 billion – just over half – of transactions with MMFs. These trades are excluded from the SOFR, however.


This quarter-end rush to the Fed’s RRP programme is exacerbated by a quirk of the market that sees foreign banks ramp up repo exposures during the quarter and dramatically shed them at the end. This was forecast to come to an end in 2018 as foreign banks are brought into the Fed’s intermediate holding company capital rules, but banks say they have no plans to change their approach (see box: Foreign repo dominance to continue).

The proportion of bilateral, non-cleared trades could increase further if some broker-dealers follow through on threats to quit the FICC if the clearing house implements a capped contingent liquidity facility. The proposal calls for clearing members to provide the FICC with committed credit lines, which it would tap in the event of a member default. The clearing house says the facility is needed to comply with new standards for systemically important financial infrastructures, but several member firms have expressed concern about its design and implementation.

“If we can’t operate under this environment then we need to bring our book down, which will hit liquidity in the marketplace, and could have a knock-on effect on other firms. Repo markets should never freeze, and if it does, it doesn’t matter what you do with the FICC because everyone is just going to transact with the Fed,” says the head repo trader at a dealer in New York.

The swaps market is being moved off Libor partly because of a lack of trades underpinning the benchmark. But Mike Bridger, a repo trader at Credit Suisse in New York, plays down the impact of not having all trades included within the SOFR. “I do think there is a lot of depth to the market and central clearing would help it, but in today’s environment there is still a tremendous amount of volume that can be used to calculate a good rate for this new index,” he says.

The clearing cure

Many see the clearing of all bilateral and tri-party dealer-to-client trades as the cure for the repo market’s ills. As all cleared trades will effectively be transferred to a single counterparty, this allows banks to net down their exposures to minimise the impact of leverage ratio requirements. According to a report published in March by the OFR, extending central counterparty (CCP) services to the buy side would reduce risk exposures for dealers by as much as 81%.

Until June 29, the FICC was only available to banks and broker-dealers for GCF repo, but the CCP has now launched a new programme – dubbed the centrally cleared institutional tri-party (CCIT) service to coax in the buy side.

The first trade was executed between Morgan Stanley and Citadel, and the service allows institutional investors – including corporates, asset managers and insurance companies – to participate directly in the FICC. However, the CCIT does not cater for registered investment companies (RICs) that are regulated under the Investment Company Act of 1940. This is due to a law that forbids RICs such as MMFs to contribute to margin and a default fund.

“The FICC would be a great place to have a clearing platform, but when it comes to the CCIT itself, the buy-side clients that are trying to sign up would be forced to provide liquidity in a default event against their counterparties, which is not really feasible for RICs in their current format,” says Pimco’s Berman.

To date, the CCIT member directory, which is published by the FICC, has only Citadel listed.

Debbie Cunningham
Debbie Cunningham, Federated Investors: Repo growth “good for liquidity”

The FICC has also expanded a long-standing sponsored access programme that has been operational since 2005 but which has historically had little take-up. This service allows well-capitalised bank members to sponsor RIC clients into the CCP and its expansion will allow qualified institutional buyer clients to lend cash and US Treasuries via their sponsored banks during the day.

“As sponsored access grows, it could potentially have a broader impact that see things get a little more competitive, but you could also see the ability of everyone to net down their balance sheet,” says the head of repo trading at a French bank in New York. “It is something we’d like to do with some of our clients to help them gain access to the CCP, but we’re still in the early stages of talking to the FICC about it.”

Two asset managers have already used the service, according to OFR data. Both Goldman Sachs Asset Management and Federated Investors executed a total of $10.2 billion over the course of June and July via the FICC’s sponsored access program.

But not all asset managers are convinced the sponsored access model will suit their needs. “Dealers paying into a risk pool will impact them from a capital perspective and so they could charge us more for the transaction. There are issues with both CCIT and sponsored access,” says a repo trader at a large buy-side firm.

Lack of incentive

Banks also need incentives to clear dealer-to-client repo trades, and these are currently lacking. Dealers have been earning wide spreads between what they charge clients in the dealer-to-customer market and what they fund at in the interdealer cleared market at the FICC, causing some banks to increase the amount of balance sheet they are putting towards this business in 2017. This has led some to question whether clearing is the right route for maximum profitability.

Banks borrow cash from MMFs for a few basis points over the lower boundary of the Fed target rate, which is currently 100bp, but then lend that cash at a premium to other banks that rely on them for funding in the GCF market. According to FICC data, the highest weighted average rate charged in the GCF market in August was 121bp, but that can be significantly higher at quarter-ends when the market becomes more constrained. In June, for example, the rate reached 137bp.

“Repo clearing is a Trojan horse,” says a former repo trader at several Wall Street banks. “If you bring the buy side into the CCP, then the fat spreads banks are getting now will go away and the balance sheet gets reduced even further. Many banks are wondering, when they’ve finally got the business into a good place, why they would support central clearing and impact their bottom line.”

Many banks are wondering, when they’ve finally got the business into a good place, why they would support central clearing and impact their bottom line
Former repo trader at several Wall Street banks

“If you put a Fidelity into the CCP then spreads will collapse because everyone has access to that liquidity,” says the former repo trader. “If you have balance sheet and you’re making 50bp, but spreads collapse to 25bp or less because pricing becomes more competitive, then instead of doing $50 billion–$100 billion per day, you have to do double that just to break even. That’s a lot of trading to make up the difference and a lot of banks don’t have the capacity.”

Another potential threat to central clearing is a US Treasury report that was published in June this year, which proposed removing Treasuries from US banks’ supplementary leverage ratio exposure calculations. If Treasuries are removed from the leverage ratio, this would reduce banks’ incentives to net down repo exposures at a CCP.

“Depending on the outcome of that, it could unfortunately deter some of the movement to clearing,” says the head of repo trading at a broker-dealer.

Foreign repo dominance to continue

Foreign banks such as BNP Paribas, Crédit Agricole, HSBC, and ING have slowly become the largest counterparties to US money market funds (MMFs), according to data from the US Treasury’s Office of Financial Research. They have also been complemented by insurance firms such as Metlife and Prudential. This is thanks to leverage ratio rules which allow European, Swiss and Japanese entities to measure their leverage on the last day of each quarter, leading to significant volatility at quarter-ends. US and UK banks, on the other hand, report their leverage as averages of their daily value over the quarter.

This was originally forecast to be less of an issue come 2018, when foreign banks registered as intermediate holding companies will be held to the same capital, liquidity and risk management standards as US bank holding companies as a result of Fed prudential standards published in 2014. But three foreign banks interviewed by say these rules will not impact their repo business.

“You might have different answers depending on who you speak to because it depends on the bank structure and how they are set up. For us in the US, we don’t foresee any major impact as a result of the new rules,” says the head of short-term markets at a French bank in London. understand numerous foreign banks affected by the rules have altered the entity in which their US repo trades are booked. So instead of diminishing their activity, foreign banks have instead been increasing the amount of repo they do with MMFs, according to data from the OFR, and have continued to significantly diminish the amount of repo they do at quarter-ends.

In July, US banks made up roughly $40 billion of the $647 billion market, equating to a 6.2% market share, and the distortions in the repo market caused by this imbalance have been of prior concern. This will undoubtedly make it harder for the Fed to remove its RRP, which itself distorts the capacity in the market.

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