Repo netting curbs threaten government bonds, say dealers

Repo netting criteria in the revised leverage ratio may be less forgiving than banks first thought

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Banks fear it will be impossible for them to use a safe harbour designed to protect repurchase agreements from the worst impacts of the Basel Committee on Banking Supervision's new leverage ratio. That could drive up transaction costs and hurt the liquidity of government bond markets, some claim.

The industry initially welcomed revisions to the ratio, finalised on January 12, because it allows the netting of repos and reverse repos with the same counterparty under certain circumstances – something that was not permitted when the revisions were proposed in July last year. But a closer reading has left some institutions worried bilateral repos may be excluded - that is around 50% of the market, according to some estimates. Without the ability to net, each new trade would add to a bank's leverage exposure, forcing it to hold more capital.

"Where the market could be most impacted is government bond repos – larger markets like Germany, France and the UK especially. These markets are very liquid and they don't have large spreads as a result, meaning they look worse from a return-on-capital point of view," says a senior financing specialist at a US bank in London.

The January text sets out criteria for the netting of repos and reverse repos, the first two of which are relatively straightforward: the transactions need to have the same final settlement date, and the legal right of set-off needs to exist. However the third criterion – set out in paragraph 33(i)(c) – is being interpreted differently from one bank to another, with some arguing it closes the door on netting altogether for bilateral repos.

To obtain netting, it says counterparties must "intend to settle net, settle simultaneously, or the transactions are subject to a settlement mechanism that results in the functional equivalent of net settlement." It adds that the transactions to be netted must go through the same settlement system and be supported by liquidity arrangements that ensure they will both settle by the end of the day.

Where the market could be most impacted is government bond repos

Some banks argue this criterion is academic because institutions generally intend to settle net and simultaneously, and will therefore pass the test.

Others see it differently. Around 10% of bilateral repo trades fail to settle on time due to operational issues, according to one banker's estimate, which might mean only repo transactions that are handled by a central counterparty (CCP) could be seen as satisfying the intent criterion – because it's the only way to be sure a trade will settle net.

"If you take the intent definition on a tight basis, then you may say only CCP trades are nettable. Why? Because a CCP trade, by definition, must settle on a net basis. When you look at the CCP regulation, there is no way for trades with a CCP to settle gross," says the financing specialist at the US bank. Sources at two other banks – one a UK institution and one a US bank – share those concerns.

The problem is that only around 30% of repo transactions are cleared, according to the International Capital Market Association, and CCPs currently only handle interdealer trades – meaning client-to-dealer repo transactions would remain bilateral, and may not qualify for netting.

This would have a number of effects, in particular on government bonds, which make up around 85% of the repo market, claims the financing source. First, he says banks may have to reduce their involvement in the government bond repo market because the small spreads and increased leverage costs mean it is no longer profitable. Second, repo trades between clients and dealers would be a leverage burden for the latter, meaning customers would face higher transaction costs.

"I'd end up with a balance sheet exposure when I do a trade with a client, which means I have to charge him more. Potentially, a lot of relative value strategies will not be profitable at current spreads," says the financing source.

Relative value players could compensate for this by waiting for spreads to move further than they currently do before stepping into the market, he adds – creating additional bond market volatility.

Paragraph 33(i)(c) does suggest a way out of all this. Instead of clearing the trades, market participants may be able to net if they use a mechanism that is the "functional equivalent of net settlement". But the conditions attached to this have left some dealers confused – they appear to suggest that if one party does not post the securities as expected, the counterparties would need to settle on a net basis regardless, with the securities being delivered at a later date. That makes no sense, banks argue.

"We don't really know what they meant by that. We've been struggling – not just us but the industry as a whole – to get clarity from the regulators on what they really mean. Clearly, you're not going to pay away cash to a counterparty that hasn't settled a security leg," says a New York-based regulatory source at a US bank.

The Basel Committee is understood to be planning to tackle industry questions via an FAQ document later this year. The document is also expected to address other controversial topics raised by the revisions to the leverage ratio, such as the requirement for cash variation margin to be in the same currency as the settlement currency of the underlying.

The committee did not respond to requests for comment.

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