Buy-side firms ice repo clearing plans as spreads tighten

Resurgent bilateral market a headwind for services at Eurex and LCH

  • After a repo squeeze at the end of 2016, buy-side funds in the UK and Europe began considering clearing repo for the first time.
  • Eurex launched a buy-side clearing service in mid-2016, and LCH followed in September 2017.
  • But tighter spreads and improved liquidity in bilateral repo is causing some firms to hold fire on clearing for the time being.
  • The recovery of bilateral repo has been driven by a combination of new entrants and better netting of offsetting transactions.
  • Some market participants think the recovery of bilateral repo trading undermines the business case for buy-side repo clearing.
  • However, LCH argues the rationale is not just about spreads and liquidity but also connectivity and risk management.
  • Some buy-side firms say how repo liquidity behaves over the year-end will influence the decision whether to clear repo in 2018.

This time last year, buy-side repo users in the UK and Europe were panicking. A regulatory-driven year-end balance sheet clampdown from dealers in the bilateral market meant liquidity was scarce, and prices soared. For the first time, the buy side started to take the idea of clearing their trades seriously.

Twelve months later, things have completely turned around. Users says spreads on bilateral UK government bond repo are 12 basis points tighter, having declined progressively in every quarter during that period.  

“Liquidity has increased in the repo market and consequently spreads have tightened,” says Rosa Fenwick, a liability-driven investment (LDI) portfolio manager at BMO Global Asset Management. “There have been new entrants to the market, a redeployment of balance sheet from the US, and banks in general can afford to be more forward thinking in terms of how they allocate balance sheet; having completed internal balance sheet and leverage ratio reviews.”

Since it came into force, the Basel III leverage ratio has penalised activities such as repo trading that are low risk but balance sheet intensive. To help alleviate this, Eurex and, more recently, LCH – have opened the doors of their repo services to the buy side for the first time. Clearing allows dealers to net down their repo exposures, reducing capital requirements and allowing banks to provide cheaper pricing.

Like others, BMO began considering repo clearing for the first time earlier this year. But with liquidity and pricing in the bilateral market now improving, Fenwick’s team is now less convinced of the business case for clearing repo.

Of the six large buy-side repo users spoke to for this article, five said they have no immediate plans to clear in the immediate future. Some cite the fact that spreads have come down as competition among dealers has returned. Others say dealers are now better able to net down bilateral repo exposures, opening up balance sheet capacity and lowering prices.

“There are two key reasons that would cause the buy side to use cleared repo,” says Fenwick. “First, because you are unable to source repo bilaterally; second, because the pricing shows an obvious benefit in clearing. Neither of those is the case at the moment.”

However, Paul Elkins, global head of product for LCH RepoClear, says there are a host of other benefits to clearing. He concedes balance sheet capacity does appear to have increased for bilateral repo, but says that may not be the case for everyone.

“For firms that don’t have balance sheet constraints, there is perhaps a little less urgency to begin clearing. But we are having conversations with people on both sides of the equation. Some participants are more urgently seeking access to clearing because they don’t have the allocated balance sheet they are looking for. There are also a number who do have a fully allocated balance sheet that are looking to do business with us,” says Elkins.

Nightmare after Christmas

The repo market’s problems largely stem back to the Basel III leverage ratio, which requires dealers to hold capital against banks’ balance sheet assets, including securities exchanged through repo.

Banks effectively take a double hit when trading repo. The cash received boosts the asset side of the balance sheet while, at the same time, the assets posted in the transaction are not derecognised. Dealers had estimated repo rates would need to jump at least fivefold if they are to make an acceptable return on capital.

The impact of the leverage ratio treatment is most visible towards month, quarter and year ends, when banks look to shed assets to window-dress their balance sheets ahead of reporting dates. This has led to some curious effects, such as French banks dominating the US repo market around these times.

In Europe, though, this led to the €6 trillion ($7.1 trillion) bilateral repo markets freezing over in December 2016. Over the course of the month, volumes fell by about 40% from €500 billion to €325 billion by December 27. The shock also hit pricing, with spreads on some German and French government bond repo blowing out. 

Eonia vs repo

Some buy-side firms were told they would not be able to place cash without the promise of ancillary business. Others found they were unable to access the repo market, at any price. Scarred by the experience, many of these firms began to think about clearing.

“The first reason we decided to look into clearing of repo was what we saw at the end of last year with a big squeeze in liquidity,” says a collateral manager at one pension fund in the Netherlands.

“We had to look for liquidity in mid-December and most counterparties we deal with had no interest. We had to rely heavily on the business relationships we have with some entities.”

“At end-of-year banks are trying to close their balance sheet,” he adds. “So we thought maybe if they are doing repo with us at a central counterparty (CCP) then they would have more room to trade over periods like this. That is what we’ve been trying to confirm.”

Increased access

As buy-side firms were worrying about waning bilateral liquidity, CCPs were beginning a push to expand access to their repo services.

The leverage ratio only allows exposures to be netted for trades with the same counterparty and maturity. Clearing was seen as a boon, because all cleared trades will effectively be transferred to a single counterparty.

Eurex was the first to move, unveiling in the third quarter of 2016 its ISA Direct Service, which allows certain buy-side participants to have a direct contractual relationship with the clearing house and clear repo with the assistance of a clearing agent. In September 2017, LCH RepoClear also launched a new model that allows buy siders to clear through an intermediary sponsor.

There are some cosmetic differences between the platforms in coverage and functionality. For instance, clients access Eurex via the CCP’s own proprietary platform; LCH uses a host of trading platform vendors, such as EBS Brokertec.

Clearing does appear to have an impact on repo prices. According to the European Central Bank’s Money Market Statistical Reporting (MMSR) data, cleared euro government bond repos across all counterparties consistently traded at lower rates than non-cleared repos over the past 18 months – a trend that is especially true on reporting dates.

Just over a year after launch, 17 non-banks are now clearing repo on Eurex’s ISA Direct. So far only one buy-side firm – London-based Insight Investments – appears to be signed up to LCH RepoClear’s sponsored clearing model. However, the clearing house claims more sponsoring agents, funds and other potential members are currently progressing towards using the model.

“We do see demand from a number of prospective buy-side and sell-side members,” says LCH’s Elkins. “We are taking those relationships forward and expect to see an uptick in membership and activity in early 2018.”

Repo’s recovery

Yet just as Eurex and LCH were launching their buy-side services, something was happening in bilateral repo – spreads were beginning to tighten. According to Bank of England data, gilt repo spreads tightened from 50bp in December 2016 to 10bp by November 2017. In the euro repo market, funding pressures have also been relatively muted. At the March 2017 quarter-end, for example, German general collateral repo settled around the –150bp to –200bp level, compared to around –500bp at the end of 2016.

One theory is that dealers have been finding ways to minimise the impact of repo on their balance sheets. In particular, asset managers have been conducting so-called nettable repo trades, where they use the same maturity date for lending and borrowing transactions. This allows dealers to net the trades off under the leverage ratio, reducing their capital requirements.

Some banks have also redeployed capital from the US to the UK gilt repo market to take advantage of the high spreads available, says BMO’s Fenwick, bringing in extra balance sheet capacity.“Australian and Canadian banks have come into the market recently and are keen to offer balance sheet for better returns than they can get in their domestic markets, and in some cases to gain a foothold in the LDI market,” she says. 

This isn’t necessarily a long-term effect: “New players have joined the market and we have seen capital being redeployed. If spreads continue to tighten there will come a point where it is no longer economic for them to keep capital here, at which point balance sheets will begin to reduce again,” she adds.

As a result, many buy-side repo users have put their clearing plans on ice for now.

“We are still investigating all the options,” says a portfolio manager at an asset manager in the Netherlands. “But the first option for me is still the bilateral route.”

A senior trader at one London-based LDI manager is also content to carry on trading bilaterally for the time being. He says that while the CCP could act as an extra counterparty for short-term repo for credit risk diversification purposes, the increased netting of bilateral repo trades by his dealers should keep existing repo liquidity stable for the foreseeable future.

“We looked at it very seriously this year, but it is just not near the top of the list of things that are helping repo liquidity at the moment. In a world of unlimited bandwidth you’d have it as an option, but you’ve always got to prioritise and it is just not as compelling a way to access liquidity as some of the others,” says the trader.

“Nettable repo is helping enormously because we have some control over being able to do trades with the same day, same legal entity, and netting down the balance sheet,” he adds. “The balance sheet is the big deal for the bank, and this gives them another option.”

Others say the high costs of participating in a CCP mean there has to be a significant benefit in pricing compared to bilateral to make participation worthwhile but this is simply not evident at the moment.

If clients are not finding it difficult to finance in a bilateral format, why would they want to finance via a CCP, which in some cases is more expensive?
Michael Manna, Barclays

Michael Manna, head of fixed income and financing at Barclays, says the absence of a pricing benefit will inevitably slow buy-side uptake of clearing solutions in the near term. “If clients are not finding it difficult to finance in a bilateral format, why would they want to finance via a CCP, which in some cases is more expensive?” he says.

“We definitely feel there has been more leverage put into the system and that’s caused spread compression. So the buy side are finding it much easier to source direct balance sheet – and to my mind that undermines the entire business case for putting the buy side onto a CCP,” he adds.

BMO’s Fenwick agrees, saying they are in no rush to move to clearing while bilateral repo remains liquid. Firms need to factor in not just the spreads in bilateral repo versus the clearing house, but also the ancillary costs of clearing any financial product. “The costs of using repo clearing versus bilateral are quite high,” she says. “There is the default fund contribution, whether you or your sponsoring agent pay it, and there are trade-booking, clearing and agent fees. Cash must also be put aside for variation margin. These can be significant and there is no offsetting benefit currently.”

Clearing also doesn’t help with the fundamental liquidity problem that asset managers face when trading repo – counterparties wanting to trade at very different tenors to the needs of the funds that they manage. A pension fund will typically try to source repo with longer maturities to manage its roll-over risk. But money market funds and corporates want to lend short-term to minimise liquidity risk.

“A lot of the challenge is the kind of tenor our schemes want, usually three months or six months,” says the senior trader at the London-based LDI fund. “This is nowhere near the tenor that the cash lenders want to do at a CCP. So while it is still in its infancy I don’t see the sponsored model opening up any more liquidity to end-users in the repo market.”

To maintain access to liquidity, buy-side firms must therefore maintain good relationships with a large pool of counterparties that can manage the tenor mismatch, says Fenwick. That might be more challenging for a firm that routes most of its trades through a clearing house.

“That is what the banks have been doing in the bilateral space for a long time – managing that tenor mismatch,” she says. “The justification for better pricing from banks in LCH is the netting benefit, yet there is unlikely to be significant netting in the longer tenors as there is one-way demand from LDI.”

Future proofing

Nevertheless, some buy-side participants have decided decided gaining access to clearing still has merits, despite the improved conditions in bilateral repo markets. One of them is London-based LDI fund Insight Investment, which in September became the first buy-side firm to clear repo on LCH’s RepoClear platform with the help of its sponsor NatWest Global Markets.

For Insight Investment, broadening its access to liquidity in the repo market was the fundamental driver for signing up to RepoClear. But even accounting for tighter spreads in the bilateral market, the firm reports seeing some cheaper prices at the CCP over bilateral trading.

“We are certainly experiencing an improvement in pricing,” says Adrian Pogson, head of solutions management at Insight Investment. “And it’s still early days – going forward we expect to see an uptick in the number of banks we can trade with [at the CCP], and the reduced capital charges for banks should facilitate further improvements in pricing.”

LCH’s Elkins concedes that new entrants in the market have driven an increase in allocation of balance sheet over the course of the year. But he says there are a host of other factors that he sees driving interest in repo clearing among buy side firms, such as counterparty risk management and, in particular, connectivity.

“Membership of a clearing house gets you access to a broad range of counterparties through a single piece of documentation,” Elkins says. “In bilateral repo, a new fund has to go through the process of signing agreements for each relationship they have. If those relationships change and balance sheet gets reallocated then they need to produce new documentation.”

Nick Gant, head of prime brokerage for Europe, the Middle East and Africa at Societe Generale, agrees it is sensible for active repo users such as Insight Investments to expand their access to liquidity even if there is currently plenty of repo liquidity for them in the bilateral space.

Societe Generale is continuing to speak with clients about clearing opportunities both at Eurex and LCH. Clearing with Eurex, for example, could give a firm access to more than 150 counterparties across dealer and non-dealer members. “There is an element of future proofing liquidity because it could give access to a far bigger liquidity pool for the buy side. If we’ve learned anything from 2008 it is that liquidity can move aggressively, very quickly. Just because there is liquidity here today doesn’t meant there will be liquidity tomorrow,” says Gant.

The collateral manager at the Dutch pension fund says it will be keeping an eye on how markets behave around the turn of the year before making any decision. “We have decided to continue watching for a while. At the end of the year it will be a good exercise to look at pricing and liquidity. Banks will be trying to close their balance sheet, but if more is going through CCPs maybe there will be a bit more room,” he says.

“I wouldn’t be surprised if we start clearing [repo] at some point though,” he adds. “We already clear derivatives and have found that to be a much cheaper way of trading.”

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