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DOW JONES     Prepare For Repo Defaults (Christina)

Author Message ▼ Last message
Christina     posted : 23/07/13   07:28 pm

according zero hedge Wake up guys

"As we warned here most recently, the shadow-banking system remains the most crisis-catalyzing part of the markets currently as collateral shortages (and capital inadequacy) continue to grow as concerns. In recent weeks, between The Fed, Basel III, and the FDIC, regulators have signalled the possible intent to change risk, netting, and capital rules that could have dramatic implications on the repo markets and now, it seems, the SEC has begun to recognize just how big a concern that could be. As Reuters reports, the SEC urged funds and advisers last week to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance.

A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities. Most repos, around 80%-90%, are against government-related collateral and it is the repo market which makes government securities relatively more liquid by allowing fast and efficient financing and short covering. It is not accidental that trading volumes in bond markets are so closely related to the outstanding amount of repos.

Via Reuters,


The U.S. Securities and Exchange Commission on July 17 quietly issued new guidance to money funds that spells out the risks they could face if borrowers in the tri-party repurchase market collapse.

"There are a variety of ways in which a money fund and its adviser may be able to prepare for handling a default of a tri-party repo held in the fund's portfolio," the SEC wrote. "Such advance preparation could be part of broader efforts by the money market fund and its adviser to follow best practices in risk management."

In a four-page document, the SEC urges funds and advisers to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance.

It also calls for funds to consider the operational aspects of managing a repo, and to contemplate whether there are any legal issues that could arise in the event of a repo default.

The SEC's guidance comes at a crucial time for the money fund industry. The SEC is weighing controversial new rules that seek to reduce the risk of runs on money funds by panicked investors - a scenario that took place during the financial crisis.

The Federal Reserve is separately eyeing a new rule that would force investment banks that rely on risky short-term funding such as found in the repo markets to hold more capital.


And as JPMorgan explains,

...Regulators have introduced a simple non risk-based leverage ratio framework, i.e. capital over un-weighted assets, as a complement to the risk-based capital framework. The Basel Committee’s revisions to the framework in the 26th of June release relate primarily to the denominator of the leverage ratio, the Exposure Measure.


The most significant impact is likely to be on repo markets. As with derivatives, the proposals do not allow netting of collateral, i.e. repos are accounted for on a gross basis in the calculations of the Exposure Measure. Effectively both derivatives and repos are accounted for as loans on a gross basis rather than a securitized net product. In fact the revised guidance is even more punitive for repo transactions as it not only forbids netting of collateral but it does not allow netting of exposure either, i.e. repos and reverse repos cannot be offset against each other.


Repos are a $7tr universe approximately across the US, Europe and Japan. This is equal to close to 10% of the $77tr of the reported assets of G4 commercial banks including US broker-dealers. However, off-balance repos as well as accounting reporting which allows for netting between repos and reverse repos under both IFRS and US GAAP as well as collateral netting under US GAAP, means that most of this $7tr of repos is not captured in reported balance sheets, i.e. it is not included in the above $77tr figure of commercial bank assets.


If we apply the same 10% to the whole of the $7tr of G4 repos, i.e. we assume that around $700bn is accounted via existing reporting of net repos in banks’ balance sheets, then under the revised Basle proposal which forces reporting of total gross rather than net exposures, the Exposure Measure would increase by more than $6tr.

Applying the 3% minimum capital requirement to this $6tr potentially results to additional capital of $180bn across the whole of the G4.


These new regulations are hitting repo markets at a time when they are struggling to recover from their post-Lehman slump.

At a time of rising 'fails', rising leveraged-carry-trades, and no real end in sight for Fed intervention, a repo default contagion could indeed be the self-inflicted wound to bring down the risk-markets in spite of Fed liquidity."

I\'m happy to receive any constructive criticism about my trades. I\'m always ready to learn more.
Christina     posted : 05/08/13   07:14 pm

From Less Repo, To Less Collateral Transformation, To Less Quantiative Easing In One Shadowy Step

First it was the TBAC's May presentation "Availability of High Quality Collateral" piggybacking on reasoning presented previously by Credit Suisse. Then JPM's resident "flow and liquidity" expert Nikolaos Panigirtzoglou rang the bell on regulatory changes to shadow banking and how they would impact the repo market and collateral availability (and transformation) in an adverse fashion. Now, it is the turn of Barclays' own repo chief Joseph Abate to highlight a topic we have discussed since 2009: the ongoing contraction in quality collateral as a result of transformations in shadow banking and the Fed's extraction of quality collateral from traditional liquidity conduits (i.e., QE's monetization of bonds). To wit: "Several recent regulatory proposals will increase the pressure on banks to reduce assets that carry low risk weights. Repurchase agreements are a large source of banks’ low-risk assets, and we expect banks to reduce their matched book operations in response to these proposals."

Abate's highlights:

•Given inelastic demand for repo, we expect banks to increase margins to offset reduced volumes.
•The implications for market liquidity are potentially more severe, as banks and dealers may become less willing to facilitate short positions and warehouse risk.
•A reduction in repo activity will reduce the supply of investible assets for short-end investors, widen bid-ask spreads and could encourage the development of riskier substitutes for collateralized borrowing.
•Smaller securities inventories could reduce cash market liquidity. In the Treasury market, these banks may become less aggressive bidders at auctions.
•Likewise a reduction in repo balances will limit the market’s ability to transform weaker collateral into the high quality assets necessary to meet new margin requirements.
What this means explicitly for repo volumes is nothing new and has been covered here extensively in the past, and can be seen quite vividly in the periodic slide of OTR repo into "special" status, usually just ahead of Treasury auctions:

We expect repo volumes to fall for both U.S. and foreign banks. Repo in the U.S. has already fallen by 40% since its pre-crisis peak (Figure 1). We believe the U.S. repo market can reasonably be expected to decline 10% and possibly more across domestic and foreign banks as a result of these new rules and their proposed revisions. In fact, we believe this has already begun, although empirical evidence is difficult to find outside of discussions with money market funds regarding the decline in repo availability.

The most concrete evidence that the pressure on repo has already begun is the occurrence at quarter-end of plunging bank repo borrowings as primary dealers tighten their balance sheets ahead of end-of-period reporting. This is particularly acute for money market funds, whose repo balances from primary dealers typically fall 15% ($75bn) in the final day of a quarter, only to recover over the first two months of the following one. Money funds have attempted to replace some of these lost balances from non-primary dealers, but the credit ratings of these other institutions prevent much of this potential repo replacement. We estimate that nonprimary dealer collateral replaces only about $5bn of the $75bn lost on quarter-end from primary dealers. Unsurprisingly, since money fund balances generally have the same amount of cash to invest at quarter-end, the closing out of primary dealer repo positions results in a steep plunge in repo rates on the final day of the quarter.

The danger from the imposition of a "higher supplementary leverage ratio" is that while on the surface banks may demonstrate stronger balance sheets and less counterparty exposure, it will simply force them to seek "near-substitutes" that behave not exactly according to plan. See Lehman.

Lower repo and bill yields may seem like a small price to pay for stronger bank balance sheets, but there is a strain of research that argues that such scarcity encourages the creation of near-substitutes that may not behave quite like the original. Auction rate securities are an example of an imperfect substitute that under normal market conditions was a perfectly adequate liquidity investment, but ultimately became illiquid during the financial crisis.

Digging into the implications of "thinner dealer inventories" which is already a direct result of changes in the repo market:

In addition to maintaining inventories of securities for proprietary trading and their own portfolios, as significant capital market’s players, these banks hold stockpiles of Treasuries and other securities as part of their market making operations. Net positions in Treasuries across all the primary dealers totalled $80bn in mid-July. Market making – along with hedging inventories – are generally financed in the repo market so a reduction in repo balances will translate into thinner market-making inventories. Similarly, with less dedicated balance sheet, we expect banks to become less aggressive participants in the Treasury’s auctions. This could result in sloppier auctions with bigger tails and ultimately, higher borrowing costs for the Treasury.

A significant reduction in repo might reduce the ability of a dealer or other investors to short securities – without fear of delivery fails. In the Treasury market, a higher risk of failing and consequently incurring the 300bp fails charge, might influence how aggressively dealers participate in auctions and might affect actual auction pricing – even though fails are currently very low (Figure 2). Further, the possibility of increased fails could mean greater volatility in rates as dealers’ willingness to make markets and intermediate between buyers and sellers declines. To avoid the risk of fails, banks and dealers will spend more time searching for available supply to short. Higher search costs reduce the ability of the market to match buyers and sellers, further widening bid-ask spreads.

Repo also plays an important role in intermediating between buyers and sellers outside the Treasury market. Any activity in which banks act as securities “distributors” requires some amount of financing. Whether this financing is done via the repo market will depend on the asset’s underlying liquidity. By reducing balance sheet capacity, the leverage rules are likely to reduce market liquidity as banks ration their available inventory capacity. We expect this rationing will increase bid-ask spreads in any market where banks act as market makers between buyers and sellers.

Finally, and getting straight to the heart of the TBAC's May warning, we focus on the biggest issue of all: collateral transformation, or literally getting something from nothing (or absolute junk) courtesy of the murky, off-balance sheet transformations that take place in the shadow banking system:

In a typical transaction, the customer pledges weaker collateral to the bank in return for higher quality collateral, such as Treasuries or cash. These are then used to meet the customer’s margin requirements on derivatives trades. Since these trades are typically structured as repo transactions using the bank’s balance sheet, they are sensitive to the new supplementary leverage requirements, especially as other regulations are expected to increase the demand for this type of collateral transmutation significantly.

Dodd-Frank sections 731 and 764 change the margin rules for cleared (trades over an exchange) and un-cleared or bilateral derivatives transactions. These are expected to boost the demand for high-quality liquid assets over the next six years. According to estimates from the U.S. Treasury, the incremental demand for high-quality liquid assets to meet the new margin rules will be $1.6-3.2trn. These estimates grow considerably larger if, during the six-year interval estimated, there is a financial crisis or shock that results in a sudden, sharp increase in the demand for safe assets.

Although the supply of high quality collateral to meet this new demand source is likely to come from government issuance as deficits persist globally, we expect banks also to play a role via collateral transformation. After all, most of these derivatives customers are likely to be naturally long non-eligible collateral – such as equities or corporate bonds – but somewhat less so with respect to Treasuries and cash. As intermediaries, banks can use their balance sheets and repo transactions to “extend” the supply of eligible margin collateral for their customers – for a price. As noted above, this is the type of higher margin business for which banks might be willing to use their capacity constrained balance sheets, provided the spread between lower and higher risk collateral is sufficiently wide. To the extent that the supply of government collateral is insufficient to meet the new margin demand, transformation trades are an important safety valve if bank balance sheet capacity is available.

Note the highlighted, underlined text above, because it gets to the bottom of the tapering discussion: in a world in which "deficits persist", the Fed has all the liberty to do as much QE as needed, and absorb quality collateral as much as new gross collateral is injected via the Treasury (i.e., deficit funding). However, as deficits decline, as they have been in the US for the past few quarter (at least until the housing picture inevitably deteriorates again and the GSEs go from source of government funding back to use, and the demographic crunch hits in 2015 and deficits explode higher once again), ongoing monetization means collapsing the high quality collateral pool of assets far more than the TBAC advises. In fact, it is the TBAC that is pulling the strings on the Fed and making it clear, as it did in May, that the Fed has no choice but to taper as long as deficits don't return on their normal, upward trajectory (whether this means a war is inevitable to boost contracting defense spending remains to be decided).

However, it is this aspect of the Fed "cornering itself" that is the underlying driver of all behind the scenes tapering discussions, which have nothing to do with the economy. Because while all the rhetoric and regulatory discussion focuses on the economy, the open markets, and deficits - this is all for general popular consumption. What the Fed and the BIS are truly concerned about, and have been for the past four years, is ongoing instability in the repo world, and other aspects of shadow banking. The last thing the Fed, and Treasury, will want to do is override the TBAC on its advice to moderate collateral extraction and plough on with even more quality asset imbalances in shadow banking. And this is why, at least until the Treasury proceeds to spend itself back into "drunken sailor" mode, that all hopes that the Fed will monetize everything that is not nailed down, will have to be deferred indefinitely.

And with Credit Suisse, the TBAC, JPM and Barclays all having now covered this issue, we look forward to that final "liquidity" guru, Citi's Matt King to chime in on precisely this topic, and make it clear just what the real considerations driving the Fed's tapering "logic" are at this moment.
I\'m happy to receive any constructive criticism about my trades. I\'m always ready to learn more.
Hedge21     posted : 14/09/13   08:15 am

On Italian Repo and Butterflies’ Wings

By Christopher Emsden and Neelabh Chaturvedi

CitigroupC +0.46% reckons that a shift in the way Italian bonds are processed could end up being a flap of a butterfly wing that unleashes chaos on the country’s debt. Italian government bonds have been relatively stable in the last week or so and most traders don’t seem so worried. Here’s what you need to know.

1: What has changed?

In a near 70-page rule book published last month, clearinghouse LCH.Clearnet said that in a doomsday scenario, it would move to so-called cash settlement of repo contracts involving Italian government bonds. In theory, that heightens counterparty risks in the case of a default.

The point of clearinghouses is to minimize that risk: In the type of repo at issue, one bank borrows from another by pledging a government bond as collateral. When the loan is repaid, the borrowing bank gets back its bonds. A clearinghouse such as LCH.Clearnet stands in the middle. If the borrower doesn’t repay the loan, LCH.Clearnet seizes the collateral and makes sure the lender gets paid, even if the collateral is insufficient. Users of the clearinghouse pay a monthly insurance charge for the privilege.

But with the rule change, LCH.Clearnet is saying that should its allied clearinghouse in Italy, Cassa di Compensazione e Garanzia, or CCG, default, LCH.Clearnet would shift to “cash settlement.” That means it sells the collateral and gives the lender the proceeds—with no guarantee of full compensation. A default of CCG is a remote possibility, but it’s not zero. Hence banks lending in the repo market are likely to pay closer attention to the financial health of the party they’re dealing with. Smaller banks that have benefited from a centralized clearing system in the past are likely to be treated with a little more caution.

Friday, CCG followed suit, saying it would do the same if LCH.Clearnet defaulted. Italy’s economy minister Fabrizio Saccomanni played it down, saying regulators had been working on it for months.

2: What did Citi say?

“LCH boots Italy out”, the bank wrote Sept 11, adding “we have long argued that the [euro-zone] situation is more fragile than it seems on the surface – both in peripherals, and more broadly. Nudge the ball gently, and it comes back to rest in the bottom of the bowl. Nudge it rather harder, and it might fall out.”

Given the close links between government bonds and the interbank market, Citigroup reckons that the LCH.Clearnet move could potentially have grave consequences for Italian banks and consequently Italian government bonds, whose purchase in many cases is financed by raising money in the repo market. Liquidity is more at risk than price levels, as such. Still, it said:

“While it is tough to tell how far spreads will move given the generally positive trend in peripheral growth numbers, by the same token we feel there is so little priced in at this point that the risk-reward favors selling Italian government bonds versus Bunds, selling the sovereign basis, and shorting Italian banks vs Italian corporates or vs banks elsewhere.”

Why is Citi so gloomy? Getting a handle on the size of repo transactions in any country is tricky business but Citi’s own estimates, which it admits are very rough, peg the funding needs of banks from overseas counterparties routed through LCH.Clearnet at €70 billion ($92.4 billion). While Italian banks could knock at the door of the European Central Bank to raise this money should the LCH.Clearnet window be shut , the ignominy of stepping up borrowing from the central bank would be too much. Bilateral transactions are another option but to have a secure and well-developed market would take time, Citi believes. As Italian banks sit on heaps of sovereign debt, the final option to free up some cash would be to sell these government bonds.

“While this seems unlikely for now, at a minimum we suspect the reduction in availability of private funding is likely to reduce domestic banks’ appetite for future bond purchases.”

The report’s author, Matt King, emphasized that these changes would matter only if CCG defaulted. “So it’s an extreme tail-risk scenario that would require all of Italy’s biggest banks to roll over. But that’s the kind of scenario regulators are supposed to be thinking about, and the fact that’s it is remote does not mean everyone will ignore it.”

3: Do I need to worry?

Well, you’d be joining a very small club.

Crucially, the LCH announcement deals with a theoretical event: the collapse of CCG—a large clearinghouse. Stranger things have happened (it’s the fifth anniversary of the Lehman collapse after all) but that looks unlikely in the immediate future. Sure, some banks will now be a bit more aware of the risks, but the prospect of stronger banks abandoning a centrally cleared platform is remote.

Italian government bonds haven’t done that much. Yields on 10-year Spanish government bonds are now below their Italian peers for the first time since early 2012, but that’s got more to do with Italian political jitters, traders say.

Italian bond yields are little changed from where they started the year despite sharp sell-offs in markets such as U.S. Treasurys and German Bunds. Funding costs for Italian banks haven’t jumped either since the LCH.Clearnet notice was released over a month ago.

Despite their unglamorous status, repo transactions are the bedrock of financial markets, as banks of all stripes use them to raise cash. So any change that could theoretically push up borrowing costs for banks bears monitoring. But few see any reason to fret.
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