Single legal doc and reduced risk may spur more corporate repo lending.
Corporates in the US have tended to avoid the repo market despite the security it provides and relatively attractive returns for short-term investments. They may want to think again, however, following the recent regulatory approval of a service to access a repo countparty that facilitated its first trade June 29.
The tri-party repo market has long provided Wall Street firms with short-term funding by selling securities in their inventories and agreeing to buy them back again at an agreed higher price and time. The higher price is effectively interest on a loan. Institutional investors—especially mutual funds—have been the primary lenders in that market, setting up bilateral agreements with sell-side counterparties.
Traditional repo transactions are more operationally intensive than money market funds, bank term deposits, and other short-term investments. And while they are collateralized typically at 102% and thus very secure, monetizing collateral from a defaulting counterparty can take time. In addition, the 2008 financial crisis revealed the risk of asset fire sales in financial markets including repos. The Dodd-Frank Act instituted measures over the next several years to limit the risk of panic-fueled sales in asset classes such as swaps and money funds.
In early 2014, the Federal Reserve Bank of New York introduced tri-party repo reform efforts, but that didn’t address fire-sale risk. Later that year the Depository Trust & Clearing Corp. (DTCC) applied for regulatory approval to establish a repo central counterpary (CCP) service that would reduce fire-sale risk. In May, the Securities and Exchange Commission approved the DTCC’s Fixed-Income Clearing Corp. (FICC) subsidiary to expand the availability of central clearing in the repo market, beyond its existing GCF Repo Service that has enabled dealers to trade FICC-cleared general collateral tri-party repos since 1998.
The approval permits institutional investors to access the FICC directly through its Centrally Cleared Institutional Tri-Party (CCIT) service, which went live June 29 when it completed its first trade between hedge fund Citadel and Morgan Stanley.
The SEC approval excluded Registered Investment Company (RIC) Act funds, mutual funds, which were a part of the original application and are by far the biggest portion of lenders in the current tri-party repo market. They’ve been able to access the FICC’s repo CCP since 2005 through a bank sponsor, and the DTCC is continuing to seek regulatory approval for RICs to use the CCIT service. However, a wide variety of other institutional investors can access CCP via the CCIT service, including hedge funds, pension plans, insurance companies and municipalities.
Corporate treasuries also have access to the CCP via the CCIT service, providing another arrow in their quivers as companies search for places to park cash and eek out higher returns. In May, the SEC also approved non-RICs accessing the CCP via a sponsor, which for a fee will handle operational necessities such as posting margin. So corporates can choose either sponsored access or accessing the CCP directly and pocketing the fee. The FICC is currently in talks with vendors to give clients access to the repo CCP over their electronic platforms.
Signing one legal agreement with a CCP is considerably more advantageous to resource-hampered treasury departments than inking agreements with multiple bilateral counterparties. In addition, those bank counterparties typically hold credit ratings that are a notch or two below the DTCC’s depository and clearing services, which are rated Aaa by Moody’s. Standard & Poor’s assigns it an issuer credit rating of AA.
Unlike the 102% collateral required in the bilateral repo market, the CCIT will require 100% collateral. Jim Hraska, Managing Director and General Manager for the FICC, said the additional 2% is unnecessary because transactions will have a full guarantee from the FICC and, in turn, FICC will be collecting margin from borrowers to cover its exposure.
CCP members typically mutualize any losses due to the default of another member, and that will be the case for the FICC’s full members. The DTCC notes that a centralized liquidation of a failed counterparty by the FICC would reduce the risk of fire sales that drive down asset prices and spread stress across the financial system.
Corporates, however, would join as limited members, and in such a scenario they would not be subject to full loss mutualization. A corporate could only potentially get allocated a portion of losses associated with trades it executed with a defaulted borrower, and only at the end of a long waterfall of resources. That waterfall would first absorb any potentially losses starting with the borrower’s margin and moving on to any cross guarantees that might exist and the DTCC’s own skin in the game.
“The thought there is [that] the [limited member] is significantly better off than doing the trade in a bilateral world because it has all these kinds of waterfall-type loss protections, and in a worst-case scenario it is no worse off than doing it in the bilateral space,” Mr. Hraska said.
If corporates or other non-RICs access the repo CCP via a sponsor, the sponsor would absorb any allocated losses.
Corporates have tended to participate more actively in the European tri-party repo market, in part because there are fewer alternatives to invest cash in Europe and because repo clearing firms Euroclear and Clearstream have actively sought their participation. For example, a few years ago they each developed standard legal documentation so lenders would only have to scrutinize and sign one agreement to lend to multiple parties, rather than multiple agreements with each of those parties.
The group treasury manager of a global hotel chain noted that his company began trading repos in Europe in autumn 2015 through its relationship bank. The company doesn’t invest a lot through repos – primarily cash looking for a one-, two- or three-month home. Its repo portfolio is very conservative, with the majority of collateral it receives comprising AAA-rated government and corporate bonds.
The treasury executive said repo returns provided a bit of a premium initially. However, now the returns may be slightly less than overnight money market funds, given the recent rise in rates in Europe, although the overnight money-market fund benchmark its uses provides a less than accurate comparison.
“Repos are another tool in our toolbox of investments, and if we have any sort of longer term cash to invest—one to three months—then we look to the repo side, he said, adding that cash generated in the US is almost immediately brought back to the home office, and so it wouldn’t use the US repo market.
Occasionally the issue of repos arises at NeuGroup meetings, but few members ever acknowledge investing in them. One member, a treasury executive from a pharmaceutical company that invests in repos, said a repo CCP would be attractive in light of the single legal agreement with a strong credit counterparty. He added, however, that his company typically wants to provide a share of its wallet to banks in its credit facility, and it currently only executes repos with those banks. He asked whether the repo CCP would provide visibility through to the counterparty, so that treasury could see which institution is on the other side of the trade.
“The answer is yes,” said Laura Klimpel, VP, DTCC’s Clearing Agency Services. “The CCIT product is designed for trades to be bilaterally executed between cash lenders and borrows in the same way that such trades are executed in the non-cleared tri-party repo market today.”