Plumbing problems in the repo market

Technically, the repo market doesn’t exist.

The term is shorthand for a stack of distinct – but connected – markets, in which participants do essentially the same things, subject to subtly different rules and structures.

Those subtle differences matter, as September 17 illustrated. On that day, repo rates spiked to 10%, forcing the Federal Reserve to pump liquidity into the market in a programme currently set to extend into January.

It’s a crisis that defies simple explanation, but one ingredient that has largely escaped attention is the sponsored repo clearing system run by the Fixed Income Clearing Corporation, which threw open its doors to money market funds (MMFs) in 2017.

As a result, bank members of FICC can take in cash from the market’s biggest lenders and pass it to repo borrowers in back-to-back trades that are all funnelled via the central counterparty – a structure that allows the offsetting transactions to be netted under the terms of the leverage ratio, dramatically reducing the capital consumed by the business.

It has been a big hit. At the end of August, nearly a quarter of US Treasury repo loans made by MMFs – roughly $190 billion – were cleared, compared with practically zero at the start of 2017. This makes FICC not only the largest repo counterparty today, but the largest repo counterparty ever.

Ironically, a service designed to solve the leverage ratio problem and take the pressure off dealer balance sheets may have concentrated liquidity in the hands of a small group of sponsor banks and approved borrowers

But the FICC’s sponsored clearing service comes with a few conditions attached.

First, in order to participate, cash lenders and borrowers must be sponsored by an existing FICC member. As of September 17, only three banks sponsored money market funds for clearing – Bank of New York Mellon, JP Morgan and State Street. And initially, money market funds were only permitted to lend cash to their sponsor banks. Despite a subsequent relaxing of the rules, those sponsors continued to suck up most of the cash – and an exclusive group of approved borrowers was its end destination.

Ironically, a service designed to solve the leverage ratio problem and take the pressure off dealer balance sheets may have concentrated liquidity in the hands of a small group of sponsor banks and approved borrowers, contributing to the melt-up in repo rates on September 17.

“Back when banks were limited by balance sheet restrictions, large money market fund investors would be forced to transact with many different counterparties,” says a repo trader at a broker-dealer that is a member of FICC. “Now, they just give all their cash to banks via the sponsorship programme.”

Structural shifts add to repo madness

These bottlenecks may prove to be transitory. Mizuho Securities became a sponsoring member on October 15 and Risk.net understands at least 12 more sponsors have been approved. The number of sponsored cash borrowers has also grown since September 17, with the likes of hedge funds Lighthouse Investment Partners, MKP Capital Management and Rimrock Capital joining the pool of eligible borrowers.

As it expands, the service could make repo more robust, facilitating the smooth flow of cash and collateral between buy-side lenders and borrowers.

But, in its infant state, the programme is thought by some participants to have contributed to the market’s fragility on September 17.