Repo liquidity sucked dry by regulation

The repo market has been under increased pressure from regulations.

Regulatory challenges to the repo market may undermine its flexibility and hit market liquidity according to an industry expert.

Oscar Huettner, founder of Barclays Capital’s European repo desk and author of the ‘Global Approach to Collateral Management’ white paper released by Euroclear and DTCC joint venture GlobalCollateral, suggested that Basel III and Dodd Frank have caused the repo market to lose its ability as a liquidity provider.

“In addition to the obvious impacts of reduced balance sheet allocations and the need to fund positions in specific ways, these regulations take away an important aspect of repo financing and that is the loss of elasticity.

“In the past, dealers acted as a buffer in times of market sell offs. They could expand their balance sheets as needed to act as market makers. Repo desks provided that elasticity and now regulations may prevent the dealer community from fulfilling that vital role and therefore may impact market liquidity, ” said Huettner.

When approaching Basel III and its leverage ratio requirements, the paper suggests that repo desks will be forced to decrease the volume of business they transact in or find extra opportunities to net financing transactions.

Such measures would lead to repo desks maintaining their volumes while shrinking the ‘footprint’ of their matched books.

Under Basel III leverage ratio measures a 3% non-risk-weighted ratio for all balance sheet assets, including securities financing transactions, applies. In addition, the US Dodd-Frank Act applies a further 3% for US-regulated globally systemically important banks, thus taking the leverage ratio to 5-6% of balance sheet assets.

As such, the leverage ratio makes low-margin, high-volume business in highly rated securities, i.e. repo trading, an expensive business for traditional sell-side participants.